The Great Recession began well before 2008. The first signs came in 2006 when housing prices began falling. By August 2007, theFederal Reserveresponded to thesubprimemortgagecrisisby adding $24 billion in liquidity to the banking system. By October 2008, Congress approved a $700 billion bank bailout, now known as the Troubled Asset Relief Program. By February 2009, Obama proposed the $787 billion economic stimulus package, which helped avert a global depression.Here is an overview of the significant moments of the Great Recession of 2008.
Key Points
- The Great Recession began with the subprime mortgage crisis in 2006, when banks invested in mortgages in the form of derivatives.
- Subprime borrowers started defaulting when the housing bubble burst at the same time the Fed raised rates.
- “Too big to fail” banks, hedge funds, and insurance firms found themselves holding worthless investments.
- The stock market crashed in 2008, as the Dow registered one of the largest point drops in history.
- Congress passed multiple acts and enacted economic stimulus plans to prevent the Great Recession from becoming the second Great Depression.
How the Subprime Mortgage Crisis Caused the Recession
In November 2006, the Department of Housing and Urban Development warned that new home building permits were 26% lower than the year before.At this point, themortgage crisis could have been prevented.But the Bush administration and the Federal Reserve did not realize how grave those early warning signs were.They ignored declines in theinverted yield curve. Instead, they thought the strongmoney supplyand low interest rates would restrict any problems faced by therealestateindustry.
They didn't realize how reliant banks had become onderivatives, or contracts whose value is derived from another asset. Banksandhedge fundssold assets likemortgage-backed securities(MBS) to each other as investments. But they were backed by questionable mortgages.
Theseinterest-only loanswere offered to subprime, high-risk borrowers who were most likely to default on a loan. The banks offered them low interest rates.But these “too-good-to-be-true” loans reset to a much higher rate after a certain period. Home prices fell at the sametime interest rates reset. Defaults on these loanscaused the subprime mortgage crisis. When home prices started falling in 2007, it signaled a real estate crisis that was already in motion.
Essentially, banks hadsold more mortgage-backed securities than what could be supported by good mortgages. But they feltsafe because they also boughtcredit default swaps (CDS), which insured against the risk of defaults.But when the MBS market caved in, insurers did not have the capital to cover the CDS holders. As a result, insurance giantAmerican International Groupalmost went belly-up before the federal government saved it.
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The bottom line? Banks relied too much on derivatives. They sold too many bad mortgages to keep the supply of derivatives flowing. That was the underlyingcause ofthe recession.
This financial catastrophe quickly spilled out of the confines of the housing scene and spread throughout the banking industry, bringing down financial behemoths with it.Among those deemed “too big to fail” were Lehman Brothers andMerrill Lynch. Because of this, the crisisspread globally.
2007: The Fed Didn't Do Enough to Prevent the Recession
On April 17, 2007, theFederal Reserveannouncedthat the federal financial regulatory agencies that oversee lenders would encourage them to work with lenders to work out loan arrangements rather than foreclose. Alternatives to foreclosure included converting the loan to afixed-rate mortgage and receiving credit counseling through theCenter for Foreclosure Solutions. Banks that worked with borrowers in low-income areas could also receiveCommunity Reinvestment Actbenefits.
In September, the Fed began lowering interest rates. By the end of the year, the Fed funds rate was 4.25%. But the Fed didn't drop rates far enough, or fast enough, to calm markets.
The Recession Underway
July 2008: The Recession Began
The subprime crisis reachedthe entire economy by the third quarter of 2008 when GDP fell by 2.1%.
But for early observers, the first clue was in October 2006. Orders fordurable goodswere lower than they had been in 2005, foreshadowing a decline in housing production. Those orders also measure the health ofmanufacturingorders, a key indicator in the direction of national GDP.
August 2008: Fannie and Freddie Spiraled Downward
Mortgage giantsFannie Mae andFreddie Mac were fully succumbing to the subprime crisis in the summer of 2008. The failure of the government-backed companies that insured mortgages signaled that the bottom was dropping out. The Bush administration announced plans to take over Freddie and Fannie in order to prevent a full collapse.
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Many in Congress then blamedFannie and Freddie forcausing the crisis. They said the two semi-private companies took too many risks in their drive for profits. But, in reality, the companies were trying to remain competitive in an industry that had already become too risky.
September 2008: The Stock Market Crashed
On Sept. 29, 2008, the stock market crashed.The Dow Jones Industrial Average fell 777.68 points in intra-day trading. Until 2018, it was the largest point drop in history. It plummeted because Congress rejected the bank bailout bill.
Althougha stock market crash can cause a recession, in this case, it had already begun. But the crash of 2008 made a bad situation much, much worse.
Efforts Towards Recovery
October 2008: $700 Billion Bank Bailout Bill
On Oct. 3, 2008, Congress established theTroubled Asset Relief Program, which allowed the U.S.Treasury to bail out troubled banks. The Treasury Secretarylent $115 billion to banks by purchasingpreferred stock.
It also increasedthe Federal Deposit Insurance Corporationlimitfor bank deposits to $250,000 per account and allowed the FDIC to tap federal funds as needed through 2009. That allayed any fears that the agency itself might go bankrupt.
