- The Great Recession, which ran from December 2007 to June 2009, was one of the worst economic downturns in US history.
- The economic crisis was precipitated by the collapse of the housing market, which was fueled by low interest rates, cheap lending, poor regulation, and hazardous subprime mortgages.
- New financial laws and an aggressive Federal Reserve are two of the Great Recession’s legacies.
What was the primary cause of the financial crisis of 2008?
The financial industry’s deregulation was the fundamental cause of the 2008 financial crisis. It enabled for derivatives speculation backed by cheap, indiscriminately issued mortgages, making them accessible to even individuals with questionable creditworthiness.
Who is responsible for the 2008 Great Recession?
The Lenders are the main perpetrators. The mortgage originators and lenders bear the brunt of the blame. That’s because they’re the ones that started the difficulties in the first place. After all, it was the lenders who made loans to persons with bad credit and a high chance of default. 7 This is why it happened.
What was the impact of the 2008 recession?
When the decade-long expansion in US housing market activity peaked in 2006, the Great Moderation came to an end, and residential development began to decline. Losses on mortgage-related financial assets began to burden global financial markets in 2007, and the US economy entered a recession in December 2007. Several prominent financial firms were in financial difficulties that year, and several financial markets were undergoing substantial upheaval. The Federal Reserve responded by providing liquidity and support through a variety of measures aimed at improving the functioning of financial markets and institutions and, as a result, limiting the damage to the US economy. 1 Nonetheless, the economic downturn deteriorated in the fall of 2008, eventually becoming severe and long enough to be dubbed “the Great Recession.” While the US economy reached bottom in the middle of 2009, the recovery in the years that followed was exceptionally slow in certain ways. In response to the severity of the downturn and the slow pace of recovery that followed, the Federal Reserve provided unprecedented monetary accommodation. Furthermore, the financial crisis prompted a slew of important banking and financial regulation reforms, as well as congressional legislation that had a substantial impact on the Federal Reserve.
Rise and Fall of the Housing Market
Following a long period of expansion in US house building, home prices, and housing loans, the recession and crisis struck. This boom began in the 1990s and accelerated in the mid-2000s, continuing unabated through the 2001 recession. Between 1998 and 2006, average home prices in the United States more than doubled, the largest increase in US history, with even bigger advances in other locations. During this time, home ownership increased from 64 percent in 1994 to 69 percent in 2005, while residential investment increased from around 4.5 percent of US GDP to nearly 6.5 percent. Employment in housing-related sectors contributed for almost 40% of net private sector job creation between 2001 and 2005.
The development of the housing market was accompanied by an increase in household mortgage borrowing in the United States. Household debt in the United States increased from 61 percent of GDP in 1998 to 97 percent in 2006. The rise in home mortgage debt appears to have been fueled by a number of causes. The Federal Open Market Committee (FOMC) maintained a low federal funds rate after the 2001 recession, and some observers believe that by keeping interest rates low for a “long period” and only gradually increasing them after 2004, the Federal Reserve contributed to the expansion of housing market activity (Taylor 2007). Other researchers, on the other hand, believe that such variables can only explain for a small part of the rise in housing activity (Bernanke 2010). Furthermore, historically low interest rates may have been influenced by significant savings accumulations in some developing market economies, which acted to keep interest rates low globally (Bernanke 2005). Others attribute the surge in borrowing to the expansion of the mortgage-backed securities market. Borrowers who were deemed a bad credit risk in the past, maybe due to a poor credit history or an unwillingness to make a big down payment, found it difficult to get mortgages. However, during the early and mid-2000s, lenders offered high-risk, or “subprime,” mortgages, which were bundled into securities. As a result, there was a significant increase in access to housing financing, which helped to drive the ensuing surge in demand that drove up home prices across the country.
Effects on the Financial Sector
The extent to which home prices might eventually fall became a significant question for the pricing of mortgage-related securities after they peaked in early 2007, according to the Federal Housing Finance Agency House Price Index, because large declines in home prices were viewed as likely to lead to an increase in mortgage defaults and higher losses to holders of such securities. Large, nationwide drops in home prices were uncommon in US historical data, but the run-up in home prices was unique in terms of magnitude and extent. Between the first quarter of 2007 and the second quarter of 2011, property values declined by more than a fifth on average across the country. As financial market participants faced significant uncertainty regarding the frequency of losses on mortgage-related assets, this drop in home values contributed to the financial crisis of 2007-08. Money market investors became concerned of subprime mortgage exposures in August 2007, putting pressure on certain financial markets, particularly the market for asset-backed commercial paper (Covitz, Liang, and Suarez 2009). The investment bank Bear Stearns was bought by JPMorgan Chase with the help of the Federal Reserve in the spring of 2008. Lehman Brothers declared bankruptcy in September, and the Federal Reserve aided AIG, a significant insurance and financial services firm, the next day. The Federal Reserve, the Treasury, and the Federal Deposit Insurance Corporation were all approached by Citigroup and Bank of America for assistance.
