What Caused the Great Recession of 2008-2009?
Officially the Great Recession started in December 2007, long before most Americans on Main Street realized what was about to happen. And according to the NBER, the Great Recession ended in July 2009, which most Americans on Main Street cynically laughed at 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, 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 In 1999, this act was repealed with bankers, investment firms and politicians thinking that they were too smart to ever let another Great Depression happen again.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 SEC ignored these warnings.
The Mortgage Companies and the Great Recession
Countrywide and a host of 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. Lending standards were lowered and lowered until people with no jobs, no income, no assets and no credit rating were able to get huge 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) and in two years they 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. This 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 numerous homes and renting them.
Mortgage companies didn’t really 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
The banks wanted in on this huge gravy train.
The banks used models that were developed by highly educated mathematicians. These models did not take into account high number of mortgage defaults at the same time across the country. Why, because it had never happened before. Ironically, every investment ad you ever read warn you 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 10 block area around your home. Put all those mortgages into an envelope. You don’t know the credit worthiness of those mortgages. Cut up the envelope into smaller pieces all holding all kinds 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 certain tranche paid their mortgage and did not get paid when the mortgages were not paid and the defaults and foreclosures started.
There was such a huge demand for these CDOs and not enough mortgages that the banks invented CDOs, these were called synthetic CDOs.
Two big problems caused the banks to live in their dream world during this housing “bubble”. 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 the banks didn’t have nearly the assets they claimed to have.
The second problem was leverage. Many of these banks had leverage of 30 or more to 1. Meaning for every dollar of their own they invested in these mortgages, they used $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 who’s securities they are rating, so if Citi wanted their CDOs rated, they paid the rating company to rate them, which is thought one reason they were rated highly.
Pension funds, city, state and nations by their bylaws 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 insure bonds against default. For example, if a pension fund bought bonds from GM and also 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 with everyone buying the mortgage backed CDOs, they also wanted to buy 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, they went out and just 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 increased and it was 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, more and more people owed more than their homes were worth and defaults and foreclosures were rising well beyond what the models had predicted would ever happen, 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 and 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 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 and is the worst recession since the 1930s.
- At least 8 million jobs were lost with 740,000 jobs lost in January 2009 alone
- Americans lost $13 trillion dollars of wealth
- Hundreds of bank failures
- 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 on with millions more having foreclosure filings and by 2009, 1 in 45 homes were in default.
- By March 2009, Citigroup was $1 per share and Bank of America was at $3 per share
For a more detailed account of the factors and people that led to the Great Recession of 2008, I urge you to read the following books. At least the first three listed, On The Brink is good but somewhat dry, the other three books are excellent.
- The End of Wall Street by Roger Lowenstein
- The Big Short by Michael Lewis
- Reckless Endangerment by Gretchen Morgenson and Joshua Rosner
- On the Brink by Hank Paulson
© September 2010 Sam Montana
Article picture by Mike Licht / Flickr