The Global Financial Crisis: How Did We Get Here?

From 2005 to 2007, the Dow Jones Industrial Average was shattering record high after record high, hitting an all-time high of over 14,000 in October 2007. Meanwhile, home ownership rates were increasing, and housing prices were soaring. Both U.S. coasts and Las Vegas were identified as some of the hottest real estate markets in the nation.

But even then, the cracks were appearing, and in 2008, it all began crashing down. The housing market declined as increasing numbers of Americans defaulted on their mortgages. The stock market declined by more than 40 percent, and some of the nation's largest investment firms, such as Bear Stearns and Lehman Brothers, were clearly in trouble. The crisis did not stop at U.S. borders, but was felt worldwide, as global credit markets sputtered to a halt, fueling cries for government bailouts.

So how did we get here? Too much government regulation? Not enough? Too much risky lending? Here's a quick guide to how the current financial crisis came to be.

1. Bad Lending Policies - The slump in the U.S. housing market appears to have provided the initial spark. From 2004 to as late as 2007, the U.S. real estate market was experiencing explosive growth. Housing prices increased dramatically, which unfortunately fostered an attitude of complacency. Many homeowners and mortgage bankers just assumed property values would continue rising, while forgetting that old adage that "what goes up must come down." Lenders relaxed their standards for mortgage lending, resulting in billions of dollars in "subprime" loans to borrowers with sketchy credit histories and "prime" loans to people with solid credit histories who qualified to borrow far more than they could have qualified for in the past. Lenders did not worry about losses, believing any defaults could be recovered through the value of the properties themselves.

2. Housing Market Crash - Bad lending policies were justified by the continuing rise in real estate values. The "irrational exuberance" that former Federal Reserve Chairman Allan Greenspan worried had taken hold in global stock markets in 1996 had taken hold in the housing market a decade later. Defying the assumptions of mortgage bankers, the housing market bubble burst, causing a sharp drop in home prices. Mortgage defaults increased, not only in the subprime category but also among prime borrowers who borrowed to buy second and third homes or who were engaged in "flipping" houses. The increase in mortgage defaults set off a chain reaction that led to the collapse of some Wall Street firms, such as Bear Stearns, Lehman Brothers, and insurance giant AIG.

3. Complex Financial Packaging - So, how did Wall Street investment banks become affected by bad mortgages? After all, these institutions generally deal in stocks, bonds, and commodities, not mortgages. What happened is that the investment banks bought the mortgages from lenders, which freed up the latter to lend even more. Meanwhile, the investment firms packaged these loans as complex mortgage-backed securities, selling them to investment firms, hedge funds, and banks around the world. Investors in these securities would redeem these when the borrowers made their mortgage payments. These mortgage-backed securities were rated. Prime loans received higher ratings, while subprime loans received lower ratings, but were sold anyway because they offered higher interest rates for investors. As long as housing prices continued to rise, things seemed okay. But when the bubble burst, the value of mortgage-backed securities dropped sharply, causing huge losses for investors around the world.

This chain of events led to worldwide cries for government bailouts, such as the $700 billion plan approved in the U.S. The question now is to what extent the financial rescue packages by governments around the world will be able to restore confidence in the world financial system.