February 2009: The $787 Billion Stimulus Package
On Feb. 17, 2009,Congress passed theAmerican Recovery and Reinvestment Act. The $787 billioneconomic stimulus planended the recession. It granted $212 billion in tax cuts and $575 billion in outlays, including $311 billion for new projects such as health care, education, and infrastructure initiatives.
On Feb. 18, 2009, Obama announced a $75 billion plan to help stop foreclosures. TheHomeowner Stability Initiativewas designed to help 7 to 9 million homeowners before they got behind in their payments (most banks won't allow a loan modification until the borrower misses three payments). It subsidized banks that restructured or refinanced their mortgage. However, it wasn't enough to convince banks to change their policies.
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Efforts aside, the downward momentum of the economy was too strong. On March 9, 2009, theDowhit itsrecession bottom.Itdropped to 6,547.05, a total decline of 53.8% from its peak close of14,164.53 onOct. 9, 2007. This wasworse than any otherbear marketsince theGreat Depression of 1929.
March 2009: Making Home Affordable Launched
Making Home Affordablewas an initiative launched by the Obama Administration to help homeowners avoid foreclosure.The program generated more than 1.7 million loan modifications in its lifespan.
TheHomeowner Affordable Refinance Program(HARP) was one of its programs. It was designed to stimulate thehousing marketby allowing up to two million credit-worthy homeowners who were upside-down in their homes to refinance andtake advantage of lower mortgage rates. But banks only selected thebest applicants.
The Role of the Banks in a Sluggish Recovery
August 2009: Obama Asked Banks to Modify Loans
By August,foreclosureskept mounting, dimming hopes of aneconomic recovery. Banks could have, but didn't,prevent foreclosures by modifying loans. That's because it would further hurt their bottom line. But record foreclosures (360,149 in July) only madethings worse for them as well as American families. July's foreclosure rate was the highest since RealtyTrac, a real estate information firm, began keeping records in 2005. It was 32% higher than in 2008.
Foreclosures continued rising as more adjustable-rate mortgages came due at higher rates. More than half of foreclosures were from just four states: Arizona, California, Florida, and Illinois. California banks beefed up their foreclosure departments, expecting higher home losses.
The Obama administration asked banks to double loan modifications voluntarily by November 1.
October 2009: Banks Weren't Lending
In October2009,unemploymentpeaked at10%,the worst level since the 1982 recession. Almost 6 million jobs were lost in the 12 months prior to that. Employerswere adding temporary workers as they grew too wary of the economy to add full-time employees.But the fields of health care and education continued to expand.
One reason the recovery was sluggish was that banks were not lending. Lending was down 15% from the nation's four biggest banks: Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo, according to The Huffington Post's analysis of federal data. Between April and October of 2009, these banks cut their commercial and industrial lending by $100 billion. Loans to small businesses fell sharply during the same period as well.
Lending from all banks surveyedshowed the number of loans madewas down 9% from October 2008. But the outstanding balance of allloans made went up 5%. This meant banks made larger loans to fewer recipients.
The banks said there were fewer qualified borrowers thanks to the recession. Businesses said the banks tightened their lending standards. But if you looked at the18 months of potential foreclosuresin the pipeline, it looked like banks were hoarding cash to prepare for future write-offs. In other words, banks were sitting on $1.1 trillion in government subsidies.
In December of 2009,Bank of Americapledged to President Obama that it would increase lending to small and medium-sized businesses by $5 billion in 2010.But that was only after drastically slashing lending in 2009.
Why Not Let the Banks Go Bankrupt?
People are still angryabout the $350 billion intaxpayer dollars that were used to bail out the banks. Many people feel that there was no oversight and that the banks just used the money for executive bonuses. In this case, people thought banks should not have been rescued for making bad decisions based on greed. The argument goes that, if we had just let the banks go bankrupt, the worthless assets would be written off. Other companies would purchase the good assets and the economy would be much stronger as a result. In other words, let laissez-faire capitalism do its thing.
In fact, that is what Former Treasury Secretary Hank Paulson attempted to do withLehman Brothers in September. The result was a market panic. It created arun on the ultra-safe money market funds, which threatened to shut down cash flow to all businesses, large and small. In other words, the free market couldn't solve the problem without government help.
In fact, most of the government funds were used to create the assets that allowed the banks to write down about$1 trillion in losses. The other problem is that there were no "new companies," i.e. other banks that had the funds to purchase these banks. EvenCitigroup—one of the banks that the government had hoped would bail out the other banks—required a bailoutto keep going.
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Letting the major banks go bankrupt would have left the American economy with no financial system at all. It might have led to the next Great Depression.
Why Didn't Obama Do More To End the Recession?
President Obama was dealing with more than just the recession as he looked toward the midterm elections.
He launched sorely needed but sharply criticizedhealthcare reform. He also supported the Dodd-Frank Wall Street Reform Act.That and new Federal Reserveregulations were designed to prevent another banking collapse. They also made banking much more conservative. As a result, many banks didn't lend as much, because they were conserving capital to conform to regulations andwrite downbad debt.But bank lending was needed to spur the small business growth needed to create new jobs.
