The credit crisis was a result of a variety of bad things happening at once after numerous people made bad decisions on investments and homes. Basically, it all started in 2001 when the Alan Greenspan lowered the interest rate on treasury investments to 1%.
When the interest rate became 1% on T-bills, investors across the country, despite the safety of the investment, decided that it really wasn't worth investing in something that would only gain them 1% interest on top of their original money. So they started looking for alternate investments.
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Because of the very low interest rate offered by the treasury, banks across the country started borrowing a lot of money because of the very low interest rate. The ease of credit that played so big of a role in toxic mortgages also was easy credit for banks. Because the banks had such an easy time of acquiring money to lend out at a higher interest rate, they started making more home loans.
In most home loan situations, the prospective homeowner would contact a mortgage broker and ask to be approved for a mortgage. They would take the money they saved over years to the mortgage broker and make this their downpayment on a house. With the downpayment and the credit score of the family, the mortgage broker would find the family a mortgage that would have an interest rate on it. In ideal situations, the family would acquire a fixed-rate mortgage with an excellent rating.
After the bank loans the money to the family, the broker makes a commission and the bank takes the mortgage and re-sells it with other mortgages to investment banks. The mortgages are packaged into groups that are divided into three tiers. There are safe mortgages, okay mortgages, and risky ones in somewhat equal parts in the group.
These groups are then re-sold to investors based on the level of safety they want in their investments. The safer the investment, the lower the interest rate. The highest rates, and the riskiest mortgages, were re-sold to investors that were willing to take the biggest risks. This generally included groups like hedge funds who were willing to take huge risks to make huge profits.
In the beginning, when a mortgage holder defaulted on his or her mortgage, it was OK because the investment group now held a home whose price was constantly going up. Unfortunately, as more and more people defaulted, home prices started plummeting. So now, the investors were left holding a bunch of houses worth a fraction of the amount of the mortgage they originally held.
Once this started happening, other families started skipping out on their mortgages because they thought it was ridiculous to pay interest on a house worth $90,000 when the mortgage was $300,000. This resulted in even more foreclosures and the entire system sort of went bust.
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