Great Recession was a financial crisis in the United States. A financial crisis occurs when there are problems with banking and credit. The crisis began in December 2007 and lasted until June 2009. It was part of a broader financial crisis that spread across many countries of the world. A recession is a drop in overall business and economic activity. Less business taking place leads to higher unemployment and lower incomes. During a recession, people may lose their businesses, their jobs, and their homes. The Great Recession resulted in the most severe economic decline in the United States since the Great Depression. The Great Depression was a worldwide economic slump in the 1930’s.
The financial crisis that became the Great Recession began with several contributing factors. These included (1) a crisis in the housing industry, triggered by subprime or risky mortgages, and (2) questionable practices by financial service providers that resulted in some of the largest corporate and bank failures in history.
The mortgage factor.
The problems leading up to the crisis started in the home loan or mortgage industry prior to December 2007. Mortgage is the formal term for a loan to purchase real estate. Most often, people do not have enough cash to pay for real estate in full. They usually acquire a loan from a lender. Lenders include banks, credit unions, mortgage companies, and savings and loan associations. A loan applicant does not have to go directly to a bank or lender to get a loan. There are also businesses and individuals called mortgage originators. These nonbank institutions or individuals take applications for mortgages from people who want to buy real estate. They send the applications to banks, or other lenders, and try to find financing from a bank willing to make the loan. They receive a fee for their service, but the money for the loan actually comes from the bank or other lender. Mortgage originators earn money from the fees they receive for new loans.
When a bank lends a customer money, it usually charges both a fee for the loan and interest. Interest is a charge for using the lender’s money. Borrowers pay interest until the loan is paid back. However, lenders generally do not keep collecting payments and interest until the loan balance is zero. Instead, they often earn more in fees by making new loans or earning a lump sum payment by selling the loan. The promise of interest from existing loans can be sold as a source of income to other investors. In the case of mortgages, people making their monthly mortgage payments provide a stream of income for the person or company receiving the interest. Therefore, banks often sell their finalized mortgages to other financial companies. This is done in a process called securitization. In securitization, investment banks bundle mortgages together and sell them as an investment called a mortgage-backed security (MBS). This activity turned out to be one of the major reasons for the Great Recession.
In this case, large banks often financed the mortgages from mortgage originators, providing the funds and assuming the responsibility for the default risk. Default risk is the risk that the loan will not be paid back. In mortgage-backed securities, people’s homes provided the collateral. Collateral is something of value that backs up the promise to pay. The MBS’s were generally rated as high-quality investments by companies that assess the quality of investments and provide ratings and reports. MBS’s were considered safe because they were secured by mortgages, and people usually pay their mortgages. At the time, housing prices were rising, making the mortgages appear safe, but this appearance was incorrect. These factors fueled the demand for houses and drove up home prices. Rising home prices created a bubble in the housing industry. A bubble means high prices that are not stable or sustainable.
Troubling practices.
Several issues showed serious trouble for the U.S. economy in 2007. Low interest rates—a low price to borrow money—made it possible for more people to borrow more money. Credit was easy to obtain. Readily available credit and easy proof of income requirements allowed some mortgage originators to get loans approved without in-depth scrutiny (close examination). People with low credit scores, poor credit, or no credit history were able to get subprime mortgages. In fact, banks approved many such mortgages with little documentation. Some did not even require proof of employment or income. Some people were not honest on their applications. Loans made under these circumstances are sometimes called liar loans. Some customers were taken advantage of by buying mortgages they did not understand.
Further, banks sold different types of mortgages. For example, an interest only mortgage is a loan in which the customers only paid the interest on the loan. Adjustable rate mortgages (ARM’s) also became more common. An ARM is a type of loan that has a changing interest rate. The payment on an ARM can increase at the end of a certain period, should the interest rate increase. For many customers, these mortgages were not affordable when interest rates went up. This became clear as home prices fell. ARM’s began to re-set at higher interest rates. If homeowners were able to refinance, or get another loan, they would be able to keep their homes. But banks were not always willing to refinance. Many people became unable to make their mortgage payments and unable to sell their homes. Banks soon discovered that the loans they had approved from mortgage originators were not good-quality risks. It turned out that the level of risk was much higher than the banks knew about.
Investors who had bought the highly rated MBS’s were shocked when the mortgages were going into default. Default is the failure to pay when payment is due. Investors were losing on their investments. As investors began to question whether their securities were good investments, they began to sell them to protect their other assets. The attempt to sell the securities triggered panic in financial markets. Banks, financial institutions, and investors were left with assets that had no value.
The consequences.
By 2008, the U.S. economy was in deep recession. Stock prices fell. Job losses were severe, with millions of Americans out of work. The unemployment rate reached the highest levels since the early 1980’s. Millions of homeowners defaulted on their mortgages. Foreclosures caused housing prices to plunge. Foreclosure is the process of taking back property because payment has not been made. Industries associated with housing—from construction to transportation—began to feel the effects of the financial crisis.
The Great Recession affected most Americans in some way, but it was also a global problem. Some of the world’s largest financial institutions, both in the United States and abroad, were affected as well. Some American firms failed. Others received bailout loans from the Federal Reserve System (also called the Fed), which is the central banking system of the United States; the U.S. Congress; or the U.S. Department of the Treasury. Foreign firms received loans from the government of the country in which they were headquartered.
The difficult times many large financial firms experienced during the financial crisis made international headlines. For example, in the United States, in the largest banking collapse in U.S. history, government regulators seized Washington Mutual Inc. and sold off its assets. The government also took control of the private mortgage giants known as Fannie Mae and Freddie Mac as they neared collapse. The companies had invested heavily in subprime mortgages and faced heavy losses. Meanwhile, on Wall Street, some investment titans that struggled during the crisis failed or were sold. In the auto industry, some of the nation’s top automakers faced bankruptcy. They were rescued with billions of dollars in federal loans.
In addition, some insurance companies had provided credit insurance against loss for investors in the housing market. Many of these companies found themselves in serious financial trouble. For example, the world’s largest insurer, American International Group (AIG), had insured subprime mortgages and lost billions of dollars in 2008. It was on the brink of collapse. Its failure could have wreaked financial havoc worldwide. The federal government rescued AIG with billions of dollars in emergency loans.
As the U.S. financial crisis deepened, its effects could be felt in many European countries as well as other industrialized nations. Many countries suffered economic downturns, but some more so than others. For example, Latvia faced one of the deepest recessions during the crisis with an 18 percent decline in its gross domestic product (GDP) and an unemployment rate of 20 percent. Iceland and Ireland faced severe recessions following the failure of some of their major financial institutions. Organizations such as the International Monetary Fund (IMF), which oversees the international financial system, and the Group of Twenty, which consists of the world’s largest economies, worked together to slow the worsening global economic conditions. The IMF provided billions of dollars in financial resources to support the slumping economies of member countries, particularly low-income countries. The Group of Twenty, often called the G-20 or G20, is an organization of finance ministers and central bank governors from 19 countries and the 28-nation European Union.
