The 2008 financial crisis, explained: how bad home loans nearly broke the global banking system.

For years leading up to 2008, US banks and Mortgage lenders had been issuing home loans to borrowers with increasingly shaky finances, often called subprime borrowers because their credit history put them below the safest lending tier. Rather than holding those risky loans themselves, lenders bundled thousands of them together into complex investment products called mortgage-backed securities, then sold slices of those bundles to banks and investors around the world. Because the bundles mixed loans of different quality, and because credit rating agencies stamped many of them with top-tier safety ratings, investors treated them as far safer than they actually were. On top of that, many of the banks buying these products did so with borrowed money, a practice called Leverage, meaning a relatively small drop in the value of their mortgage holdings could wipe out a much larger share of their own capital.

The trouble started when home prices, which had been rising for years, began to fall, and a growing number of subprime borrowers stopped making payments. As defaults piled up, the mortgage-backed securities built on those loans lost value fast, and because so many major banks held large amounts of them, the losses spread through the entire financial system at once. On September 15, 2008, Lehman Brothers, a major Wall Street investment bank, failed to find a buyer or a government rescue and filed for bankruptcy. Because banks constantly lend to and do business with one another, and because nobody knew exactly who else was holding bad mortgage debt, Lehman's collapse triggered a full-blown panic. Banks became afraid to lend even to each other, and credit, the basic fuel that keeps businesses and households running, briefly seized up worldwide.

Governments and central banks stepped in with extraordinary measures to stop the panic from spiraling further, including emergency loans, a roughly $700 billion US bailout program for banks, and a rescue of the insurance giant AIG. Even so, US stocks fell by roughly half from their 2007 peak to their 2009 low, and unemployment in the US climbed to about 10 percent by late 2009 as the crisis pushed economies into recession worldwide. In the years that followed, regulators introduced tougher rules on how much capital banks must hold and how much risk they can take on, precisely to make a repeat of 2008 harder. The crisis remains one of the clearest lessons in modern finance about how risk that looks spread out and diversified can actually be deeply interconnected, and how leverage turns a manageable loss into a systemic one.

Key takeaways

• •The crisis grew out of risky subprime home loans that were bundled into mortgage-backed securities and sold worldwide as safe investments.
• •Heavy borrowing (leverage) by banks meant that losses on those mortgage bundles wiped out far more than the loans were actually worth.
• •Lehman Brothers' September 2008 bankruptcy, at the time the largest in US history, triggered a worldwide freeze in bank-to-bank lending.
• •Massive government bailouts and near-zero interest rates stopped the panic, but a deep global recession and job losses followed anyway.
• •The crisis led to major banking reforms requiring banks to hold more capital and take on less risk.