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Explaining the 2008 Financial Crisis to kids

I recently watched a documentary called ‘Inside Job’ about the 2008 financial crisis. I’d highly recommend it.


After watching the program, I thought I’d try and explain the crisis to my daughters (aged 8 and 10). I wanted to do this for many reasons, and I set out these reasons at the end of this blog.


First, let me go through how I explained the 2008 financial crisis to my daughters.


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Mortgages are at the root of the 2008 financial crisis


The financial crisis was largely based on house prices and mortgages, so I had to start by giving my daughters a refresher on mortgages. This is something we had spoken about over a year ago.


My eldest had remembered what a mortgage was but my youngest looked at me blankly, as if I was speaking another language. I then said “Red Bushes”. She then said, “Oh, I remember now. The red bushes grow on the purple trees (our language for houses) and people slowly cut them down (pay them off) over time”. This filled me with pride. Whilst she didn’t remember the technical name (as she was only 7 at the time), she did remember my visual version.


I recommend you read my blog 'How to teach kids about mortgages'. As I hope you know, mortgages are loans given to people so they can buy a house.


How mortgage companies decide whom to lend to


With the quick recap on mortgages out of the way, we then talked about how mortgage companies make money.

I explained that before someone takes out a mortgage, the mortgage company assesses if the person borrowing the money is likely to pay that money back. To do this, they look at how much they want to borrow, how much they spend and how much they earn.

I asked my daughters which type of people were more likely to pay back the money they borrowed:

A) Someone who wanted to borrow $1,000,000 and earned $250,000 per year

B) Someone who wanted to borrow $500,000 and earned $50,000 per year


My eldest quickly saw that A was the safest option.


This process worked really well for many years. As a result, nearly everyone, the mortgage companies lent money to, paid back what they borrowed. However, there were always some unfortunate events which meant people couldn’t pay the money back, such as if they lost their job and couldn’t find another one.


Then things changed.


Taking the risk away from the mortgage companies


In the 1970s, some people felt they could make a lot of money from these mortgages. These people said to the mortgage companies:

“We’ll pay you some money each time you give a mortgage to someone. We’ll take the mortgage away from you. Therefore, there is no risk for you to worry about and you still get paid a nice profit”.

I asked my daughters “If you were a mortgage company, would you think this is a good deal or not?”

Like everyone else, they thought it was a great deal. They got paid a profit and didn’t have to worry about people not paying back their mortgages.


Turning mortgages into investments


My eldest then asked, “Who are the people who took the mortgages and why did they want the mortgages?”


This is when I let them know that there are companies called ‘Investment Banks’ who do some ‘complex things’ to make money.


These investment banks took the mortgages from the mortgage companies and sold them to the public (including some very large retirement funds).


They sold them as investments to people by saying “If you invest some of your savings with us, you will receive a nice return each year. The amount you receive will be much more than if you keep your savings in the bank. The risk of not getting your money back is much lower than putting your money in the stock market. This is because the money is based on house prices and house prices always go up. Essentially, your money will grow without taking much risk”


My daughters both started calling out “Scammy Sam, Scammy Sam” - which is a character from my book Grandpa’s Fortune Fables who scams Grandpa. They had learnt that if something sounds too good to be true, then it probably is.

Sadly, most people thought that the investment banks were offering an amazing deal. Billions of dollars were ‘invested’ in these arrangements called ‘Collateralised Debt Obligations’ (or CDOs for short).


Each time someone invested in a CDO, the investment banks made a lot of money. As they were so popular, lots of people invested and made a lot of money. The investment banks just needed to make sure that more and more mortgages were being given out so they could keep selling more CDOs and making more money.


Mortgage companies started to take more risk


For many years everything was ok. Investors in CDOs would only lose money if people didn’t pay back their mortgages. However, things started to change.

I then asked my daughters, “If the mortgage companies were not taking any of the risks when giving out a mortgage, do you think they would allow more or fewer people to take out mortgages?”


Straight away, I could tell that even my 10-year-old daughter knew what was coming. She knew that the mortgage companies would give out more mortgages as they weren’t bearing the risk. That’s exactly what happened. They gave mortgages to everyone who wanted one. They refer to these more risky mortgages as 'subprime mortgages'.


“Surely someone said something and told everyone the mortgages were risky,” my eldest asked.


There was a small group who said there was a problem but people didn’t listen. No one was telling the people who were buying the CDOs that they were taking on lots of risk. In fact, even the companies that are paid to review and assess how risky these types of investments are (known as the rating agencies) didn’t even tell the public. They kept letting everyone know they weren’t risky as they were being paid by the investment banks.


