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| Photo by respres CC BY 2.0 |
The causes of The Great Recession of 2008-2009 are still disputed by some but not by others. What and who caused the Great Recession of 2008. The stupidity and greed that was a big part of the reason might surprise you. Was it the banks, the government, the mortgage writers or everyone.
According to the National Bureau of Economic Research (NBER), the Great Recession ended in July 2009. But most Americans on Main Street cynically laughed at this, knowing full well their recession was not over at that time. There is a lot of blame to go around for the Great Recession of 2008-2009.
The Government and the Great Recession
Some blame goes to politicians. Politicians and the banks wanted deregulation of the banking and investment industries. During The Great Depression of the 1930s, a regulation called the Glass-Steagall Act went into effect that separated banking from investment.
In 1999, this act was repealed with bankers, investment firms, and politicians believing that they were too smart to let another Great Depression happen again. They got their sought-after deregulation and completely abused it.
Fannie Mae and Freddie Mac also played a major role in sub-prime mortgages by lowering their standards for mortgages.
Before the Great Recession began, at least one hedge fund manager met with the SEC (Securities Exchange Commission) to explain what was going on with mortgages and what was about to happen. The Securities Exchange Commission (SEC) ignored these warnings.
The Mortgage Companies and the Great Recession
Countrywide and other mortgage companies started lending money for homes to anyone and everyone, regardless of their income or credit rating. Throughout the mid-2000s, we all heard the ads on the radio; get a mortgage for no money down.
Mortgage firms continued to lower their lending standards. At the height of the housing bubble, people without jobs, no income, no assets, and no credit rating were able to get mortgages for no money down and no proof of income.
Mortgage writers were not checking the information on mortgage applications and even encouraged applicants to lie on the mortgage applications. These loans were known as sub-prime, Alt-A, and NINJA loans (No income, no job or assets).
These mortgages came with low initial teaser rates and were ARMs (Adjustable Rate Mortgages). In two years, these ARM mortgages would reset to a much higher payment. Some people were actually defaulting on their first mortgage payment.
The thinking was home prices would never go down and continue upward, which caused increased speculation with people buying numerous houses. Flipping was buying a home, waiting a short amount of time, and selling it for a profit while others were buying multiple homes and renting them.
Mortgage companies didn’t care since they sold most of these mortgages they wrote, so they would not be on the hook if these mortgages defaulted.
The Banks and the Great Recession
Highly educated mathematicians developed models predicting housing prices. These models did not take into account the high number of mortgage defaults occurring at the same time across the country.
Why, because it had never happened before. Ironically, every investment advertisement warns that past performance is not a guarantee of future performance. They certainly ignored that advice.
These mortgages were securitized or turned into mortgage-backed securities that people could invest in. For example, take a ten-block area around your home. Put all those mortgages into an envelope.
You don’t know the creditworthiness of those mortgages. Cut up the envelope into smaller pieces holding various types of mortgages, and then sell those pieces to investors. These pieces were called tranches.
These were called collateralized debt obligations (CDOs). Those who owned them would get paid when each person in that particular tranche paid their mortgage. They did not get paid when the mortgage payments were not made, and the defaults and foreclosures started.
There was such a huge demand for these CDOs and not enough mortgages that the banks invented CDOs, which were called synthetic CDOs.
Two big problems caused the banks to live in their dream world during this housing “bubble." One problem was how they listed their assets on their books. They listed these CDOs at inflated prices when in reality they were dropping like a rock. When they had to list them properly at current market value, everyone could see that the banks didn’t have nearly the assets they claimed to have.
The second problem was leverage. Many of these banks had increased their leverage to 30 or more to 1. Meaning for every dollar they invested in these mortgages, they used another $30 borrowed dollars to invest.
Other bank problems that led to the Great Recession include shadow banking; the unregulated derivatives market, and the repo market or repurchase agreements.
The Rating Companies Role in the Great Recession
The rating companies Moody’s, Standard and Poor’s, and Fitch contributed to the Great Recession. Their job is to properly rate securities anywhere from the highest investment grade down to junk status.
