What happened in 2008. Article 2. The Great Recession slightly more in detail

Background briefing

Due to low-interest rates, lax lending standards and the expectation of a continuous increase in housing prices, many people bought houses by utilizing mortgage loans. Some had lousy credit statuses and high debt ratios to their income. They are called subprime debtors.

In August 2008, more than 16% of mortgage loans were in a status of default. A vicious cycle kicked in when a decrease in housing prices led to bankruptcy and decreased housing prices further.

One could easily reason or anticipate the result, except they did not realize the truth because the housing market's strength was strongly believed and presumed to be solid.

Many financial institutions either ignored or did not recognize the problem, and some even promoted the housing market bubble.

What story did they believe to happen?

Subprime-related securities or CDOs had high-interest rates and reputations because those financial products seemed to diversify the risk by bundling up many mortgage loans and yield good interests due to risk premium. Yes, a mortgage loan is safe when the interest rate is low enough, and the housing prices continuously increase. In the case of a subprime loan, however, interest rates are low only in the first several years. After that period, the rates become high and floating.

The reality

Namely, to maintain the fragile CDO fever caused by the housing market bubble in roughly 2006 and 2007, either condition following must be met. 1. housing prices should continuously increase by a certain amount enough to cover both subprime loans' risk premium and increased interest rates in the market because the loan employs floating interest rates which means the market interest rates and mortgage interest rates are correlated. 2. Subprime debtors should pay back all the money they owe. Otherwise, subprime-related securities or CDOs would be worthless, and as a result, they turned out to be valueless.

People, including those in the financial sector, firmly believed that housing prices continued to increase and that it was unlikely for people to ignore the mortgage payment and default. That is partly why huge hedge funds invested much capital in CDOs and were popped with the bubble while causing financial disaster for almost all of us.