In the 1970s, class contradictions in the United States gradually became apparent. Stagnant income levels for ordinary people meant their consumption demands could not be met. To alleviate this pressure, the U.S. government began implementing a “credit welfare” policy, significantly lowering loan interest rates and relaxing lending conditions, making it easy for ordinary people to obtain low-interest loans.
Subprime lending emerged accordingly. These loans specifically targeted people who did not meet traditional bank lending criteria, providing loans to high-risk borrowers at interest rates far higher than standard bank rates, essentially acting as “loan sharking” within the banking system. From the Clinton administration to the Bush administration, subprime lending was actively promoted because it both met the housing needs of lower-income groups, creating a prosperous image of “homeownership for all,” and spurred the development of the financial industry, allowing financial institutions to reap substantial interest income.
The timing was perfect: the housing market was on fire. Banks kept dropping standards, handing out loans to riskier and riskier people. They knew the dangers, sure, but figured they had it covered. With property values climbing, even if someone defaulted, they could just seize the house and sell it for a profit. Loans ballooned, and leverage went through the roof. Statistics show that between 2001 and 2007, U.S. household mortgage debt soared by 63%, with some financial institutions leveraging up to 30 times: meaning $1 in capital corresponded to $30 in investment funds.
Financial Wizardry and Spreading Risk
Banks didn’t hang onto these subprime loans for long. They’d bundle them up and flip them to investment banks, who then mixed them with other assets into fancy derivatives that looked safe and promised big returns.
Credit rating agencies were the enablers here. Big names like S&P, Moody’s, and Fitch slapped top ratings on these subprime-packed products, making them fly off the shelves.
It all formed this neat little loop: People who couldn’t afford homes got loans, banks raked in interest, Wall Street packaged and sold the stuff for profits, and investors snapped up what seemed like low-risk, high-yield goodies. The economy boomed, class divides felt patched over.
Leverage, CDS, and Securitization: Brewing the Crisis
To understand the transmission mechanism of the crisis, several key concepts need explanation:
- Leverage is gambling with borrowed money. Say you’ve got $1 million and borrowed 30 times that ($30 million) to invest. A 5% gain? That’s 150% on your original cash. But a 5% loss wipes you out and leaves you owing half a million.
- CDS (Credit Default Swaps) are like insurance for bad bets. A bank makes a risky loan, buys a CDS from another firm. If the borrower pays up, the bank pays premiums. If they default, the insurer covers the loss. But CDS became tradable too. These contracts were repeatedly traded among investors, forming a massive CDS market. Warren Buffett warned as early as 2003 that CDS were a “time bomb” and “financial weapons of mass destruction,” and directed his company, Berkshire Hathaway, to exit the CDS market.
- Subprime Securitization is the heart of it. Take illiquid subprime mortgages with steady payments, isolate them in bankruptcy-proof bundles, boost their credit, and turn them into tradable securities. The process where investment banks package subprime loans into financial products, rate them, and sell them is subprime securitization. That’s how investment banks turned junk into gold.
The Meltdown and How It Spread
By late 2006, the housing bubble popped. Teaser rates on subprime loans expired, payments spiked, and defaults kicked off.
Lenders foreclosed and dumped houses on a sinking market. Speculators walked away. Subprime loans often had no recourse, so you just hand over the keys. More defaults meant more homes for sale, prices tanked further, more defaults. Vicious cycle.
It hit everyone in the chain:
- February 2007: HSBC announced massive losses in its North American mortgage business, writing down $10.8 billion in assets, marking the beginning of the subprime crisis.
- April 2007: New Century Financial Corporation, the second-largest U.S. subprime mortgage lender, filed for bankruptcy protection.
- August 2007: Bear Stearns, the fifth-largest U.S. investment bank, announced the collapse of two of its hedge funds.
- July 2008: The U.S. mortgage giants Fannie Mae and Freddie Mac suffered $70 billion in huge losses and were taken over by the U.S. government.
- September 2008: Lehman Brothers, with 158 years of history, filed for bankruptcy protection, becoming the largest bankruptcy in U.S. history and shattering global investor confidence completely.
The collapse of Lehman Brothers marked the peak of the crisis. Three of Wall Street’s big five collapsed; only Goldman and Morgan Stanley limped on. The crisis rapidly spread globally: stock markets fell continuously, numerous European institutions that had invested in subprime products faced difficulties, the Euro plummeted against the Dollar, and even stock markets as far away as China were affected. (But not too much)
Crisis Response and Far-Reaching Impact
To counter the crisis, the Federal Reserve implemented a series of emergency measures:
- Implemented a zero-interest-rate policy, cutting rates 10 times consecutively starting in August 2007.
- Engaged in large-scale purchases of Treasury bonds and asset-backed securities to inject liquidity into the market.
- Purchased financially troubled assets guaranteed by the state to rebuild confidence in financial institutions.
- Between 2008 and 2009, decided to buy $300 billion in long-term Treasury bonds and large quantities of mortgage-backed securities.
By 2009, U.S. financial institutions had gradually stabilized, but the impact on the real economy was already severe: GDP fell, unemployment surged, reaching a record high in 2009 not seen in over 50 years.
Although the subprime crisis seemed to conclude around 2009, its global impact was far from over. This crisis revealed the dual nature of financial innovation, exposed flaws in the rating agencies and regulatory systems, and demonstrated the speed at which financial risks spread in a globalized context. Although the younger generation may no longer feel the pain of that storm, understanding the formation mechanism and transmission process of this crisis remains crucial for recognizing the vulnerabilities of the modern financial system.
This article was written on March 28, 2022, by Diffie. The author uses DeepSeek to translate.
Original article is below:
A Wanderer’s Reflection 
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