Whilst things were changing, the problems didn’t really start until the mid-2000s.


People borrowed more money to pay for their mortgages


Whilst some homeowners were worried as they couldn’t afford the monthly amounts they had to pay for their mortgages, the mortgage companies said:

"Your house has gone up in value so you can borrow more money and use that money to pay back what you already owe. In the future, you can sell your house and pay back all the money you have borrowed and still be left with some money!”.

The mortgage companies and the investment banks simply wanted more people to have more mortgages as that’s how they could make more money.


They didn’t think there was anything wrong with what they were doing as they made a big assumption that house prices would always go up.

As more people were allowed to get mortgages, more people bought houses. This led to house prices going up and up. To keep up with the demand for houses, more houses were built. It seemed like everyone was happy.


The people who invested in the CDOs were also happy as they were getting a nice return on their investments.


Then it all started to go wrong!



House prices started to fall


Two things happened that led to house prices falling and kick-starting the financial crisis.


First, too many homes were built. There were now more homes than people needed. So the price of houses started to fall.


Second, interest rates started to go up. This meant mortgages were more expensive. Especially, for those that couldn’t afford them in the first place. As house prices were now falling, these people couldn’t simply borrow more money. Some people had more than one mortgage on their house!


The 2008 financial crisis started


As house prices fell and people couldn’t afford to repay their mortgages, people left their homes and stopped paying their mortgages back. This caused house prices to fall even more.


With people not paying back their mortgages, people (and companies) who had invested in CDOs now lost a lot of money, and people started to panic.

Some large banks that made big bets that CDOs would continue to do really well went bankrupt. This led to people worrying about the stock market and other investments. This in turn led to the stock markets around the world falling a lot!


During 2008, millions of people lost their jobs, homes and savings due to the risks taken by mortgage companies and investment banks.

Explaining the 2008 financial crisis to kids


The aftermath of the financial crisis


Guess what happened to most of the ‘greedy people’ who caused the problem? Many of them still got paid big bonuses and didn’t even get a telling-off!

Their greed led to a crisis and the regular everyday people suffered. They took full advantage of people as they knew more about risks than everyone else.


The next financial crisis


Will there be another financial crisis in the future due to greed?


Sadly, yes there will be. No one really knows when or how but it will happen as some people are so greedy they will find a way to make money even if it ends up hurting others (financially).

Why doesn’t the government do something to stop it?


I’m not a political person but I know that many financial companies have an influence on governments to avoid new regulations restricting what they do. With the lack of regulation, another crisis will happen at some point.

Does this mean I won’t invest?


Of course not. Over the long term, money flows to companies so I want my money to be invested. I just accept that money flows from different people during the process due to greed and will cause storms in the stock market from time to time. Like a tree after a storm, it grows back bigger and stronger (just like the stock market recovered after the 2008 financial crisis). I just make sure my family has enough saved to survive the storm.


Why did I explain the 2008 financial crisis to my kids?


I believe that if my kids grow up knowing about different financial events, they will be prepared for future financial events when they are managing their money on their own as adults. I believe this will give them a big advantage.


There are also some lessons about money which I can remind them of:

  1. Don’t get greedy. Short-term desire to make money could lead to long-term harm to others

  2. Always keep some money safe as there will be times when greedy people cause a lot of trouble

  3. Don’t panic when things go bad. Stay invested.


We have been investing for my daughters since they were very young and their investments have gone through market falls due to COVID and a ‘cost of living crisis’ (high inflation) and still seen their money grow (on average). I want them to appreciate that investing is a bumpy ride but worth it over the long term. If you are a parent reading this, I hope you still consider investing for your kids to give them an unfair advantage.



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Summary

Explaining the 2008 financial crisis to my kids was fun. They got a reminder about mortgages and learned about a historic event.


I note that there were many other factors that played a role in the 2008 Financial crisis, such as the use of financial leverage (e.g. people betting on the outcome of an investment, insurance companies, and another financial product called ‘credit default swaps’). I stuck with the underlying issue of overselling mortgages and turning mortgages into CDOs to keep things as simple as I could.


I have to admit, I was surprised by how engaged my eldest daughter was in this subject, despite only being 10 years old. She asked some great questions. As you might expect, my 8-year-old lost interest as it started to get a bit more technical 😳


Apologies that this wasn’t the most uplifting of blogs but I hope you found it insightful. I promise the next one will be more fun!

Thanks again for reading - make sure you subscribe for more money stories.


Will


P.S., Thank you to the thousands of readers who bought my money book for kids, Grandpa's Fortune Fables. If you have read it, it would be amazing if you could leave a review on Amazon, it really does help it reach more families.

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