When a person wants to buy a house, he/she borrows a sum from a bank and in return, the bank lends the piece of paper called a Mortgage.
Every month the owner is expected to pay back a portion of principal along with interest to whoever holds the paper and if he/she fails to do so, it is called default and whoever holds the piece of paper gets the house.
Mortgage papers are often sold by banks to third parties.
Now, earlier people with low credit ratings and no steady jobs didn't get the loans because of the risk that is involved with them of defaulting the repayment.
However, it all changed in the 2000s.
Investors in the US and abroad looking for low-risk and high-return investments started investing in the US housing market as they thought they could get better returns from the interest rates that homeowners paid on the mortgage than they could by investing in bonds that offered very very low-interest rates. These investors didn't buy individual mortgages. Instead, they bought mortgage-backed securities. They are created when large financial institutions securitize mortgages by buying thousands of individual mortgages, bundle them together, and sell shares of that pool to investors. Securitize means the process of taking illiquid assets and transforming it into security.
This all seems like a safe game that was giving out high-interest rates as home prices were going up. Lenders also thought that even the worst-case scenario when buyers won't be able to pay comes true, they have an option of putting the house on sale.
Now there was a great demand for mortgage-backed securities and these financial institution needed more mortgages so lender loosened their standard and made loans to people with low income and poor credit called subprime mortgages. Some of the institutions began practicing predatory lending practices that is giving out loans without verifying income and offered an absurd adjustable-rate mortgage with payments people could afford at first but quickly ballooned beyond that means.
Hence mortgage-backed securities investment began becoming less and less safe but credit rating agencies couldn't see it and thus investors didn't stop.
Meanwhile, traders also started selling a more risky product called collateralized debt obligation or CDOs. They were also given a higher credit rating despite being very risky loans.
Because of all this, investors and traders, and bankers threw their money into US housing and the prices of houses went up and up and up.
The new LAX lending requirement and low-interest rate drop housing prices higher which only made mortgage-backed securities and CDOs seem an even better option. This was because even if borrowers defaulted the banks will have a super valuable house with them. Right? No.
This gave rise to the housing bubble which means a rapid increase in prices due to irrational decision. What happened is people soon become incapable to pay back the mortgages and defaulter rate rose resulting in more and more houses on the market for sale. So, supply rose and demand fell which led to house prices collapsing.
To explain with the flow diagram as prices of the houses fell it led to some borrowers mortgages rise more than what their house currently worth. This led to the incapability of borrowers to pay the mortgage any further resulting in defaulters rising rates and ultimately the housing price falling with a much greater pace.
As this was happening financial institutions stopped buying subprime mortgages and subprime lenders got stuck with bad loans. By 2007, many big lenders declared bankruptcy.
The problems spread to big investors who had poured their money into mortgages back security and CDOs as they started losing them.
There was another financial instrument that financial institutions had in their books that made all this problem even worse. They were called credit default swaps and were sold as insurance against mortgage-backed securities. The AIG sold millions of dollars of insurance policy without money to back them up when things went wrong. These credit default swaps were also turned into other securities that allow traders to bet huge amounts of money on whether the values of mortgage went up or down.
All these bets and financial instruments resulted in an incredibly complicated web and when things started going wrong the whole financial system went wrong. Trading and the credit market froze. The stock market crashed and the US economy experienced a disaster recession.
Some will fully ignore the problems. And some were simply unethically motivated by the massive amount of money involved and hence no one saw that coming.
To conclude I will be paraphrasing Shakespeare, that the " fault lies not in the stars but in us."
