Causes of the Great Recession: Factors, Effects, and Legacy

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  • The Great Recession, one of the worst economic downturns in US history, officially lasted from December 2007 to June 2009.
  • The collapse of the housing market, fueled by Low interest rates, easy credit, insufficient regulation, and toxic subprime mortgages led to the economic crisis.
  • The legacy of the Great Recession includes new financial regulations and a fueled activist.

Many factors contributed to the Great Recession of 2007-2009, the second worst economic crisis in US history.

Reading: What caused the stock market crisis of 2007

what caused this economic chaos? Economists cite as the main culprit the collapse of the subprime mortgage market (defaults on subprime mortgage loans) that led to a credit crunch in the global banking system and a sharp drop in bank lending.

but, in fact, the reasons are more complex. According to a 2011 report by the Commission of Inquiry into the Financial Crisis, the Great Recession was an “avoidable” disaster caused by widespread failures, including in government regulation and risky behavior on Wall Street.

While the relative impact of each cause is still debated today, the Great Recession stands as a warning about risk, investing in what you know, and the dangers of fully relying on financial experts and institutions.

the great recession in numbers

  • recession lasted 18 months
  • the net worth of American households declined, wiping out $19.2 trillion in wealth
  • gross domestic product (gdp) fell by 4.3%, the largest decrease in 60 years
  • the unemployment rate reached 10% in October 2009; rates were even higher among black and Hispanic households at around 15% and 12% respectively
  • the united states lost $7.4 trillion in stock market wealth from july 2008 to march 2009
  • Foreclosures skyrocketed, at nearly three million a year in 2009 and 2010

1. excessive investment and deregulation

The two decades before the Great Recession were largely prosperous, with rising GDP, low inflation, and two relatively mild recessions.

this period, from the mid-1980s to 2007, was optimistically called the great moderation. the name refers to the contemporary belief that the traditional boom-and-bust business cycle had been overcome in favor of average but stable economic growth.

However, unbridled optimism led to outsized spending, especially for risk-loving investors. everyone from homeowners to bankers believed the economy would continue to grow. this made traditionally risky behavior such as aggressive investing and leverage strategies, as well as taking on excessive debt, seem safe.

Assumptions about economic growth also contributed to a period of deregulation, most significantly the reversal of the Glass-Steagall Act in 1999, a landmark Depression-era legislation that separated commercial from investment banking.

The repeal of key provisions of the glass-steagall law allowed banks and brokerage houses to grow significantly and opened the floodgates for giant mergers. While only one contributing factor to the Great Recession, changes in the Glass-Steagall Act ushered in a period of national expansion for corporations and the engulfment of small, independent institutions, creating entities that were “too big to fail.” , or something like that. everyone thought.

2. flexible lending standards in the housing market

In the decade leading up to 2007, real estate and property values ​​rose steadily, encouraging people to invest in property and buy homes.

During the early to mid-2000s, the residential housing market was booming. To capitalize on the boom, mortgage lenders rushed to approve as many home loans as they could, even to borrowers with sub-par credit.

These risky loans, called subprime mortgages, would later become one of the main causes of the Great Recession.

A subprime mortgage is a type of loan made to borrowers with poor credit ratings. A potential high-risk borrower could have multiple credit issues or questionable income streams. In fact, the loan verification process was so lax at the time that it earned its own nickname: ninja loans, which means “no income, no job, and no assets.”

Because subprime mortgages were given to people who previously couldn’t qualify for conventional mortgages, it opened up the market to a flood of new homebuyers. easy housing credit resulted in the increased demand for housing. this contributed to rising house prices, leading to the rapid formation (and eventual bursting) of the housing bubble of the 2000s.

While interest rates were low at the time, subprime mortgages were adjustable-rate mortgages, initially charging low, affordable payments, followed by higher payments in later years. the result? Borrowers who were already financially unstable had a good chance of not being able to make payments when the interest rate rose in subsequent years.

In the rush to take advantage of an active market and low interest rates, many home buyers took out loans without realizing the risks involved. but common wisdom held that subprime loans were safe since home prices would surely continue to rise.

3. risky behavior of wall street

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Along with issuing mortgages, lenders have found another way to make money off the real estate industry: by bundling up subprime mortgage loans and reselling them in a process called securitization.

Using securitization, subprime lenders bundled loans together and sold them to investment banks, which, in turn, sold them to investors around the world as mortgage-backed securities (MBs).

Finally, investment banks began to reorganize and sell mortgage-backed securities on the secondary market as collateralized debt obligations (CDOs). These financial instruments combined multiple loans of varying quality into a single product, divided into segments or tranches, each with their own levels of risk suitable for different types of investors.

The theory, backed by elaborate mathematical models from Wall Street, was that the variety of different mortgages reduced the risk of CDOs. The reality, however, was that many of the tranches contained poor-quality mortgages, which would weigh on the profitability of the entire portfolio.

Investment banks and institutional investors around the world borrowed significant sums at low short-term rates to purchase CDOs. And because financial markets seemed generally stable, investors felt safe taking on more debt.

To further complicate matters, banks used credit default swaps (cds), another financial derivative, to insure against cdo defaults. Banks and hedge funds began buying and selling CDO swaps in unregulated transactions. In addition, because the CD transactions did not appear on the institutions’ balance sheets, investors could not assess the real risks that these companies had assumed.

important: the intricate jumble of financial products including mbs, cdos and cdss created a domino-like collapse of the housing market, and the main reason the financial crisis was so widespread .

4. weak watchdogs

like corporate bonds and other forms of debt, mbs and cdos required approval from credit rating agencies to be traded. The “Big Three” credit rating agencies include Moody’s, S&P, and Fitch Group.

