U.S. Financial Crisis of 2007-2010
While scholars, economists and leaders continue to compare the 2007-2010 recession to the Great Depression of the 1930's, it is clear that the 2007-2010 financial crisis had a profound impact on a number of key industrial sectors as well as individual consumers. This paper will an overview of the root causes of the financial crisis and discuss efforts to foster a long-term recovery.
Keywords: American International Group (AIG); Housing Bubble; Mortgage-backed Securities; Recession; Repurchase Agreement; Subprime Lending; Troubled Asset Relief Program (TARP); Unemployment
Not long after the start of the Great Depression, famed economist John Maynard Keynes was asked by a reporter if any event like it had occurred before. "Yes," he answered, "it was called the Dark Ages, and it lasted 400 years" (www.Anecdotage.com). While the Great Depression did not last nearly as long as the Dark Ages, it did have an indelible impact on American history. The Depression changed the relationship between the government and the free market, leading President Franklin D. Roosevelt to adopt Keynes's ideal of government intervention in a time of crisis. It also forced upon Americans the notion of self-subsistence, as all family members sought work wherever it could be found, regardless of the location of a job or its suitability, in order to survive and rebuild from the economic collapse.
The Great Depression remains one of the most significant events in modern U.S. history. Since it came to an end during World War II, political leaders in the decades that followed took great steps to implement measures to protect against a recurrence. Entrepreneurs also took great pains to safeguard their businesses in the event of another Depression. Even those whose lives are more than two generations removed from the Depression look back on it in fear, comparing any economic downturn to that devastating period.
In 2007, the global economy began to suffer a series of events that would lead to a staggering economic recession that many dubbed the worst economic period since the Depression. This recession brought corporate and financial industry giants to the brink of failure, resulting in millions of job layoffs and forced property losses for countless businesses and homeowners. While scholars, economists and leaders continue to compare this recession with the Great Depression, it is clear that the relatively short recession of 2007-2010 had a profound impact on a number of key industrial sectors as well as consumers themselves. This paper will look at the root causes of the financial crisis and discuss efforts to foster a long-term recovery.
Depression or Recession?
The Great Depression was indeed one of the most significant periods of economic stagnation in modern history. In the view of many, there were many smaller "depressions" that took place before the Wall Street collapse of 1929. Within this school of economic thought, a depression was simply a period in which a downturn in economic activity occurred. However, the Great Depression was an iconic event, so widespread and devastating that many felt it simply deserved its place in history — any "smaller depression" that occurred after this period would therefore be dubbed a "recession" (Moffat, 2010).
There is very little universal agreement on the difference between a recession and a depression. A common definition of a recession is a period in which a country's gross domestic product (GDP) is in a period of decline over two or more consecutive quarters, although this definition is considered somewhat simplistic, as it does not consider unemployment rates or consumer confidence. What is agreed upon is that the Great Depression, in light of its severity, is typically the benchmark by which subsequent recessions are gauged (Moffat, 2010).
By 2007, the state and the national economies had largely returned to a state of reasonable growth after several years of stagnancy that lasted between 2001 and 2004. However, a number of factors that went largely unnoticed during this recovery helped lay the groundwork for another recession, one that would draw comparisons to the most significant recession in modern history.
The Housing Bubble
In the spring of 2005, Chairman of the U.S. Federal Reserve, Alan Greenspan — whose nearly 20 years in the position gave him instant credibility among political leaders — acknowledged that there was a change in the housing landscape. However, he stopped short of saying there was cause for concern, saying instead that some housing markets had become "frothy" (Freeman, 2005). Others, however, expressed concern that this "froth" was in fact a housing bubble.
A housing bubble in essence is an unexpected increase in the valuations of residential real estate until they reach unsustainable levels. Housing bubbles typically lead to a point at which home values exceed incomes and employment growth, in addition to other economic factors. When a housing bubble "deflates" — a process that is gradual and not explosive — it can even result in negative equity for the homeowner (a mortgage debt that exceeds the value of the property).
The roots of this housing bubble extend back to a 2001-2004 recession and recovery period. The Federal Reserve ("the Fed") recommended that interest rates remain low in order to stimulate spending, as most consumers opted to minimize spending until the crisis was over. Some observers argue that these rates should have been increased after a short period, rather than held low for several years.
While the low interest rates almost certainly played a role in spurring home buying, it is believed that a major culprit was subprime lending. This practice entails offering fixed-rate mortgages to individuals who could afford monthly payments but had poor credit histories. Because it offered growth to the housing industry, subprime lending was even endorsed by the government-backed Fannie Mae and Freddie Mac, the two corporations charged with purchasing and securitizing mortgages for lending institutions (Lynch, 2010). This approach satisfied many political leaders, who were under pressure (and who therefore applied pressure to the relevant agencies) to enable low-income Americans to purchase homes.
As subprime lending became more and more popular in 2004, the housing bubble began to grow. Lenders offered interest-only mortgages and other creative packages to entice lower-income people to buy. They also loosened their credit standards, which further broadened the market. Lenders, according to one real estate analyst, became more concerned with the quantity rather than quality of the mortgages they secured (Burry, 2010). To lower the risks, the lenders would then sell them on Wall Street as mortgage-backed securities. Meanwhile, the government (including Alan Greenspan and Fed officials) openly encouraged Americans to take advantage of record low interest rates and buy a home. Such pronounced endorsements sent buyers to legitimate lenders, but it fostered increased cases of mortgage fraud as well (Burry, 2010).
In 2008, the housing bubble began to collapse upon itself. Homeowners, many of whom were coerced into thinking they could afford their mortgages, could not keep up with monthly payments or increases due to adjustable rate mortgages. In Florida, a state with a traditionally vibrant real estate market, more than one-fifth of the state's mortgages were either 90 or more days behind in payment or were in foreclosure in 2009. The state's population concurrently dropped by 57,000 people (it normally grew by 200,000 to 400,000 people annually), and fewer state tax revenues sent the state budget into a $3.5 billion deficit ("Paradise," 2010, p. 5).
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