The Events That Led to The Great Recession

Time Period: December 2007 - June 2009

Duration: 18 months

Global GDP: -5.1%

Global Unemployment Rate: 10%

Similar Instance: The 1930s Great Depression

The Great Recession was an economic decline era which lasted from 2000 to 2009. It spanned through the time of the US real estate market crash in the late 2000s until the 2007-08 financial crisis. Thereby, making it the worst economic period in the US since the 1930s. As a result of the great recession there was a scarcity of valuable assets in the market economy, a crash in the global financial sector (financial institutes including banks), some US banks were bailed out by the US government. Millions of people forcefully lost their savings, a lot of jobs were lost, and home mortgage foreclosures greatly increased. 

This economic decline wasn’t just in the US but spread across other developed and developing countries only that the impact was not felt equally in all the affected countries. Economies like North America, South America, and some parts of Europe experienced a recession in intensity while economies like China, Poland, and India experienced a lesser impact of the recession. According to the International Monetary Fund (IMF), the Great Recession was the most severe economic and financial decline since the Great Depression of the 1930s. 

What is a Recession?

In economics, a recession is a decline or stagnation in economic growth. The International Monetary Fund (IMF) also, describes recession as a decline in real per-capita world GDP for a period of two or more consecutive quarters.

What was The Great Recession?

The Great Recession can be said to be a long-lasting period in time when an economy suffers a steady decline causing a financial meltdown and societal hardship. In economics, it is referred to as the contraction phase of a business cycle lasting for at least two consecutive quarters.

During the Great Recession, in 2008, the US GDP dropped 0.3% and 2.8% by 2009 while unemployment increased to 10%; it was nothing compared to the Great Depression which experienced a decline of 10% and unemployment of 25%.

Economists like Robert Kuttner have argued that the term “Great Recession” is inappropriate and doesn’t correlate with the reality of what happened. He believes that recessions are a normal part of every economic cycle which can be corrected by fiscal or monetary stimulus. He, therefore, believes that the “Great Recession” should be called The Great Deflation or The Lesser Depression. 

The US National Bureau of Economic Research, official arbiter of US recessions reported that the recession began officially in December 2007 and ended in June 2009, lasting a period of eighteen months. Although, it wasn’t until 2009 that the Great Recession spread global, thereby, meeting the IMF standard of a global recession. 

By meeting the IMF standard of global recession, it implied that there was a huge drop in international trade, a collapse in the prices of commodity, and the unemployment rate increased. Many economists predicted that there wasn’t going to be a recovery until 2011 and there was every likelihood that the recession was going to be worse than the 1930, Great Depression.

What Events Led to The Great Recession?

The years that built up to the Great Recession were characterized by a boom in economic demand and a rise in the prices of assets. Also, as a result of the US shadow banking system rivaling the depository banking system though, not subject to the same regulation, was made vulnerable to a bank run. 

Mortgage lenders, were also, marketing high-risks mortgage-backed securities around the world, offering better and higher yields compared to the US government bonds. Thus attracting quite, a number of private investors and institutional investors. A majority of the mortgage-backed securities were subprime mortgages which eventually collapsed and burst the US housing market bubble in 2007. With the collapse of the housing market and the calculated subprime mortgage losses, a financial crisis was just around the corner.

Adding to this was the fall of the Lehman Brothers in September 2008. Shortly before then, in March 2008, Bear Stearns, a huge investment bank collapsed, attributing its fall to the investments of subprime mortgages, also, its assets were acquired at a cut-rate price by JP Morgan Chase. The mortgage losses and the fall of big financial institutes led to a major inter-bank loan market panic. It was equivalent to the shadow banking system’s bank run, thus causing large and well established commercial and investment banks both in the US and Europe to suffer huge losses and bankruptcy. As a result of it, large government bailouts were required. A beneficiary of the government bailout was the AIG, an insurance and investment company which the government considered “too big to fail”, as the slightest failure of the company would lead to a wide economic destabilization. The Feds agreed to lend the company $85 billion to remain afloat.  

Though the Great Recession is said to have originated from the subprime mortgage, other national policies contributed as well. Not many analysts believe the subprime mortgage was the major cause of the Great Recession considering that there was a negative correlation between the increase in subprime share of home purchase mortgage and the growth in house prices at the county level. Also, The Financial Crisis Inquiry Commission in a 2011 report stated that the Great Recession was avoidable. 

The “greed” of the subprime mortgage can be said to be the root of the economic decline such that too many financial institutions purchased subprime security-back mortgages in bulk. Since the subprime mortgage was high-risk by nature, it could only imply that these financial institutions (banks inclusive) took up a large number of financial risks at one time, according to the report. As a result of this, the deposit banking system and the shadow banking system were in contention in as much as they were not under the same regulation. The failure of the shadow banking system affected credit flow to businesses and consumers altogether.

The inability of the government to regulate the financial industry can also be held as another factor that led to the economic decline. There was a lot of high-risk mortgage and investments in circulation, yet the Feds did little or nothing to regulate it until mortgage lenders started declaring bankruptcy.

