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How did the credit crisis happen?

Although this can't be summed up in a sentence, paragraph, chapter, or even a book, there were a number of important events that caused and/or fueled the crisis. First, over several years, consumer and corporate borrowing reached record levels due to low interest rates and friendly borrowing conditions. This led to a significant expansion in corporate growth from personal spending. In this expansionary cycle, many individuals and corporations were lent money they should not have been, which led to a massive amount of supply in the new-issue securities markets, most notably the mortgage market and the credit markets. People were buying new homes at record rates, and companies were completing a record number of deals.

However, as demand from investors for these new types of assets evaporated and the economy slowed, a massive amount of new supply that had not yet been sold (new mortgages, LBOs, etc.) was stuck in the system. These new deals were then sold at a discount (or never even sold at all), thus depressing market values. Furthermore, this oversupply and the effects of the slowing economy led to increased consumer defaults on mortgages, increased corporate defaults on loans and bonds, massive write-downs by financial institutions, and significant losses in the financial markets.

The true difference between this and other cycles was the record amount of consumer and corporate leverage, as well as the creation of significant investor value that led to a period of insatiable demand and new innovative financial products. However, once the demand slowed in 2007, the markets were left to deal with the repercussions.