The Great Recession: The U.S. Economy 2007-2009
What follows below is a very brief discussion of the worst financial crisis since the Great Depression of the 1930s. The complete story is very complex and not easy to understand. Even people in responsible positions were unable to see what was really happening. As a result, decisions were made that instead of helping the situation actually made it worse. This overview will give you the general idea of what happened.

Part 1: The Housing Bubble and the Financial Crisis

The financial crisis that hit the United States in the first decade of the 21st century was born out of good intentions. Ownership of a home is a goal for which many if not most Americans strive. At any given time, only a portion of the population has the resources necessary to pay cash for a home, at least for their first home. Thus achieving home ownership means that the first step after selecting the home one wants to buy is to go into debt. As long as the value of the home remains constant or rises, the debt people incur with mortgages is usually manageable. With a typical 30-year fixed rate mortgage, the monthly payments remain nearly constant, rising only with increased tax or insurance costs. At the same time, as the value of the home rises, the owners build up equity on which they can draw if necessary. So home ownership is also a good investment. As long as the loan is fixed rate, there is usually little risk.

For much of the post-World War Two period, a young couple, perhaps recently married, perhaps living in an apartment or rented home for a number of years and having saved up enough money to think about purchasing a home, would contact a Realtor, select a house and arrange for a loan, usually from a bank or savings and loan association. Until the early 2000's, in order for the couple to be approved for that loan, the bank would go look at the family's income, its assets and other relevant information such as prevailing interest rates for home loans and determine whether or not the persons applying for the loan could afford it. As a general rule, down-payments were required to provide additional security for the bank.

During the administrations of Bill Clinton and George W. Bush, federal regulation of the financial industry was eased, enabling banks to loan money more aggressively. The goal was to enable more Americans to achieve that dream of owning their own home. Since banks and other lending institutions make money by earning interest on loans, many of them were eager to take advantage of the looser environment. To encourage potential buyers, banks began granting more loans using variable rate mortgages. What that meant was that the couple getting a loan might start with a low interest rate, perhaps somewhere around 3 or 4%, but after a certain time, usually two years, the interest rate would kick up to a higher level, which would make the monthly mortgage payments much steeper than they had been before.

The interest rates on those variable loans could rise to 11% or even higher, meaning that the owner's mortgage payment would go up 300% or more. That situation was in many cases likely to lead to default, and the owners would lose their home. For a time, as home values continued to rise, many owners were able to stay ahead of the curve by refinancing their loans at a lower level based on the increased equity of their home. Prices often rose so fast that a home worth perhaps three hundred thousand dollars might be worth four or five hundred thousand within a year or two. People who could afford it often bought second or third homes, hoping to profit from the escalating values in what became the “housing bubble.”

At the same time, requirements for down payments, examination of income, the normal procedure of approving those who applied for home loans became more relaxed. Banks started granting loans to people who in earlier times could never have qualified. Those loans were known as subprime, and they charged higher interest rates because the possibility of default was higher. Because they were making so much money, lenders began granting loans that under closer examination would have made little sense. One sort of loan was called a “ninja loan,” an epithet for no-income, no-job. Even people who could afford houses were encouraged by Realtors, who profited from the loans, to purchase houses that were beyond what they could realistically afford. The situation thus created was unsustainable, and a crash was all but inevitable.

One typical example of how things went wrong involved a married couple who were employees in a public school, one a janitor, the other a secretary—both decent jobs with regular pay. When they started looking, they were told that they were qualified for a home that cost $945,000. Because they started with a very low interest rate—called a “teaser rate”—they were at first able to make the payments. But two years later when the higher rates kicked in, they could no longer afford the monthly payments, and they were forced to forfeit the house.

This happened in thousands of cases, not only to low income people who were talked into buying houses they couldn't really afford, but also to wealthier people who purchased expensive homes, hoping to flip them later for a higher price. During the period of the housing boom the rise in the market value of more expensive homes accelerated at a rate that made such practices extremely profitable. But once housing prices leveled off, disaster followed.

A housing bubble was being formed, and it was almost inevitable that the bubble would burst. The problem was that too few people in important positions saw it coming.

As people who could afford it continued to pay their mortgages, a condition which prevailed until around 2005, the flow of income from these mortgages was a steady stream. Banks then created what amounted to mortgage bonds, bundling groups of mortgages together into packages that continued to earn income. Those mortgage bonds were bought and sold by speculators. As long as a large majority of the mortgage payments continued uninterrupted, the value of those bonds continued to rise. The riskier mortgages, those that were liable to default, were few enough in number that the mortgage bonds themselves were not hurt. Those riskier loans were packaged together with safer loans, and the credit rating of those bonds remained artificially high. The danger was that if the default rate continued to rise, those bonds would lose value rapidly. Eventually, the bonds that were created contained higher percentages of riskier loans, and the default rate was bound to increase.

In order to guard against possible losses, a small number of savvy investors, foreseeing that the housing bubble was likely to burst, had banks create for them what were called credit default swaps (CDS). That term, like much of the arcane language surrounding this whole financial world, has a simple meaning. A credit default swap is nothing but an insurance policy on the bond that enables the holder of the mortgage bond to protect against loss. When purchasing a CDS, the bond holder pays a premium, but if the bond fails, the owner recoups the face value.