The Dangers of Derivatives
The cause of the meltdown was the deregulation ofderivativesthat was so complicated that even their originators didn't understand them. Banks became so quick to resell mortgages on the secondary market that they felt immune to the dangers of taking riskier and riskier mortgages. Other aggressive moves by banks to sell more collateralized debt obligations (CDOs) and corporations to sell more asset-backed commercial paper helped to push the economy toward a bubble. These derivatives were designed to increase liquidity in the economy, but that liquidity drove housing prices and debt to unmanageable levels.
How the Bailout Affects You
The Dodd-Frank Act stopped the bank credit panic, allowed LIBOR interest rates to return to normal, and made it possible for everyone to get loans. Without the credit market functioning, businesses were not able to get the capital they need to run their day-to-day business.
Without the bill, it would have been impossible for people to get credit applications approved for home mortgages and even car loans. In a few weeks, the lack of capital would have led to a shutdown of small businesses, which couldn't afford the high interest rates. Also, those whose mortgage rates reset would have seen their loan payments jump. This would have caused even more foreclosures. The Great Recession would have become a depression.
That gives us hopebecause we learned more about how the economy works and became smarter about managing it. Without that knowledge, we would be in much worse shape today.
Frequently Asked Questions (FAQs)
How long did the Great Recession last?
The Great Recession lasted 18 months. That's the longest recession since 1960. Before the Great Recession, the average recession lasted 11 months.
How did the amount of bank reserves change in the wake of the Great Recession?
Bank reserves are the amount of cash that banks keep on hand. After the Great Recession, the Federal Reserve increased its reserve requirements for banks, especially larger "systemically important" banks. By requiring banks to keep more capital sitting in reserves, the Federal Reserve sought to improve the stability of the banking system.
As a financial expert with a deep understanding of the events surrounding the Great Recession of 2008, I will provide comprehensive insights into the concepts mentioned in the article.
1. Subprime Mortgage Crisis (2006):
- Background: The crisis originated in 2006 when the Department of Housing and Urban Development warned of a 26% decline in new home building permits compared to the previous year.
- Causes: The housing bubble burst, leading to a decline in home prices. Banks, relying heavily on derivatives, had sold mortgage-backed securities (MBS) backed by questionable subprime loans. Interest-only loans offered to high-risk borrowers resulted in defaults as home prices fell.
2. Federal Reserve's Response (2007):
- Actions: In response to the subprime crisis, the Federal Reserve added $24 billion in liquidity to the banking system in August 2007.
- Impact: Despite efforts, the Fed's actions were insufficient to prevent the recession, and the crisis spread globally.
3. Troubled Asset Relief Program (TARP) (2008):
- Government Intervention: In October 2008, Congress approved the $700 billion TARP to bail out troubled banks, including the purchase of preferred stock and increased FDIC limits.
4. Economic Stimulus Package (2009):
- Initiative: In February 2009, President Obama proposed a $787 billion economic stimulus package to avert a global depression.
- Components: The package included tax cuts, outlays for new projects in healthcare, education, and infrastructure.
5. Stock Market Crash (2008):
- Event: On September 29, 2008, the stock market crashed, with the Dow Jones Industrial Average experiencing a historic point drop of 777.68.
- Impact: The crash exacerbated the ongoing recession, making the economic situation worse.
6. Making Home Affordable (2009):
- Initiative: Launched in March 2009, the program aimed to help homeowners avoid foreclosure, with programs like the Homeowner Affordable Refinance Program (HARP).
7. Dodd-Frank Wall Street Reform Act:
- Purpose: Enacted in response to the financial crisis, the act aimed to prevent another banking collapse and introduced regulations to make the banking sector more conservative.
8. Derivatives and Dangers:
- Role in Meltdown: Deregulation of derivatives contributed to the complexity of financial instruments, leading to risky behaviors by banks. Reselling mortgages and creating collateralized debt obligations (CDOs) fueled the economic bubble.
9. Bank Rescues and Criticisms:
- Bailouts: Controversial bank bailouts, including TARP, faced criticism for using taxpayer dollars to rescue banks. Arguments were made against letting banks go bankrupt, fearing it could lead to a more severe economic downturn.
10. Dodd-Frank's Impact on Credit Markets:
- Positive Outcomes: The Dodd-Frank Act helped stabilize credit markets, allowing LIBOR interest rates to return to normal. This played a crucial role in preventing a complete shutdown of small businesses.
11. Duration of the Great Recession:
- Length: The Great Recession lasted 18 months, making it the longest recession since 1960. The average recession before this period lasted 11 months.
12. Changes in Bank Reserves Post-Recession:
- Federal Reserve Actions: Post-recession, the Federal Reserve increased reserve requirements for banks, especially larger "systemically important" banks. This was aimed at improving the stability of the banking system.
In conclusion, the Great Recession was a complex interplay of factors involving housing market dynamics, financial instruments like derivatives, government interventions, and the subsequent efforts to recover and stabilize the economy. Understanding these concepts is crucial for comprehending the intricacies of one of the most significant economic downturns in recent history.
