Causes of the Great Recession: Factors, Effects, and Legacy

The combination of high interest rates and falling home prices made it extremely difficult for buyers to make payments on their homes. It’s worth noting that credit rating agencies who is to blame for the great recession of 2008 are supposed to be independent. But an inherent conflict of interest seems to have existed since the banks issuing the securities were the ones paying the agencies to rate them.

And Reinhardt said the markets seemed to be doing so well that few analysts, either in government or the private sector, had a critical eye. “The crisis definitely happened on their watch,” said Kenneth Rogoff, a professor of economics at Harvard University who advises the Republican presidential candidate John McCain. “This is eight years into the Bush administration. There was a lot of time to deal with it.” Former and current officials named in the report, as well as financial institutions, declined Tuesday to comment before the report was released. While the panel, the Financial Crisis Inquiry Commission, accuses several financial institutions of greed, ineptitude or both, some of its gravest conclusions concern government failings, with embarrassing implications for both parties. But the panel was itself divided along partisan lines, which could blunt the impact of its findings.

FAQs about the Great Recession

U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis. This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn. To illustrate, there is a hedge fund strategy best described as credit arbitrage. It involves purchasing subprime bonds on credit and hedging the positions with credit default swaps. By using leverage, a fund could purchase many more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs.

These products offered low introductory rates and minimal initial costs such as no down payment. Their hopes lay in price appreciation, which would have allowed them to refinance at lower rates and take the equity out of the home for use in another spending. However, instead of continuing to appreciate, the housing bubble burst, taking prices on a downward spiral with it. By one measure, for about every $40 in assets, the nation’s five largest investment banks had only $1 in capital to cover losses, meaning that a 3 percent drop in asset values could have wiped out the firm. The banks hid their excessive leverage using derivatives, off-balance-sheet entities and other devices, the report found. The speculative binge was abetted by a giant “shadow banking system” in which the banks relied heavily on short-term debt.

The failures of a few investment managers also contributed to the problem. Just as the homeowners are to blame for their purchases gone wrong, much of the blame must also be placed on those who invested in CDOs. Investors were the ones willing to purchase these CDOs at ridiculously low premiums instead of Treasury bonds. These enticingly low rates are what ultimately led to such a huge demand for subprime loans. Still, the White House, in the view of critics, fostered a free-market hothouse in which these excesses were able to flower.

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These included the monthly payments, the total amount owed, the likelihood you will repay, and future home prices. The following year, the Commodity Futures Modernization Act exempted credit default swaps and other derivatives from regulations. This federal legislation overruled the state laws that had formerly prohibited this form of gambling.

Laughably given an honorary knighthood in 2002 for his “contribution to global economic stability”, Greenspan’s responsibility for the crash cannot be underestimated. The U.S. economy bottomed out in 2009, but recovery—both in the U.S. and around the globe—was a long, slow process. Enron wanted to engage in derivatives trading using its online futures exchanges. Enron argued that foreign derivatives exchanges were giving overseas firms an unfair competitive advantage. TIME’s picks for the top 25 people to blame for the financial crisis includes everyone from former Federal Reserve chairman Alan Greenspan and former President George W. Bush to the former CEO of Merrill Lynch and you — the American consumer. As you read our choices, we’d like to know who you think deserves the most blame, and the least.

Carl Shapiro: Why Dropping Market Power from the Merger Guidelines Matters

They didn’t want other banks to give them worthless mortgages as collateral, so interbank borrowing costs (Libor), increased. The Fed began pumping liquidity into depository institutions via the Term Auction Facility (TAF), but that wasn’t enough. The profitability of MBS generated more demand for the mortgages they were backed by, further encouraging banks to write loans to unqualified borrowers to keep the supply of derivatives flowing.

But the Fed chooses not do so and this leads to a passive tightening of monetary policy. Aiming to boost borrowing and capital investment, the Fed reduced interest rates to zero for the first time ever and launched a quantitative easing program, whereby it bought financial assets to add more money into the economy. In April 2007, New Century Financial, the largest independent provider of subprime mortgages, declared Chapter 11 bankruptcy. By mid-2006, home prices were peaking and the market was slowing down.

These big institutions were not only unwitting victims of an unforeseen financial collapse, as they have sometimes portrayed themselves, but enablers that bankrolled the type of lending that has threatened the financial system. The generation that came of age at the worst of the crisis, Millennials still feel the effects of the Great Recession. They have a reluctance to buy homes and overall less wealth than previous generations at a comparable age. A 2019 Country Financial survey revealed that half (50%) of Millennials rate their level of financial security as fair or poor, compared to 44% of Americans overall. After staying low throughout the early 2000s, interest rates began to rise starting in 2004 in response to an overheating economy and fears of inflation.

The British banking giant HSBC got into the U.S. mortgage business in a big way when it bought Household International in 2003. It also purchased Arizona-based DecisionOne Mortgage, and operated under the Beneficial and HLC brands. An HSBC spokeswoman said HSBC Finance was primarily a portfolio lender, meaning it did not sell mortgages to third parties. HSBC, however, did package loans from its subprime subsidiaries into securities, according to SEC filings. Merrill Lynch bought First Franklin Corp. (No. 4 on the Center list) in late December 2006 for $1.3 billion — just before the bottom fell out of the market.