Other causes such as excessive borrowing and lawmakers who lacked the ability to properly understand the implication of the subprime mortgage increase were also identified in the report.

The US Financial Crisis Inquiry Commission, which was made up of six Democratic and four Republican appointees, report of the findings causes that led to the financial crisis can be summarized as thus:

• The Federal Reserve’s failure to regulate the outbreak of toxic subprime mortgages
• Disorder in financial institutions which led to breakdowns in corporate governance
• Excessive borrowing risk 
• Lack of preparation for the economic implications on the part of key lawmakers

Others like Peter J. Wallison, commissioner American Enterprise Institute (AEI) believed that the main blame of the financial crisis should have been on the US housing policy backed by the actions of Fannie & Freddie. In a report, he wrote, “When the bubble began to deflate in mid-2007, the low quality and high-risk loans endangered by the government policies failed in unprecedented numbers.”

The Leaders of the G20 in its “Declaration of the Summit on Financial Markets and World Economy” cited the causes they believed led to the financial crisis. 

“During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators, and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of the domestic regulatory actions.”

Subprime Mortgages and Subprime Crisis

The subprime mortgages were high-risk home loans given to borrowers worth poor credit history. This came after the US housing boom in the early 2000s. In order to capitalize on the rising home prices, mortgage lenders became less restrictive in terms of the kind of borrowers that were granted home loans. As a result of this, many financial institutions in North America and Western Europe began to acquire large amounts of mortgages in the form of mortgage-backed securities as investment, hoping to make a huge profit from it. In only a matter of time, what seemed to be a great financial and investment strategy came crumbling down and the economy was highly threatened with a recession.

As the years continued to roll by the housing market still thrived until February 2007 when the Federal Home Loan Mortgage Corporation announced that it was no longer going to purchase subprime mortgages or their securities equivalent. The reason for the decision was because there was no market for the bulk mortgages it owned, implying that there was no way they could possibly recover their initial investment. Shortly after, in April 2007 New Century Financial, a mortgage lender declared bankruptcy. By August 2007, American Home Mortgage Investment Corp., a major mortgage lender also declared Chapter 11 bankruptcy after it had cracked under the pressure of the raging subprime crisis.

As the robust housing market began to collapse gradually, following the bankruptcy declarations of different firms the credit rating services, Moody’s and Standard and Poor’s both announced that they would reduce the ratings on over 100 bonds backed by second-lien subprime mortgages. The Standard and Poor’s went ahead to place over 600 securities-backed subprime residential mortgages on credit watch.

The market continued to struggle and the value on a lot of homes was less than their total loan amounts. By October 2007, the Dow Jones Industrial Average reached an all-time high exceeding 14,000 for the first time ever. It was yet short-lived as the market swung into a financial crisis by December 2007. For the next 18 months, the Dow lost more than half of its all-time high, dropping to about 6,500 points. The fall of the Dow implied a loss of stock investment for investors.

Over the same period of time, houses in America and non-profits experienced over 20% net worth decline from a high of $69 trillion in late 2007 to $55 trillion in mid-2009, amounting to a $14 trillion loss.  Also, by September 2007, interest rates were at 5.25% and by December 2008 there were cut to zero by the Feds for the purpose of encouraging liquidity, capital investment, and borrowing. 

Measures to Taken to Curb the Recession

To further bring a quick end to the recession, the US government under the Bush administration signed into law the Economic Stimulus Act (Also called the Fiscal Policy or Monetary Policy). The lawmakers intended to refund taxpayers $600 to $1200 worth of taxes encouraging them to spend. Thereby, lowering taxes and increasing loan limits for mortgage loan programs like Freddie Mac and Fannie Mae. In all, the Fed hoped to boost the economy and develop new home sales. The purpose of the Fiscal Policy was to stimulate national economies and lower the risks in financial systems. The stimulation was done in the form of a $787 billion deficit spending under the American Recovery and Reinvestment Act, as reported by the Congressional Budget Office. Through this, the Feds were able to provide businesses with incentives and provided banks with $7.7 trillion emergency loans to encourage liquidity and capital investment. Adding to the stimulus package, the government introduced financial regulation. 

The government offered a bailout to large companies that were considered “too big to fail” for the concern that the collapse of such companies would greatly affect the US economy. To further ensure that other major companies and financial institutions are prevented from going bankrupt, President George Bush signed the Troubled Asset Relief Program (TARP) into being; this was in October 2008. Through the TARP, the US government had access to $700 billion funds which were to be used to purchase assets of struggling companies in order to keep them afloat. After acquiring the assets, the government had an expectation of selling them at a later date, at a profit.

Conclusion

The Great Recession which lasted for 18 months, eventually came to an end in June 2009, however, many countries including the US suffered the aftermath for a long while. Many developing countries are yet to recover fully from the effect, yet again, many fear another global recession may hit the global economy following the coronavirus epidemic.