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This is a simplified analysis of the causes of the 2008 Financial Crisis, also known as the Sub-Prime Lending Crisis and the Credit Crisis of 2008. I don't intend to go into too much detail about the actual events of the crisis or more complex concepts such as Collateralized Debt Obligations (CDOs) or Credit Default Swaps (CDSs) or credit rating agencies here though a writeup on the topics and how they relate to the current economic situation would be great.

For nearly a year now we've been hearing about the weakening economy with new statistics every day about unemployment, the stock markets, and foreclosure rates. However, despite 24-hour coverage by niche cable channels such as CNBC, nobody seems to really want to explain what actually happened. The reason why no one in the media wants to talk about the actual cause of the financial crisis is because they work for ratings and they think you'll find the reasons pretty boring. Why do they think that? Well, because all the drama of bankrupt investment firms, manufacturing layoffs, and a foreclosure rate not seen since the Great Depression essentially comes down to this: a bank balance sheet. Fortunately I know you're all fascinated with accounting, so ratings shouldn't be a problem!

All balance sheets are pretty similar no matter what they're used for whether it's an international financial institution dealing with hundreds of millions of dollars a day or your checkbook (or more likely your debit card--credit cards are special cases). On the one side you have assets--the money you have in your account--and on the other side you have liabilities--the money you owe to others. If you're a responsible consumer, you try to keep each side in balance; that is, you don't let your liabilities exceed your assets.

The same goes for banks. A healthy bank has many kinds of assets but the two most significant are reserves and loans. Reserves are the amount of cash that they have in their accounts at the moment, usually represented as a percentage of the bank's total assets. The major liabilities for a bank are the deposits customers make in the bank's accounts. This may sound backwards but it actually makes sense. Customers deposit money in the bank with the understanding that they may, at any time, withdraw their deposit; the bank is liable to return a customer's deposits upon their request. Banks then turn around and loan out those deposits to other people, making profit off the interest. In return, depositors get interest payments from the bank for allowing the bank to loan out their money. Because banks are making money off of the loans they give out, loans are an asset to a bank. A simplified bank with $100 million would look something like this on the balance sheet:

           ________________________
          |  ASSETS   | LIABILITIES|
          |  Reserves |  Deposits  |
          |$10 Million|$100 Million|
          |  Loans    |            |
          |$90 Million|            |

What does all this have to do with the financial crisis you ask? Don't worry, I'm getting there. The largest loan that most Americans will take out in their lifetime is a home loan. Mortgages are special kinds of loans where the house is put up as collateral for the loan, allowing the bank to repossess the property if the debtor defaults on the loan. When assessing a customer for a loan, banks collected the person's information--credit history, employment, income, assets--and divided them into two categories: prime and sub-prime. Historically, sub-prime mortgages had much higher interest rates attached to compensate the bank for the increased riskiness of the loan. However, when the United States' housing market began to take off in 2002, banks began approving more and more sub-prime mortgages at lower and lower interest rates. As far as the banks were concerned, it was a win-win situation. If the loans were repaid, the banks would profit off of the interest. If the homeowners defaulted on the loans, the banks could repossess the house and sell it at a profit. Because of this repossession, the banks added Houses to their balance sheet under assets because they could sell the houses for cash whenever they wanted.

           ________________________
          |  ASSETS   | LIABILITIES|
          |  Reserves |  Deposits  |
          |$10 Million|$100 Million|
          |  Loans    |            |
          |$80 Million|            |
          | Houses    |            |
          |$10 Million|            |

As you can see, both sides of the balance sheet are still equal, so the bank doesn't have a problem. However, this practice only worked so long as housing prices kept going up. This is because the banks counted houses on their balance sheet using a system known as mark to market accounting. Mark to market accounting basically states that banks are allowed to count both the cash they have on hand (reserves) as well as the cash that they could have if they sold their houses as their assets at this point in time. The wealth they have from the houses is not 'real' cash--it's locked up in real estate--but it's still counted as the same as currency. This was completely fine when the housing market was booming; real estate was very liquid at the time i.e. it could easily be converted into other forms of wealth such as currency.

When the housing market started slowing down and eventually crashed in late 2006, it became apparent that it was actually a bubble. Housing values, especially in the areas of highest growth and the Sun Belt, plummeted and construction (as well as the industries supporting construction) began to wane. This had two major effects on banks: First, the decline of the economy in general as a result of weakening industry made it harder for sub-prime debtors to make their loan payments and, as a result, the banks started repossessing more and more homes. The other effect was that the values of the houses which they were repossessing were dropping, quickly. In some cases, the market value of the houses dropped to below the value of the loan made to the customer to buy that house so when the bank repossessed it, the bank was actually suffering a loss.

Now they had a problem. Not only were the banks repossessing increasing numbers of houses that they were finding increasingly difficult to sell but they were also losing money with each house they actually did manage to sell. These repossessed houses and the securities based on those houses and mortgages eventually became known as toxic assets. The falling value of their assets wreaked havoc with banks' now unbalanced balance sheets. Mark to market accounting meant that the houses they had before the bubble burst were now losing value, and loans were continually being replaced by properties of non-equivalent worth.

           ________________________
          |  ASSETS   | LIABILITIES|
          |  Reserves |  Deposits  |
          |$10 Million|$100 Million|
          |  Loans    |            |
          |$60 Million|            |
          | Houses    |            |
          |$20 Million|            |

Here our example bank has lost $20 million in loans and gained only $10 million in houses. Their assets and liabilities are now unequal and the bank is insolvent. This is generally a bad thing (Banks actually go slightly insolvent all the time and have to borrow money from each other or the Fed to balance their sheets at the end of the day. This is the reasoning behind the existence of the Federal Funds Rate and the Discount rate). Since the bank only has $10 million on hand, if depositors try to withdraw more than that amount, the bank will be forced to declare bankruptcy.

This still doesn't explain why the financial crisis of 2008 turned into a complete financial meltdown. Simply put, it wasn't just one bank making the bad loans, it was all of them. And, even if a bank had managed to make only a few of these bad loans, it was most likely still heavily invested in banks that did. They don't call it the 'financial system' for no reason. All the banks and investment firms are interconnected and invested in each other and, because they all make similar types of investments, a problem with one bank is likely to cause a systemic failure as one bank after another fails. The interconnectedness is why it's necessary to bail out companies. The failure of one will set off a chain reaction that will both destroy wealth and cause a crisis of confidence that will lead further bank runs and stock dumping. These two factors will cause the failure of all but the most robust of firms which will in turn cause the failure of additional firms until the entire financial and economic system is in collapse. Contrast, for example, the differing reactions of the market after the government bailed out Bear Stearns in June 2008 and after they let Lehman Brothers fail in September 2008.

So there it is, the Bank Balance Sheet of the Apocalypse. It's so simple that it sometimes makes you wonder why people didn't see it coming. Entire governments released studies which came to the conclusion that housing values would never fall again, something the banks, with their repossessed properties, liked to hear very much. The truth, of course, is that some people did see it coming and near the end--between the failure of Bear Stearns and Lehman Brothers--most in the financial sector knew that it was going to crash any day; they just wanted to make their quick buck and then get out before they got burned. In the end, what it really comes down to is a simple combination of hubris and greed.

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