012006. How the Subprime Mortgage Crisis Caused the Recession
In 2006, the subprime mortgage crisis erupted. On November 17, 2006, the Commerce Department warned that October's new home permits were 28 percent lower than the year before.
At this point, the mortgage crisis could have been prevented. But the Bush administration and the Federal Reserve did not realize how grave those early warning signs were. They ignored declines in the inverted yield curve. Instead, they thought the strong money supply and low-interest rates would restrict any problems to the real estate industry.
They didn't realize how reliant banks had become on derivatives, or contracts whose value is derived from another asset –– essentially betting that these assets will perform well. Banks and hedge funds sold assets like mortgage-backed securities (MBS) to each other as investments. But they were backed by questionable mortgages.
These interest-only loans were offered to subprime borrowers. These high-risk people are most likely to default on a loan. The banks offered them low interest rates. But this “too-good-to-be-true” loan type resets to a much higher rate after a certain period. Home prices fell at the same time interest rates reset. Their defaults caused the subprime mortgage crisis.
Banks had sold too many mortgage-backed securities than what could be supported by good mortgages. When home prices started falling in 2007, it signaled the onset of the real estate crisis.
Banks felt safe because they also bought credit default swaps (CDS). They insured against the risk of defaults. But when the MBS market caved in, insurers did not have the capital to cover the CDS holders. As a result, insurance giant American International Group almost went belly-up. The federal government saved it.
Banks relied too much on derivatives. They sold too many bad mortgages to keep the supply of derivatives flowing. That was the underlying cause of the recession. This financial catastrophe quickly spilled out of the confines of the housing scene and spread throughout the banking industry, bringing down financial behemoths with it. Among those deemed “too big to fail” were Lehman Brothers and Merrill Lynch. Because of this, the crisis spread globally.
On April 17, 2007, the Federal Reserve announced that the federal financial regulatory agencies that oversee lenders would encourage them to work with lenders to work out loan arrangements rather than foreclose. Alternatives to foreclosure include converting the loan to a fixed-rate mortgage, and receiving credit counseling through the Center for Foreclosure Solutions. Banks that worked with borrowers in low-income areas could also receive Community Reinvestment Act benefits.
In September, the Fed began lowering interest rates. By the end of the year, the fed funds rate was 4.25 percent. But the Fed didn't drop rates far enough, or fast enough, to calm markets.
03July 2008. The Recession Began
04August 2008. Fannie and Freddie Went Bankrupt
Mortgage giants Fannie Mae and Freddie Mac succumbed to the subprime crisis. They were government-backed companies that insured mortgages.
Many in Congress then blamed Fannie and Freddie for causing the crisis. They said the two semi-private companies took too many risks in their drive for profits. But the companies were trying to remain competitive in an industry that had become too risky.
On September 29, 2008, the stock market crashed. The Dow Jones Industrial Average fell 777.68 points in intra-day trading. Until 2018, it was the largest point drop in history. It plummeted because Congress rejected the bank bailout bill.
Although a stock market crash can cause a recession, in this case it had already begun. But the crash of 2008 made a bad situation much, much worse.
On October 3, 2008, Congress established the Troubled Assets Relief Program. It allowed the U.S. Treasury to bail out troubled banks. Treasury Secretary lent $115 billion to banks by purchasing preferred stock.
It also increased Federal Deposit Insurance Corporation limit for bank deposits to $250,000 per account. It allowed FDIC to tap federal funds as needed through 2009. That allayed any fears that the agency itself might go bankrupt.
07February 2009. The $787 Billion Stimulus Package
On February 17, 2009, Congress passed the American Recovery and Reinvestment Act. The $787 billion Economic Stimulus Plan ended the recession. It granted $288 billion in tax cuts, $224 billion in unemployment benefits, and $275 billion for "shovel-ready" public works. It also included $54 billion in tax write-offs for small businesses. It followed the plan outlined in Barack Obama's campaign platform.
On February 18, 2009, Obama announced a $75 billion plan to help stop foreclosures. The Homeowner Stability Initiative was designed to help 9 million homeowners before they got behind in their payments. Most banks won't allow a loan modification until the borrower misses three payments. It subsidized banks who restructured or refinanced their mortgage. But it wasn't enough to convince banks to change their policies.
08March 2009. Dow Hit the Recession Low
09March 2009. Making Home Affordable Launched
Making Home Affordable was an initiative launched by the Obama Administration to help homeowners avoid foreclosure. The program generated more than 630,000 loan modifications in its lifespan. That wasn't nearly enough though.
The Homeowner Affordable Refinance Program was one of its programs. It was designed to stimulate the housing market by allowing up to 2 million credit-worthy homeowners who were upside-down in their homes to refinance, taking advantage of lower mortgage rates. But banks only selected the best applicants.
10August 2009. Obama Asked Banks to Modify Loans
By August, foreclosures kept mounting. That dimmed hopes of an economic recovery. Banks could have, but didn't, prevent foreclosures by modifying loans. That's because it would further hurt their bottom line. But record foreclosures such as 360,149 in July only made things worse for them as well as American families. July's foreclosure rate was the highest since RealtyTrac, a real estate information firm, began keeping records in 2005. It was 32 percent higher than in 2008.