The Federal Reserve’s assistance to specific financial firms was hardly the only instance of central bank credit expansion in reaction to the crisis. The Federal Reserve also launched a slew of new lending programs to help a variety of financial institutions and markets. A credit facility for “primary dealers,” the broker-dealers that act as counterparties to the Fed’s open market operations, as well as lending programs for money market mutual funds and the commercial paper market, were among them. The Term Asset-Backed Securities Loan Facility (TALF), which was launched in collaboration with the US Department of Treasury, was aimed to relieve credit conditions for families and enterprises by offering credit to US holders of high-quality asset-backed securities.
To avoid an increase in bank reserves that would drive the federal funds rate below its objective as banks attempted to lend out their excess reserves, the Federal Reserve initially funded the expansion of Federal Reserve credit by selling Treasury securities. The Federal Reserve, on the other hand, got the right to pay banks interest on their excess reserves in October 2008. This encouraged banks to keep their reserves rather than lending them out, reducing the need for the Federal Reserve to offset its increased lending with asset reductions.2
Effects on the Broader Economy
The housing industry was at the forefront of not only the financial crisis, but also the broader economic downturn. Residential construction jobs peaked in 2006, as did residential investment. The total economy peaked in December 2007, the start of the recession, according to the National Bureau of Economic Research. The drop in general economic activity was slow at first, but it accelerated in the fall of 2008 when financial market stress reached a peak. The US GDP plummeted by 4.3 percent from peak to trough, making this the greatest recession since World War II. It was also the most time-consuming, spanning eighteen months. From less than 5% to 10%, the jobless rate has more than doubled.
The FOMC cut its federal funds rate objective from 4.5 percent at the end of 2007 to 2 percent at the start of September 2008 in response to worsening economic conditions. The FOMC hastened its interest rate decreases as the financial crisis and economic contraction worsened in the fall of 2008, bringing the rate to its effective floor a target range of 0 to 25 basis points by the end of the year. The Federal Reserve also launched the first of several large-scale asset purchase (LSAP) programs in November 2008, purchasing mortgage-backed assets and longer-term Treasury securities. These purchases were made with the goal of lowering long-term interest rates and improving financial conditions in general, hence boosting economic activity (Bernanke 2012).
Although the recession ended in June 2009, the economy remained poor. Economic growth was relatively mild in the first four years of the recovery, averaging around 2%, and unemployment, particularly long-term unemployment, remained at historically high levels. In the face of this sustained weakness, the Federal Reserve kept the federal funds rate goal at an unusually low level and looked for new measures to provide extra monetary accommodation. Additional LSAP programs, often known as quantitative easing, or QE, were among them. In its public pronouncements, the FOMC began conveying its goals for future policy settings more fully, including the situations in which very low interest rates were likely to be appropriate. For example, the committee stated in December 2012 that exceptionally low interest rates would likely remain appropriate at least as long as the unemployment rate remained above a threshold of 6.5 percent and inflation remained no more than a half percentage point above the committee’s longer-run goal of 2 percent. This “forward guidance” technique was meant to persuade the public that interest rates would remain low at least until specific economic conditions were met, exerting downward pressure on longer-term rates.
Effects on Financial Regulation
When the financial market upheaval calmed, the focus naturally shifted to financial sector changes, including supervision and regulation, in order to avoid such events in the future. To lessen the risk of financial difficulty, a number of solutions have been proposed or implemented. The amount of needed capital for traditional banks has increased significantly, with bigger increases for so-called “systemically essential” institutions (Bank for International Settlements 2011a;2011b). For the first time, liquidity criteria will legally limit the amount of maturity transformation that banks can perform (Bank for International Settlements 2013). As conditions worsen, regular stress testing will help both banks and regulators recognize risks and will require banks to spend earnings to create capital rather than pay dividends (Board of Governors 2011).
New provisions for the treatment of large financial institutions were included in the Dodd-Frank Act of 2010. The Financial Stability Oversight Council, for example, has the authority to classify unconventional credit intermediaries as “Systemically Important Financial Institutions” (SIFIs), putting them under Federal Reserve supervision. The act also established the Orderly Liquidation Authority (OLA), which authorizes the Federal Deposit Insurance Corporation to wind down specific institutions if their failure would pose a significant risk to the financial system. Another section of the legislation mandates that large financial institutions develop “living wills,” which are detailed plans outlining how the institution could be resolved under US bankruptcy law without endangering the financial system or requiring government assistance.
The financial crisis of 2008 and the accompanying recession, like the Great Depression of the 1930s and the Great Inflation of the 1970s, are important areas of research for economists and policymakers. While it may be years before the causes and ramifications of these events are fully known, the attempt to unravel them provides a valuable opportunity for the Federal Reserve and other agencies to acquire lessons that can be used to shape future policy.