The rating companies rated these CDOs as investment-grade securities without even knowing what was in each piece. Rating companies are paid by the bank or company whose securities they are rating. If Citi Bank wanted their CDOs rated, they paid the rating company to rate their CDOs. This is one reason why they were probably rated so highly.
Pension funds, cities, and states can (usually) only invest in investment-grade securities, not junk. So many of these entities invested in these mortgage-backed CDOs thinking they were of high investment grade because the rating companies all said so.
AIG and the Great Recession
AIG is an immense insurance company; one of its functions is to ensure bonds against default. For example, if a pension fund bought bonds from GM and wanted to insure those bonds from default, the pension fund would buy insurance from AIG. This insurance is called a credit default swap (CDS), and the pension fund pays a premium for this insurance.
As the sub-prime mania continued, banks and other entities were buying mortgage-backed CDOs. In addition, they were also purchasing insurance in the form of credit default swaps, in case some of the mortgages defaulted.
This transferred the risk of the bonds defaulting to the seller of the credit default swaps, in this case, AIG.
There were also those who believed the sub-prime mortgage industry was a disaster waiting to happen, so they went out and bought the credit default swaps.
When defaults started on the mortgages, they also made money by owning the credit default swaps, something like shorting a stock, you think it will go down, and you short it. Owning these credit default swaps was a way of shorting the sub-prime mortgage market.
And AIG collected the premiums on all of these credit default swaps insurance and happily sold and sold and sold the credit default swaps to all. Even as foreclosures were increasing, and it became apparent there was a problem, AIG continued to sell the swaps for the premiums.
By the fall of 2008, AIG was losing billions of dollars per day.
Credit Crunch, Bank Failures and Business
By the fall of 2008, it became clear there was a major problem as house prices continued to fall. With falling housing prices, more homeowners were underwater or owing more than their house was worth.
Defaults and foreclosures were rising well beyond what the models had predicted would ever happen, and it was beyond their worst-case scenario.
Banks started to have severe capital and liquidity problems as home prices fell and their mortgage-backed CDOs dramatically sank in value.
Banks were in danger of running out of money on any given day. People were pulling their money out of the banks as banks were desperately trying to find buyers and mergers before they went bankrupt.
- On March 16, 2008, Bear Stearns was sold to JP Morgan for $2 per share (later amended to $10). In January 2007, the price of Bear Stearns was $171 per share.
- In July 2008, IndyMac failed, becoming the second-largest bank failure in US history.
- On September 7, 2008, the government took over Freddie Mac and Fannie Mae.
- On September 15, 2008, Lehman Brothers failed, and that shook Wall Street and the financial world.
- Washington Mutual failed on September 26, 2008, becoming the largest US bank failure.
At this time, banks were afraid to lend to each other or anyone else, this is what really started the Great Recession on Main Street. Companies use this borrowing to finance their business. For example, Target will take a 30-day loan to pay for its inventories and payroll. Without any way to borrow, as usual, the layoffs started.
Once the layoffs started, more people couldn’t pay for their mortgage, causing more defaults and foreclosures. And the consumer stopped buying. Construction was halted on the building of new homes. The economy came to a halt causing the Great Recession to move from Wall Street to Main Street America.
The Damage from the Great Recession
The damage from the Great Recession of 2008 has been widespread and long-lasting. It became the worst recession since the Great Depression of the 1930s.
- At least 8 million jobs were lost, with 740,000 jobs lost in January 2009 alone.
- Americans lost $13 trillion of wealth.
- Hundreds of banks failed.
- The S&P 500 dropped 57% from its high in 2007 with an almost stock market panic mentality.
- In some parts of the country, home prices fell 32%.
- According to RealityTrac Inc, the Great Recession caused 2.5 million homes to be foreclosed, with millions more having foreclosure filings. By 2009, 1 in 45 homes were in default.
- By March 2009, Citigroup was trading at $1 per share, and Bank of America was trading at $3 per share.
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