Banks believed it was more profitable to foreclose on a house than to make a loan modification, according to some industry analysts. Foreclosures continued rising as more adjustable-rate mortgages came due at higher rates.
More than half or 57 percent of foreclosures were from just four states: Arizona, California, Florida, and Nevada. California banks beefed up their foreclosure departments, expecting higher home losses.
The Obama administration asked banks to double loan modifications voluntarily by November 1. Some analysts said that banks were waiting for housing prices to improve before making loan modifications in the hopes they won't lose as much profit.
11October 2009. Banks Weren't Lending
In October 2009, unemployment peaked at 10.2 percent, the worst since the 1982 recession. Almost 6 million jobs were lost in the 12 months prior to that. Employers were adding temporary workers. They grew too cautious about the economy to add full-time employees. But the fields of health care and education continued to expand.
One reason the recovery was sluggish was that banks were not lending. A Federal Reserve report showed that lending was down 15 percent from the nation's four biggest banks: Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo. Between April and October of 2009, these banks cut their commercial and industrial lending by $100 billion. Loans to small businesses fell 4 percent or $7 billion during the same period, according to Treasury Department data.
Lending from all banks surveyed showed the number of loans made was down 9 percent from October 2008. But the outstanding balance of all loans made went up 5 percent. This meant banks made larger loans to fewer recipients.
The banks said there were fewer qualified borrowers thanks to the recession. Businesses said the banks tightened their lending standards. But if you looked at the 18 months of potential foreclosures in the pipeline, it looked like banks were hoarding cash to prepare for future write-offs. In other words, banks were sitting on $1.1 trillion in government subsidies.
In December of 2009, Bank of America pledged to President Obama that it would increase lending to small and medium-sized businesses by $5 billion in 2010. But that was only after slashing lending by 21 percent or $58 billion in 2009.
12Why Not Let the Banks Go Bankrupt?
People are still angry about the $350 billion in taxpayer dollars that was used to bail out the banks. Many people feel that there was no oversight. They believe that the banks just used the money for executive bonuses. In this case, people think banks should not have been rescued for making bad decisions based on greed. The argument goes that, if we had just let the banks go bankrupt, the worthless assets would be written off. Other companies would purchase the good assets and the economy would be much stronger as a result. In other words, let laissez-faire capitalism do its thing.
In fact, that is what Former Treasury Secretary Hank Paulson attempted to do with Lehman Brothers in September. The result was a market panic. It created a run on the ultra-safe money market funds, which threatened to shut down cash flow to all businesses, large and small. In other words, the free market couldn't solve the problem without government help.
In fact, most of the government funds were used to create the assets that allowed the banks to write down about $1 trillion in losses. Also, there were The other problem is that there were no "new companies," i.e. other banks that had the funds to purchase these banks. Even Citigroup required a bailout to keep going, though it was one of the banks that the government had hoped would bail out the other banks.
If we had let the major banks go bankrupt, we would have ended up with no financial system. Then we truly could have had another great depression on our hands.
13Why Didn't Obama Do More to End the Recession?
Part of the problem was that Obama wanted to accomplish some of his other objectives before the mid-term elections.
He also supported the Dodd-Frank Wall Street Reform Act. That, and new Federal Reserve regulations, were designed to prevent another banking collapse. It also made banking much more conservative. As a result, many banks didn't lend as much. They were conserving capital to conform to regulations and write-down bad debt. Bank lending was needed to spur the small business growth needed to create new jobs.
The bill stopped the bank credit panic, allowed Libor rates to return to normal, and made it possible for everyone to get loans. Without credit market functioning, businesses are not able to get the capital they need to run their day-to-day business.
Without the bill, it would have been impossible for people to get credit applications approved for home mortgages and even car loans. In a few weeks, the lack of capital would have led to a shutdown of small businesses, which couldn't afford the high-interest costs. Also, those whose mortgage rates reset would have seen their loan payments jump. This would have caused even more foreclosures. The Great Recession would have become a depression.
The cause of the meltdown was deregulation of derivatives that were so complicated that even their originators didn't understand them. Find out what they are, how they work, and how they will muck up the economy for years to come.
16Other Economic Crises
The U.S. economy has suffered from many other economic crises. That gives us hope because we learned more about how the economy works and became smarter about managing it. Without that knowledge, we would be in much worse shape today.
The Great Recession of 2008 Explained with Dates
What Happened and When?
The first signs of the Great Recession started in 2006 when housing prices began falling. By August 2007, the Federal Reserve responded to the subprime mortgage crisis by adding $24 billion in liquidity to the banking system. By September 2008, Congress approved a $700 billion bank bailout, now known as the Troubled Asset Relief Program. By February 2009, Obama proposed the $787 billion economic stimulus package. His move to create an economic stimulus helped avert a global depression. The financial crisis timeline reveals the early warning signs and causes that sparked the financial crisis in 2007.