Defaults on mortgages for homes were a major driver of the US recession that began in 2008.
Human greed and a lack of judgment are the root causes of the subprime mortgage crisis. Banks, hedge funds, investment houses, ratings agencies, homeowners, investors, and insurance companies were the main actors.
Even individuals who couldn’t afford loans were lent to the banks. People took out loans to buy properties they couldn’t truly afford. Investors raised demand for subprime mortgages by creating a market for low-cost MBS. These were packaged into derivatives and marketed to financial traders and institutions as insured investments.
People defaulted on their loans that were packaged in derivatives when the housing market grew saturated and interest rates began to climb. This is how the housing market crisis pushed the financial industry to its knees and triggered the Great Recession of 2008.
How did the United States emerge from the Great Recession of 2008?
Congress passed the Struggling Asset Relief Scheme (TARP) to empower the US Treasury to implement a major rescue program for troubled banks. The goal was to avoid a national and global economic meltdown. To end the recession, ARRA and the Economic Stimulus Plan were passed in 2009.
What were the three main causes of the 2008 financial crisis?
The Great Recession, which ran from December 2007 to June 2009, was one of the worst economic downturns in US history. The economic crisis was precipitated by the collapse of the housing market, which was fueled by low interest rates, cheap lending, poor regulation, and hazardous subprime mortgages.
Did Covid cause the downturn?
The COVID-19 pandemic has triggered a global economic recession known as the COVID-19 recession. In most nations, the recession began in February 2020.
The COVID-19 lockdowns and other safeguards implemented in early 2020 threw the world economy into crisis after a year of global economic downturn that saw stagnation in economic growth and consumer activity. Every advanced economy has slid into recession within seven months.
The 2020 stock market crash, which saw major indices plunge 20 to 30 percent in late February and March, was the first big harbinger of recession. Recovery began in early April 2020, and by late 2020, many market indexes had recovered or even established new highs.
Many countries had particularly high and rapid rises in unemployment during the recession. More than 10 million jobless cases have been submitted in the United States by October 2020, causing state-funded unemployment insurance computer systems and processes to become overwhelmed. In April 2020, the United Nations anticipated that worldwide unemployment would eliminate 6.7 percent of working hours in the second quarter of 2020, equating to 195 million full-time employees. Unemployment was predicted to reach around 10% in some countries, with higher unemployment rates in countries that were more badly affected by the pandemic. Remittances were also affected, worsening COVID-19 pandemic-related famines in developing countries.
In compared to the previous decade, the recession and the associated 2020 RussiaSaudi Arabia oil price war resulted in a decline in oil prices, the collapse of tourism, the hospitality business, and the energy industry, and a decrease in consumer activity. The worldwide energy crisis of 20212022 was fueled by a global rise in demand as the world emerged from the early stages of the pandemic’s early recession, mainly due to strong energy demand in Asia. Reactions to the buildup of the Russo-Ukrainian War, culminating in the Russian invasion of Ukraine in 2022, aggravated the situation.
Quizlet: What was the cause of the 2008 financial crisis?
(1) Chinese money invested in the United States: Global imbalances, primarily America’s massive current-account deficit and China’s huge surplus, are some of the causes of the financial crisis. -> The United States leveraged savings from overseas to finance beneficial investments. (2) A torrent of cash: reduced interest rates and higher home prices.
What procedures were put in place to prevent a repeat of the 2008 financial crisis?
Dodd-primary Frank’s sections set laws and establish regulatory agencies to keep an eye on the financial services industry and safeguard consumers.
The Financial Stability Oversight Council (FSOC)
The Financial Stability Oversight Council (FSOC) is in charge of preventing “too big to fail” banks and other financial institutions. One of the causes of the 2008 financial crisis was that a few financial corporations had grown so huge and crucial to the financial system’s functioning that the US government was forced to intervene to save them from their own bad judgments.
Dodd-Frank granted the Financial Stability Oversight Council (FSOC) significant authorities to prevent any single corporation from growing to be this large or crucial to the economy. The group is tasked with detecting risks to financial stability and is made up of Treasury Department and Federal Reserve officials who are advised by industry specialists and academics. But probably its most powerful tool is the capacity to impose stringent rules on, and even break up, businesses that pose significant economic dangers.
Banking Industry Stress Tests
Dodd-Frank required the Federal Reserve to keep a closer eye on the country’s major banks and financial institutions, including insurance giants. The act mandated special annual examinations to guarantee that these massive financial institutions were ready for future recessions and financial crises.
These “stress tests” employ hypothetical scenarios to evaluate the impact of various financial shocks on their stability. If a bank doesn’t have enough capital on hand in certain conditions, the Fed can halt share repurchases or limit dividends to guarantee that the bank is strong enough to lend to struggling businesses and weather economic downturns.
