The 2008 crisis: how one segment's problem became the world's

The crisis began in a narrow segment of the American mortgage market and became global within months. The transmission mechanism matters more than the story.

What happened

Loans to low-quality borrowers were pooled and securities were issued against them. Splitting a pool into tranches allowed the senior tranches to receive high ratings even though the underlying loans were risky.

While house prices rose the construction worked: a struggling borrower sold the house and repaid the loan.

Why it spread through the system

The securities ended up on bank balance sheets worldwide. Nobody knew precisely who held how much — and that ignorance turned out to matter more than the losses themselves.

Banks stopped lending to each other. The short-term funding market froze, and a credit problem became a liquidity problem.

What changed afterwards

Bank capital requirements were tightened, stress tests appeared, regulators' powers expanded. Some of the mechanisms that worked in 2008 are restricted today.

What stayed the same

Growth built on borrowed money and a belief that the underlying asset cannot get cheaper. Both features recur — How a bubble works: the general pattern.

Related: Economic cycles: why downturns repeat and Correlation: why diversification sometimes stops working.