Read on to find out more about each individual player and what role they played in the crisis. The primary blame for the Great Recession could be bestowed upon lax lending policies that allowed many consumers to borrow beyond their financial capabilities. But let’s not forget the predatory lenders who marketed homeownership to these individuals, as well as the investment firms who bought those bad mortgages and rolled them into bundles for resale to investors. Moreover, massive responsibility lies on the rating agencies who gave those derivative products triple-A ratings, making them appear safe. Ultimately September 2008, with the bankruptcy of Lehman Brothers, the country’s fourth-largest investment bank, marked the climax of the subprime mortgage crisis, as panicked banks stopped lending almost entirely, and the global banking system became short of funds. In 2007, as the value of these derivatives plummeted, banks began to panic and cut back on lending, causing a credit crunch (a reduction in lending activity by financial institutions brought on by a sudden shortage of capital).

Banks and hedge funds started trading swaps on MBSs and CDOs in unregulated transactions. Furthermore, because CDS transactions didn’t show up on institutions’ balance sheets, investors couldn’t evaluate the actual risks these enterprises had assumed. Furthermore, the underlying loans of these derivative products were often rated incorrectly, inflating their value and misleading investors.

How much did the 2008 financial crisis cost?

In fact, of the $600 billion in debt owed by the company, $400 billion was supposed to be covered by CDS. Others have pointed to the passage of the Gramm–Leach–Bliley Act by the 106th Congress, and over-leveraging by banks and investors eager to achieve high returns on capital. Paulson’s big mistake was to put Freddie Mac and Fannie Mae into conservatorship, wiping out the stakes of those who had invested $20bn in the two government-backed mortgage lenders over the previous 12 months. Here, then, is a (far from exhaustive) list of those who might be considered most culpable – who caused, exacerbated or failed to prevent the worst downturn in the global economy since the 1930s.

Ameriquest, according to Center research of prospectuses, had relationships with virtually every major Wall Street investment bank. The lender sold billions of dollars in loans to Lehman Brothers, Bear Stearns, Goldman Sachs, Citigroup and Merrill Lynch. Some of its other financial supporters included Morgan Stanley, JPMorgan Chase, Deutsche Bank, UBS Securities, RBS Greenwich Capital, Credit Suisse First Boston, and Bank of America. Several other lenders among the Top 25 were subsidiaries of Wall Street banks or hedge funds. Encore Credit Corp. (No. 17), for example, was a subsidiary of Bear Stearns, and BNC Mortgage Inc. was part of Lehman Brothers (No. 11). Most of the top subprime lenders were high-volume, “non-bank” retail lenders that advertised heavily, generated huge profits, and flamed out when Wall Street benefactors yanked their funding.

Risk-taking behavior

“That’s why 93 out of every 100 of our mortgage customers were current on their payments at the end of 2008,” the bank’s Kevin Waetke wrote in an e-mail. In addition to the $700 billion bailout, the Federal Reserve began committing hundreds of billions of dollars to guarantee against losses on failing mortgage assets of AIG, Citigroup, and Bank of America. For the Center’s criteria and to learn how the list was created, please see our methodology. In the decade leading up to 2007, real estate and property values had been rising steadily, encouraging people to invest in property and buy homes. While the relative impact of each cause is still debated today, the Great Recession stands as a cautionary tale about risk, investing in what you know, and the dangers of putting full trust and faith in financial experts and institutions. Gramm, who thinks Wall Street a “holy place”, was the main cheerleader in Congress for financial deregulation, putting pressure on the Clinton administration to ease restrictions – not that it needed much persuading.

• Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is they were simply bringing bonds to market based on market demand.
• Still, human behavior and greed ultimately drove the demand, supply, and investor appetite for these types of loans.
• Furthermore, the underlying loans of these derivative products were often rated incorrectly, inflating their value and misleading investors.

Executives at the American International Group were found to have been blind to its $79 billion exposure to credit-default swaps, a kind of insurance that was sold to investors seeking protection against a drop in the value of securities backed by home loans. At Merrill Lynch, managers were surprised when seemingly secure mortgage investments suddenly suffered huge losses. Even the timing of austerity over the current recovery is fairly easy to pinpoint in actions undertaken by Republicans in Congress. But in 2011 Republicans in the House of Representatives demanded spending cuts as a precondition for raising the debt ceiling, a vote that had historically been pro-forma (the ceiling has been raised 78 times just since 1962). The resulting Budget Control Act of 2011 has significantly reduced the growth of discretionary spending.

Before the bubble burst, tech company valuations rose dramatically, as did investment in the industry. Junior companies and startups that didn’t produce any revenue yet were getting money from venture capitalists, and hundreds of companies went public. This situation was compounded by the September 11 terrorist attacks in 2001. Central banks around the world tried to stimulate the economy as a response. When it comes to the subprime mortgage crisis, there was no single entity or individual at whom we could point the finger. Instead, this mess was the collective creation of the world’s central banks, homeowners, lenders, credit rating agencies, underwriters, and investors.

WASHINGTON — The 2008 financial crisis was an “avoidable” disaster caused by widespread failures in government regulation, corporate mismanagement and heedless risk-taking by Wall Street, according to the conclusions of a federal inquiry. In theory, fiscal stimulus could be provided through tax cuts rather than spending. But to overturn our assessment of the effect of stimulus provided in the current recovery versus previous ones, it would have to be the case that there were much larger tax cuts since 2009 than in previous recoveries. A payroll tax holiday was enacted for 2011 and 2012, but income taxes rose substantially in 2013 as the high-income tax cuts passed in 2001 and 2003 expired. More importantly, recovery from the recessions of the early 1980s and early 2000s was accompanied by historically large cuts in income taxes signed into law by the Reagan and George W. Bush administrations.