The Consumer Financial Protection Bureau
The Consumer Financial Protection Bureau is the most visible and well-known of the new regulatory entities created by Dodd-Frank (CFPB). The Consumer Financial Protection Bureau’s mission is to safeguard customers from dangerous or abusive financial products. The bureau has the authority to supervise companies that sell financial products to consumers and to implement consumer finance discrimination laws.
In the decades leading up to the crisis, as the financial services industry was deregulated, more and more financial products were advertised and sold to consumers with minimal scrutiny from legacy banking industry regulators. The rules governing credit reporting agencies, payday lenders, consumer loans, student loans, and banking fees were murky, and customers were frequently sold costly, dangerous goods that they didn’t fully comprehend.
The Consumer Financial Protection Bureau (CFPB) was created as a sort of “Food and Drug Administration (FDA)” to clean up the consumer finance industry’s excesses. The CFPB can fine lenders who violate its regulations and monitoring as part of its enforcement powers. Consumers can also file official complaints with the bureau, which provides it with information about the problems they’re having and who’s causing them.
The Volcker Rule
Banks are prohibited from participating in speculative trading under the Volcker Rule. The Volcker Rule prohibits banks from engaging in proprietary trading, which means that agents or units of a bank cannot buy or sell securities, derivatives, commodity futures, or options in the bank’s accounts.
Banks created and traded highly dangerous derivatives, such as credit default swaps, in the run-up to the financial crisis, the majority of which produced such massive liabilities that they bankrupted whole financial institutions, such as AIG.
“What banking most needs is to become dull, the way the business was before bankers became addicted to trading profits,” one analyst memorably said of the Volker Rule. Banks are unable to benefit from their own capital if these hazardous ventures are prohibited.
Banks can only trade when it is necessary to run their company, such as currency trading, according to the rule. Banks can also trade on behalf of their customers when acting as an agent, broker, or custodian. Banks were also prohibited from investing in or supporting hedge funds and private equity firms under the rule.
Monitoring Risky Derivatives
The Securities and Exchange Commission (SEC) was given authority under the Dodd-Frank Act to oversee derivative trading, or contracts between two parties who agree on a financial asset or collection of assets. Bonds, commodities, currencies, interest rates, market indices, and stocks are all examples of trading. Regulators in charge of derivative trading can see hazards in trades and intervene before a financial collapse occurs.
Strengthening the Sarbanes-Oxley Act
The Sarbanes-Oxley Act, which was signed into law in 2002, was enacted in reaction to corporate scandals such as Enron. Sarbanes-Oxley revolutionized corporate accountability by holding CEOs personally liable for accounting errors and providing protections to people who report wrongdoing, such as whistleblowers.
Certain provisions of Sarbanes-Oxley were tightened by Dodd-Frank. It established a bounty scheme in which whistleblowers were entitled to 10% to 30% of the proceeds from successful legal settlements as a result of their reporting on wrongdoing. It also doubled the amount of time an employee has to file a claim against their company, from 90 to 180 days.
Requiring Hedge Funds to Register with the SEC
Hedge funds making complicated and sophisticated trades were a big element in the 2008 financial crisis. The Dodd-Frank Act mandates that all hedge funds register with the Securities and Exchange Commission (SEC). Hedge funds must also give essential information about their trades and holdings in order for the SEC to assess their overall risk.
Federal Insurance Office (FIO)
The FIO, which is also part of the Treasury Department, oversees all elements of the insurance industry and ensures that insurers respect the law. The FIO also keeps track of how underserved groups and individuals can get affordable non-health insurance.
The office is in charge of spotting warning indications in the insurance markets that could suggest a financial market collapse.
In addition, the FIO is a member of the FSOC’s advisory committee. This agency merely serves as a resource and does not have regulatory authority. The FIO advises on major national and international insurance problems in collaboration with the National Association of Insurance Commissioners (NAIC).
SEC Office of Credit Ratings
To oversee credit rating organizations such as Standard & Poor’s and Moody’s, Dodd-Frank established the Office of Credit Ratings (OCR) at the Securities and Exchange Commission (SEC).
Financial rating organizations assist investors in comprehending the risks associated with purchasing bonds and other credit instruments. These firms contributed significantly to the 2008 financial catastrophe by bestowing their highest ratings on special financial instruments that repackaged very dangerous debt and presented it as a safe investment.
For the protection of users and the public interest, the OCR oversees standards for determining credit ratings, encouraging accuracy in credit ratings, and striving to ensure that credit ratings are not impacted by conflicts of interest and are subject to transparency and disclosure. The OCR has the authority to require rating agencies to publish their techniques and to revoke an agency’s registration if it makes too many incorrect ratings decisions.