These agencies gave AAA ratings (generally reserved for the safest investments) on many securities, even though they contained a large number of risky mortgages.

It’s worth noting that credit rating agencies are supposed to be independent. but there seems to have been an inherent conflict of interest since the banks that issued the securities were the ones that paid the agencies to rate them.

5. the subprime mortgage crisis

After staying low in the early 2000s, interest rates began to rise beginning in 2004 in response to an overheating economy and fears of inflation. in mid-2004, the federal funds rate was 1.25%. in mid-2006, the interest rate was 5.25%.

The rate hike couldn’t have come at a worse time.

In mid-2006, home prices were at their peak and the market was slowing. when supply began to exceed demand, home prices skyrocketed. the combination of high interest rates and falling home prices made it extremely difficult for buyers to make payments on their homes.

As a result, subprime mortgage defaults skyrocketed. loan after loan became worthless. In April 2007, New Century Financial, the largest independent provider of subprime mortgages, filed for Chapter 11 bankruptcy.

The subprime mortgage crisis had begun. And because of CDOS, the crash was soon felt far beyond the real estate industry.

The defaults meant that large CDO investors such as hedge fund managers, investment banks and pension funds saw the value of investments plummet. Since the CDOs were not listed on any exchange, there was no way to get rid of them, so those who held them had to write off a substantial amount of their value.

Those who had heavily committed to cdos saw their entire balances decimated. one of the largest: investment bank bear stearns. After the bank suffered massive CDO-based losses, it lost investor confidence and its ability to borrow money. in march 2008, to avoid bankruptcy, the venerable firm was sold to jp. morgan chase for $10 per share.

6. the stock market crash of 2008

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In the spring of 2008, the cdo debacle turned into a full-blown credit crunch. Since it was unclear where all these toxic securities were, given all the packaging and repackaging, and whose balances they were, banks began charging high interest rates to lend to other banks and institutions.

It was especially disastrous for the Lehman Brothers investment bank. In fact, of the company’s $600 billion in debt, $400 billion was supposed to be covered by CDs. unfortunately, at the time, the debt was worth next to nothing.

When Lehman collapsed and declared bankruptcy on September 15, panicked banks almost completely stopped lending and the entire global banking system ran out of funds.

The stock market reacted sharply. From September 19 to October 10, 2008, the Dow Jones Industrial Average went into free fall, falling 3,600 points.

during that time, the big financial institutions started to fail:

  • bank of america (bac) announced the purchase of merrill lynch.
  • The fdic seized washington mutual, the nation’s largest savings and loan company, and transferred its assets to jpmorgan chase.
  • goldman sachs and morgan stanley, the last two of the major investment banks still intact, turned into bank holding companies, the better to get federal bailout funds.

With the decline of the global economy, international trade and industrial production fell at a rate even faster than during the great depression of the 1930s. as consumer and business confidence shattered , companies began mass layoffs and unemployment skyrocketed worldwide.

The Great Recession was in full force.

Federal Response to the Great Recession

Decisive action by the Federal Reserve, coupled with massive government spending, prevented the US economy from completely collapsing.

aimed at boosting lending and capital investment, the federal reserve cut interest rates to zero for the first time and launched a program of quantitative easing, whereby it bought financial assets to add more money to the economy .

As for the federal government, it is creating two key programs to provide emergency assistance:

  • troubled asset relief program (tarp): this initiative helped stabilize the economy by having the government buy up to $700 billion in troubled assets, and most of the money was used to bail out troubled assets. banks.
  • the american recovery and reinvestment act (arra): a stimulus package enacted in 2009, arra implemented a series of tax cuts, government spending mandates, loan guarantees and unemployment benefits to help revive the economy.

These measures were effective and prevented the recession from becoming a decade-long affair, like the Great Depression. The stock market began to recover in 2009. However, other aspects of the economy took several years to recover, in what economists characterize as an L-shaped recovery.

consequences of the great recession

The Great Recession officially lasted until June 2009, but its effects have had a lasting impact.

  • GDP did not regain its pre-recession strength until 2011.
  • Unemployment remained above 5% until 2015.
  • Real household income did not increased until 2016 .

The policies, reforms, programs, and impact of the Great Recession are still with us today. between the legacy of the great recession:

financial regulation and reform

in 2010, president obama signed the dodd-frank law, which aimed to reform the regulation of the financial industry. Some highlights include the government’s ability to take control of banks deemed fiscally unsound, regulation of the OTC derivatives market, including credit default swaps, and the requirement that banks set aside more capital reserves as mattress. It also included the Volcker Rule, which restricted banks’ proprietary trading and limited their dealings with hedge funds and private equity funds, among other measures.

a fed activist

interest rates were at 5.25% in 2007, but at the end of 2008, the federal reserve lowered them to zero. Those low interest rates and fast, strong action to keep the economy moving remain hallmarks of the Federal Reserve today. for example, it quickly moved to lower interest rates in response to the economic turmoil caused by the covid-19 crisis.

limping a generation

The generation that came of age at the height of the crisis, millennials are still feeling the effects of the Great Recession. they have low savings and high student loan debt. they are reluctant to buy houses and generally have less wealth than previous generations at a comparable age. A 2019 national financial survey found that half (50%) of millennials rate their level of financial security as fair or poor, compared to 44% of Americans overall.

the end result

The Great Recession stands as one of the worst economic collapses in US history. Although the subprime crisis was the immediate cause, multiple interconnected financial factors caused the specialty industry bubble to burst, bankrupting companies, crashing the stock market, and limping the entire economy.

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