What Caused the 2008 Financial Crisis?
There are many narratives as to why the Financial Crisis unfolded the way that it did. Homebuyers purchased homes using complicated and exotic mortgages which didn’t perform as advertised. Wall Street was reckless and bundled these mortgages into bonds that was sold off to unsuspecting investors. Ratings agencies and regulators were oblivious to the activities of banks and mortgage brokers. Insurers blindly sold insurance on those bonds so they could collect the insurance premiums to pad their profits. In one way or another, these are all factual. Yes, people bought homes that probably shouldn’t have. And yes, wall street was reckless, and nobody was paying attention, and insurers wrote too many policies and so on. But, if you peel the onion further, you get to a far different explanation – It is what is supposed to happen.
Now before you go all conspiracy theory on this, let me explain. In the aftermath of the internet bubble in 2001, the US Economy was in a recession. In an effort to increase economic activity, George W. Bush encouraged people to buy homes. He wanted everyone American to be able to live the “American Dream”. Below is a transcript from a speech in Atlanta in June, 2002.
It sounds great, right? However, the problem was that incomes weren’t rising as fast as home prices. The result was the adoption of adjustable rate mortgages that provide a lower monthly payment for a fixed period of time. At the end of the fixed period, the interest rate (and monthly payment) would adjust to the current market rate. This only becomes a problem when the current market rate is much higher than the rate during the fixed period. The result is a spike in the homeowners’ monthly mortgage payment. This is precisely what happened in 2007 to millions of homeowners and not only sank the housing market, but the entire US Economy.
Impacts of Moves by the Federal Reserve
So why did interest rates rise resulting in ballooning mortgages payments that bankrupted so many American families and the entire economy? The answer is, the Federal Reserve, or the Fed. It’s the job of the Fed to regulate the growth of the economy. The Fed operates under what is often called a Dual Mandate. The dual mandate states that the Fed is responsible for maximizing employment within the economy and stabilize prices. In lay terms that means they should make sure the economy is growing fast enough so that anyone who wants a job can find one, but not so fast that the demand for products grows too fast resulting in rapid inflation.
The Fed’s primary tool for regulating the economy is it’s ability to sets short term interest rates. This has a direct impact on all sorts of debt ranging from credit cards, home equity lines of credit, and even business lines of credit. When they want to encourage more economic growth, they lower interest rates making it more affordable to borrow. On the other hand, if they want to slow the economy down, they raise interest rates.
In the early 2000’s, the Fed held interest rates below 2%. Something it hadn’t done since the early 1960’s. This was done by design to increase economic growth after the recession in 2001. As the economy began to gain momentum and housing prices rose, it’s the job of the Fed to make sure they don’t rise too fast (remember, stable prices), so they raise short term interest rates. Unfortunately, the average borrower doesn’t follow the moves of the Federal Reserve and didn’t realize that this meant they’d have to pay more for the home they just bought. The rest is history.
Why a Recession Will Happen Again
Unfortunately, recessions are a normal part of our economy. Since the year 1900, recessions have occurred every four years. It’s been nearly nine years since the Financial Crisis, so the next one is only a matter of time. Every recession over that time has been preceded by the Federal Reserve raising interest rates. Much like the period leading up to the Financial Crisis, the Federal Reserve is again raising interest rates to slow the economy.
So how do we know when the next recession will occur? I asked myself that question back in 2010. After years of studying business cycles and recessions, I developed an algorithm that tracks the economic indicators that consistently predict recessions. The algorithm has been tested back to 1968 and would have predicted each of the seven recessions that occurred during that time.
Protect Yourself from the Next Recession
In the not too distant future, we will experience another recession. Like every recession before, it will be devastating to many people. People will lose their jobs, retirement savings will be lost, and homes will go into foreclosure. Lives will change because of it. It’s just the nature of how our economy works. Just because recessions happen doesn’t mean we shouldn’t be able to protect ourselves from their effects. Our goal is to protect as many people as possible before the inevitable happens again.
Protect Yourself from the Next Recession