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the Great Recession of 2008 was a devastating economic crisis that officially began in late 2007 and ended in mid 2009 just in the US alone the crisis caused 16 trillion dollars worth of wealth to vanish two and a half million businesses to close four million people to have their homes taken away through foreclosure and almost nine million workers to lose their jobs the key question then is what caused the Great Recession the first signs of the Great Recession came in mid 2006 but before that time the economy actually appeared to be performing quite well GDP had been rising for nearly 15 years the unemployment rate was low and falling and the stock market had been steadily climbing there was a kind of euphoria felt in the marketplace a good illustration of this euphoria could be seen in the housing market where more than ever Americans clamored to buy housing this extraordinary demand for a housing led to steady increases in the homeownership rate a rate that peaked in 2004 at a record of almost 70 percent at around the same time the increased demand for housing resulted in rapid growth in home prices for almost a generation home prices had done nothing but rise in the decade following the mid 1990s home prices had more than doubled counting just from 2003 to 2006 home prices had risen over 40 percent this was remarkably fast growth in fact this was the fastest growth in the nation's home prices since at least the 1920s somewhat surprisingly the tremendous rise in home prices starting in the mid 1990s led people to believe that home prices would continue to rise tremendously in the future as the Economist Robert Shiller of Yale has said times and places with high home price increases show high expectations of future home price increases so not only did home prices rise quickly but people believe that this growth would continue in the future this belief led some to think that there was easy money to be made in housing buy a house clean it and then flip it for a profit became a common theme in commercials advertising how to get rich quick the CEO of Countrywide Financial a residential mortgage lender put it well when he said housing prices were rising so rapidly that people regular people average people got caught up in the mania of buying a house and flipping it making money this mania further stimulated demand for housing which led to ever rising home prices not only was the growth in home prices historically fast it also represented a break from another historical norm home prices historically had risen at about the same rate as other prices in the economy that his prices for everyday goods and services rose at about the same rate as home prices which rose at about the same rate as people's incomes but starting in the late 1990s and continuing into the mid 2000s this connection disappeared home prices grew substantially faster than the other prices in the economy faster than the Consumer Price Index and faster than people's incomes some economists feared that this decoupling meant that there was a bubble in home prices and that its recent growth was unsustainable this fear as it turns out was justified as the growth in home prices slowed and then turned negative over the next few years this is the first major factor that caused the Great Recession of 2008 there is a huge bubble in home prices the euphoria in the housing market led not only to more people purchasing homes but it also led them to buy bigger and more expensive homes than they might have otherwise as evidence of this the average floor area of a new home rose 15% from 1997 to 2000 seven and to pay for these bigger and more expensive homes people had to take on debt lots of debt it's been estimated that total mortgage indebtedness in the u.s. rose from around five trillion dollars in 2001 to over ten trillion dollars in 2007 or put another way the average households mortgage rose from ninety thousand in 2001 to almost a hundred and fifty thousand dollars in 2007 more households were in debt and the median value of that debt per household had risen by 2007 the total size of the debt owed by Americans had grown so much over the past decade that it just about equaled the gross domestic product of the entire United States this is the second major factor that caused the Great Recession of 2008 households were heavily in debt this increase in borrowing put Americans in a vulnerable position as long as everything remained the same as long as they continued to be employed as long as housing prices continued to rise then the households would be okay and they could afford to pay off their larger debt but if anything bad happened in the meantime if people lost their jobs or housing prices stopped rising then that debt would become unmanageable and crushing so people were staking a lot on the hope that home prices would continue to rise at the same unprecedented rate for the foreseeable future the same euphoria that led households to borrow more also cause lenders to want to lend more this is because the lenders believe that home prices would continue to rise and that meant that households would be able to pay off their mortgages the lenders therefore could view these loans as a safe investment one that would with high likelihood be paid off Robert Shiller noted this when he said the boom psychology encouraged potential homeowners and encouraged lenders as well home buyers were encouraged by the potential investment returns mortgage lenders were encouraged since the boom reduces the default rate on lower quality mortgages given this incentive lenders didn't just approve loans that households applied for the lenders actively sought new opportunities to lend money lenders would give loans to people that they previously would have denied out of fear of default to see an example of this take the large seattle-based Bank Washington Mutual in 2003 the chairman and CEO of Washington Mutual announced that he wanted the bank to focus on lending to highly risky low income consumers saying we hope to do to this industry what Walmart did to theirs according to the New York Times this led WaMu to press sales agents to pump out loans while disregarding borrowers incomes and assets these ninja loans loans to people with potentially no income no jobs or assets meant that lenders were taking on substantially more risk than before it later came out that the percentage of wamuu's mortgage originations that were deemed high risk rose dramatically from 19% in 2003 to 55% in 2006 this increase in both the quantity and riskiness of its loans wasn't limited to Washington Mutual many residential mortgage originators got into the act of lending to risky consumers in fact the quantity of risky mortgages originated by the top 25 non-prime lenders tripled from a hundred billion dollars in 2000 to three hundred and ten billion dollars in 2003 one reason that these mortgage originators must have felt comfortable in lending to these risky consumers was that the originators could turn around and sell those loans to others this ability meant that the originators could offload the risky loans from their books insulating them from any future losses due to default also by selling those loans to others the money could then be used to further push loans onto eager consumers what happened to those risky loans after they were sold well they were bundled together to form incredibly complicated and opaque financial vehicles with a whole host of acronym Laden names mortgage-backed securities MBS collateralized debt obligations CDOs synthetic CDOs CEOs of CDOs and so on these opaque financial vehicles were then rated too highly as it turned out and sold to investors around the world investors like commercial banks investment banks and pension funds these investors held trillions of dollars of these risky mortgages on their balance sheets and had little idea of which specific mortgages they held or how risky they were at one point the president of the New York Federal Reserve Bank Timothy Geithner called these vehicles cooked spaghetti because it was hard to untangle who owed what to whom this is the third major factor that caused the Great Recession of 2008 financial engineering hid how much risk investors held instead of being scared off by these opaque products investors wanted to purchase as many of them as possible Lehman Brothers for example doubled its holdings of commercial and residential real estate products in the two years leading up to 2007 to finance these purchases investors and financial firms borrowed money lots of money to see this I've plotted the leverage ratios of some of the major commercial and investment banks in the u.s. increased borrowings show up as a rise in the firm's leverage ratio as we can see the rise in these firms leverage ratios is quite substantial over this seven-year period but even more important than that is the absolute size of the firm's leverage ratios by 2007 Citigroup and Goldman Sachs had leverage ratios of 32 to 1 Morgan Stanley and Lehman Brothers had leverage ratios of 40 to 1 that is outstandingly high that means for $1 down the bank would borrow $39 to buy $40 worth of financial products this choice just like for households meant that the banks were taking on an incredible amount of risk if home prices continued to rise the increased leverage would magnify their gains if home prices turned around though their losses would be catastrophic in fact a three percent drop in these company's asset values would result in the companies becoming insolvent bankrupt this is the fourth major factor that caused the Great Recession of 2008 financial firms were heavily in debt this substantial debt put financial firms in a vulnerable position as long as home prices continued to rise the companies would earn tremendous profits but if housing turned around then the company's debt would become unmanageable and they would risk bankruptcy just like for American households financial firms were staking a lot on the hope that home prices would continue to rise taken together the Great Recession of 2008 was caused by the combination of a large housing bubble hidden risk and heavily indebted households and financial firms in the next episode I'll describe how this combination helped turn a fall in the nation's home prices into the worst recession the US had faced since the Great Depression almost 80 years earlier thanks for watching