Author Michael Lewis describes what happens with the CDS as follows:

You might pay $200,000 a year to buy a 10-year credit default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for 10 years. The most you could make was $100 million, if General Electric defaulted on its debt anytime in the next 10 years and bondholders recovered nothing. It was a zero-sum bet: If you made $100 million, the guy who had sold you the credit default swap lost $100 million. (Michael Lewis. The Big Short: Inside the Doomsday Machine, New York, 2010, p. 29.)

Needless to say, a company like GE was not likely to default on its debt, but institutions holding massive amounts of variable rate or subprime loans were destined to incur failures, and those who were clever enough to see it coming benefited from the result. In other words, what the savvy investors knew was that when the housing market crashed, large numbers of those mortgage bonds would default, and huge profits could be made. Those who correctly foresaw the crash in the housing market were therefore in a position to make huge profits, but at the expense of thousands of people who lost their homes. One of the successful operators made $47 million in a matter of a few years.

The effects of the crash were widespread and eventually led to the “Great Recession” a few years later.

Part 2: The Great Recession of 2008-2009

Unfortunately, it was not only the homeowners who were in trouble. The banks and other financial institutions who had invested in these mortgage-backed securities were also in trouble. As the value of their assets declined, the damage reached to the value of their stocks, which in turn began to impact investors. The damage was deep and widespread, and for the time it looked as though the entire American and even world financial system might come crashing down. Massive government intervention was required to prevent a disaster. Housing prices rapidly rose beyond the underlying value of the property itself, and because interest rates were low at the time, banks borrowed large amounts of money to speculate in the housing market. In 2008 housing prices leveled off and then declined, and people who were unable to refinance their loans defaulted. Banks then owned properties on which the loan balance exceeded their real value. On Wall Street and at other locations around the country, when the default rate on the mortgages behind the bonds began to rise above 4%, holders of those mortgage bonds began to panic, and what is generally called a fire sale ensued as banks and other lending institutions scrambled to unload paper that was rapidly losing value. (The film Margin Call listed below is a vivid depiction of what that evolution looked like inside a fictitious but reality-based Wall Street company.)

Exacerbating the growing problem was the fact that mortgage backed securities that were connected to outstanding loans lost value as owners defaulted on those loans. Some of those securities were repackaged in order to conceal the falling value of the underlying mortgages—and those in turn were sold and resold until a huge quantity of what were known as toxic assets accumulated. In simple terms, a great amount of essentially worthless paper was being traded to unsuspecting buyers, and when the mountain of artificial debt reached unsustainable levels, the holders of that paper who were unable to move it were forced into bankruptcy. When the mortgage bonds failed, holders of credit default swaps—insurance policies against the failure of the bonds—made huge profits at the expense of the banks that had to pay up on the policies.

As the value of the bank assets declined, the damage reached to the value of their stocks, which in turn began to impact investors. The damage was deep and widespread, and for the time it looked as though the entire American and even world financial system might come crashing down. Massive government intervention was required to prevent a disaster. Even with government intervention, banks were forced into bankruptcy, as it was impossible for the government to bail out every failing institution. The results was that between 2007 and 2014 a total of 520 banks failed.

Complicating the matter even further was the fact that AIG, a major insurance company that covered millions of dollars in pension funds and individual retirement accounts, also insured the banks that were subject to huge losses when the mortgage bonds failed. In order to stave off that disaster, the government was obliged to rescue AIG with $180 billion. Its problem was described as a major failure in corporate governance in failing to assess risk.

As the system continued to collapse, the stock market fell as credit tightened and companies were unable to cover their obligations, housing prices continued to plummet, bankruptcies spread, people lost their jobs as well as their homes, and trillions of dollars of assets in retirement funds, savings accounts and other financial instruments evaporated. The crisis affected not only the United States--the recession that followed was widespread, from Europe to Asia.

The whole story of this collapse of the economy has been summarized here—the bigger picture is complicated, full of twists and turns involving hundreds of players and individual institutions. For a more complete picture, you can get additional detail from various on-line sources such as Wikipedia, and in a number of books and films. Following are a few sources that are readily accessible.

  • Michael Lewis. The Big Short: Inside the Doomsday Machine, New York, 2010. Also a motion picture by the same name. Tells the story of the major players on both sides of the picture—those who saw the crisis coming and profited from it, and those who were too blind to see it.
  • Andrew Ross Sorkin. Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System from Crisis—and Themselves. New York, 2009.  Also an HBO film by the same name. Focuses on Treasury Secretary Henry Paulson Federal Reserve Chairman Ben Bernanke and the major bankers and other political figures as they dealt with a near disaster of their own making.
  • Margin Call. A film loosely based on one of the major New York banks. It shows how the dynamics of the crisis played out inside a large institution that found itself in possession of a vast quantity of paper assets whose value was essentially worthless.

Although the situation that ensued may have started innocently enough, there is no doubt that the crisis was made infinitely worse by what can be called reckless, fraudulent, and even criminal practices. The failures occurred at many levels, including in a government that failed in its oversight responsibilities to monitor the behavior of important financial sectors. Even people in very powerful positions, such as the Chairman of the Federal Reserve System, the secretary of the treasury, and members of oversight committees in Congress failed to intercede in time to prevent the massive damage that was done. In loosening restrictions on home loans and other financial practices, the government paved to way for what occurred. In the end, the American taxpayer footed the bill.

In the end, $5 trillion of assets disappeared, 8 million people lost their jobs, and 6 million people lost their homes.

Sage History Home | Twenty-First Century Home | Updated November 7, 2018