The United States slipped into a minor recession right after 9/11, so the government used its control over how much money is circulating to make it cheaper to borrow money. Because interest rates were low, people borrowed a lot of money and used much of it to buy houses. While this was happening, home prices were increasing year after year, and everyone assumed this would continue forever.
But then the government decided the 9/11 recession was over and decided to raise interest rates nationally. Suddenly people owed creditors more money each month for their home loans, because their personal interest rates were not set in stone and instead were set to fluctuate with national rates. As the cost of paying creditors back increased, a lot of people all at the same time found themselves without enough money to keep paying for their homes. The creditors responded by taking ownership of these houses with the intention to sell them to someone else. But all of these homes going up for sale at the same meant that houses were suddenly abundant. With everyone looking to sell newly acquired houses, home prices fell. For people still paying their mortgages, payment schemes reflected the old, higher home values, so many individuals simply allowed creditors to take possession of their homes rather than pay creditors more than their homes were suddenly worth.
As these houses went up for sale, home prices were driven down even further and created a self-perpetuating cycle.
The continued fall in the home prices affected homeowners and those still committed to paying off their mortgages because the worth of their most valuable asset dropped. Importantly, the banks that originally arranged the mortgages that so many Americans were unable to pay or had walked away from no longer owned the debt of their one-time customers. They sold the right to people’s future interest payments to larger financial institutions that put the mortgages of many, many people together and allowed investors to in effect invest little slices of these huge mortgage bundles. This meant that investors were betting that people would keep paying their mortgages and would earn money so long as that was the case.
When people either couldn’t pay their mortgages or decided it was smarter to just stop paying, investors who had bet on these mortgages came to realize their earlier bets were much riskier than many of them had understood and lost a lot of money. This was the collapse of the investment banks and their related insurance organizations.
It wasn’t just investment banks who had a stake in these mortgages, though. Many ordinary Americans’ savings were to some extent tied up them through stock ownership and where their pensions were invested. As a result, many people became poorer than they had been only a few months before and reacted by spending less. Now Americans were spending less because their homes were worth less, their stock was worth less, and their savings were worth less. Businesses reacted to decreased interest in buying their products by producing fewer products. Because businesses were earning less revenue, they lowered salaries and fired employees no longer necessary for lower levels of production.
As people across the country adjusted to lower incomes and joblessness, they too cut back on their spending, which compounded the situation and led even more businesses to lower salaries and fire workers. This brings us to pretty close to where we are now. As a country, we have begun creating more jobs each month than we lose but just barely. And these new jobs pay much less than the old jobs did and are largely temporary as businesses wait to see if Americans’ demand for their goods increases to levels that justify permanent hiring.
There’s a ton more to the story about exactly why everyone was so sure housing prices would keep rising, where regulatory organizations failed, how banks encouraged reckless lending, and a bunch of other really important stuff, but this is a chain of cause and effect at the center of a lot of the mayhem.