Wednesday, October 02, 2013

The Great Recession

The following article is an excerpt from a textbook I used in a course at Ashford University:


Korgen, K. & Furst, G. (2012). Social problems: Causes & responses. San Diego, CA: Bridgepoint Education, Inc.  (2:2)


Many thanks to them.


The Great Recession and the Mortgage Crisis

In late 2007, a cascade of complex economic events converged, leading to a dramatic drop in American housing prices, the collapse of huge financial institutions, and downturns in global stock markets. These events, referred to as the Great Recession, or the Global Financial Crisis, peaked in 2007–2008 and continue to have a profound effect on the United States and the world, including lingering high unemployment and ongoing housing foreclosures. The Great Recession is the worst financial crisis since the Great Depression that began after the stock market crash of 1929.

One of the countless factors that led to this crisis was related to supply-side policies freeing businesses from regulation. In the midst of the Great Depression, in 1933, Congress passed the Glass-Steagall Act, which separated commercial banking (which accepts deposits and lends money) from investment banking (which issues securities and invests with credit).

This law was designed to prevent banks from taking investment risks that could jeopardize their solvency. For decades, banks pressed for the repeal of the act, which finally occurred in 1999 under President Clinton. This freed commercial banks to again invest their clients' deposits and practice both investment and commercial banking. During the same period, under a push to provide home ownership to as many people as possible, government mortgage providers Fannie Mae and Freddie Mac lowered their standards and began issuing mortgages to people who could not afford them. Meanwhile, as government regulators turned a blind eye, other mortgage lenders followed suit and housing prices soared as more and more people bought homes.

In the absence of government regulation, mortgage lenders profited enormously by collecting fees from homeowners who were assuming mortgages they could not afford. But the original lenders did not hold onto these risky mortgages; instead, these residential mortgages became the basis for another level of investment. Lenders bundled these so-called "toxic mortgages," whose owners were likely to default, into a type of pooled securities called collateralized debt obligations (CDO). The lenders sliced these bundles into more CDOs and sold them to banks, who sold them to investment firms, which purchased insurance against possible losses on the bundled mortgages.

Freddie Mac sign
Paul J. Richards/AFP/Getty images

Government mortgage providers Fannie Mae and Freddie Mac were among the lenders whose practices helped lead to the housing bubble burst in 2008.

Companies that insured the investors who bought CDOs failed to maintain the resources needed to fund insurance claim payments for those they insured. Lax government rules and oversight allowed these insurance companies to say they could insure far more than their resources on hand would allow. As a result, when homeowners defaulted on loans and investors filed claims to cover their losses on the CDOs, the insurance companies shirked their responsibility and the entire system crumbled.

At the same time, credit rating agencies, which rate securities so that potential investors will know the risks associated with them, also failed to sound an alarm. These credit rating agencies (Moody's, Standard and Poor's, and Fitch), in a clear conflict of interest, are paid by the banks to whom they issue credit scores. Without looking carefully into the problems with the CDOs, they granted them high credit ratings, leading investors to think their money was not at risk (Morgenson, 2008). When these CDOs started to fail, many investors lost money and some banks, such as Bear Stearns and Lehman Brothers, went bankrupt while others were saved through government bailouts to prevent further damage to the economy (Financial Crisis Inquiry Commission, 2011).

With banks reluctant to lend money, homeowners and new businesses could not obtain the funds they needed to keep the housing market and the overall economy healthy and functioning. At the same time, big businesses, fearful of further economic downturns, refused to risk major investments such as hiring new employees (Leonhard, 2011). As a result, in 2011 the national unemployment rate doubled, standing stubbornly between 9 and 10% (BLS, 2011a), and consumer confidence, which indicates people's willingness to purchase goods and services, sharply decreased (Conference Board, 2011).

The housing crisis and the Great Recession caused a catastrophic drop in the wealth of Americans. Housing prices, which had peaked in 2006, dropped precipitously, as did home equity, pensions, retirement funds and other savings and investment assets. This bursting of the housing bubble had a dramatic impact on the level of economic inequality, particularly harming many working- and middle-class Americans. The wealth of this group most commonly relies on the value of their houses. Those who do not own a home tend to have few other assets. When houses declined in value with the fall of the housing market, much, or in some cases all, of the wealth of many Americans disappeared. When adjusted for inflation, the median net worth of U.S. households fell 28% from 2007 to 2009 (Kochhar, Fry, & Taylor, 2011). People with other types of wealth such as stocks were shielded from losses by the diversity of their assets. The result was greater economic inequality between people who could afford many assets and people whose only significant asset was their home (Korgen & Furst, 2012)

To see an illustration that traces the events of the Great Recession, click on the link provided:

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