It has been more than a decade since the Great Recession ended. In what was the worst economic event since the Great Depression, the financial crisis wreaked havoc on both U.S. and global economies. Despite recent data that found the world became 25% richer in 2019, many countries and markets have yet to fully recover from the recession. It is important to understand why the 2007-2009 downturn happened in the first place.
What is a Recession?
Technically, a recession happens when the gross domestic product (GDP) rate is negative for six straight months or two consecutive quarters. But there could be other factors as well, such as a decline in manufacturing over a six-month period or a two-point increase in unemployment above 6%. On Main Street, a recession can lead to small businesses going bankrupt, people losing their homes, and young graduates unable to find work after leaving school.
The Great Recession is still etched in the memories of every generation that was around, whether it is the Baby Boomers who saw their life savings wiped out or the millennials who witnessed their parents lose their homes. Yet, many people are unsure of how it happened and what caused the contraction.
The Great Recession: A Primer
In 2006, the first signs of a major crisis started to form. That year, housing prices began to come down. The biggest problem was in subprime (mortgages that were given to borrowers with poor credit). This led to a collapse in the value of mortgage-backed securities (MBS) – a package of home loans bought from the lenders – and associated financial mechanisms. House prices declined sharply.
The housing crisis affected the rest of the economy. The GDP shrank 0.3% in the third quarter of 2008 and declined at an annual pace of 6.3% in 2009. The unemployment rate briefly reached 10%. Some of the biggest banks and mortgage lenders, such as Lehman Brothers and Fannie Mae and Freddie Mac, filed for bankruptcy; others like AIG and Merrill Lynch were quickly rescued with a huge taxpayer-funded bailout. Nearly 500 banks shut their doors in 2008.
During the recession, the federal government and the Federal Reserve sprang into action, announcing a $787 billion stimulus package, $700 billion bailout plan, and trillions in bailout funds for foreign banks.
By June 2009, the recession had come to an official end. It turned out to be the worst economic event since the 1930s.
The key question that many have is: What caused all of this?
What Caused the Financial Crisis?
Government intervention and central banking led to the housing crash in the first place.
In 1995, then-President Bill Clinton used the 1977 Community Reinvestment Act to develop an initiative that required banks to lend money to so-called underserved communities. This usually resulted in banks granting loans to unqualified borrowers with low income or credit scores who could not repay the loan. The state enabled banks to lend even more as Fannie Mae and Freddie Mac bought about $1 trillion in subprime mortgages. Fannie and Freddie are government-sponsored financial institutions that buy mortgages from lenders with the aim of providing stability to the housing market.
When the banks made loans, mainly to underprivileged borrowers, Fannie and Freddie purchased the mortgages. The banks had ditched their normal standards so they would not be penalized by government regulators or be accused of discriminating against poorer groups.
By 2007, there were roughly 27 million subprime mortgages in the banking system with an aggregate value of $4.5 trillion. A year later, three-quarters of the mortgages on Fannie and Freddie’s books were subprime.
Predictably, many mortgages given to low-income borrowers slipped into either delinquency (the borrower missed payments) or default (the borrower failed to repay the loan).
In the end, Wall Street and Fannie and Freddie faced trillions in losses.
The Great Recession eliminated $13 trillion in household wealth, cost nine million Americans their jobs, and added a couple of trillion dollars to the national debt.