Simple Explanation of the 2008 Financial Collapse

From a Reddit thread about student debt comes a pretty easy to follow explanation of the 2008 financial collapse:

“The financial crisis wasn’t just ‘a bubble bursting.’ It’s far more complicated than that. Housing prices collapsed, that’s true, and while it certainly exacerbated the crisis, it was far from the only issue.

“Mortgage loans were packaged into securities and sold to investors, including banks. The idea was that one lender may fail to pay back his loan, but if we throw 50 mortgage loans together chances were presumed to be very likely that 40+ or 45+ of those loaners would pay the loan back, making it seem like a sound, safe investment.

“But since the demand for these securities (CDOs) was so high, this in turn meant that lenders would become less stringent on who they would lend money to, since they cared less about being paid back the loan and more about repackaging it and selling it as a security.

“Now when these two issues come together, the housing bubble collapsing driving property prices way down (so that people who had recently purchased real estate got royally screwed), and the fact that everyone and their mother was getting a mortgage loan, you can see see that it presumably wouldn’t be the case anymore that we should expect 40 or 45 of those 50 mortgage loans to be paid back.

“But the rating agencies like S&P, Fitch, etc. didn’t see it that way. So they would slap their triple-A rating on these subprime securities, incentivizing investors (including banks) to keep buying them.

“As you can see, all these issues – the housing bubble, the securities, the lower standards for giving out mortgage loans, the poor underwriting of the rating agencies – they were all interconnected, and they all exacerbated each other. Without any one of those issues, we wouldn’t have had a financial crisis; or at least one as significant and dramatic.”

Full thread http://www.reddit.com/r/explainlikeimfive/comments/2luztg/eli5_what_will_happen_when_the_student_loan/

Image from this Guardian article http://www.theguardian.com/commentisfree/cifamerica/2011/dec/12/lehman-brothers-bankrupt