Student Question
What economic factors led to the Great Recession in 2007 and how did the government respond?
Quick answer:
Economic factors that led to the Great Recession of 2007 included low interest rates, which led to an increase in risky borrowing by homeowners. Banks packaged these mortgages into large debt obligations that were sold to investment banks. With so much of the economy wrapped up in these risky loans, total economic collapse became possible once homeowners began defaulting on their mortgages. The government responded by creating bank bailouts and cutting interest rates.
Several economic factors combined to create the Great Recession of 2007. The seeds of the recession were planted in 2001, when the federal reserve lowered interest rates to a low of 1.75% in December 2001. This led to a massive increase in borrowers with poor credit being issued loans to buy expensive homes. Banks were all too eager to provide loans to these homebuyers. The price of homes rose sharply, but it was still easy for homebuyers to acquire subprime mortgages at less than favorable interest rates. During this time, the federal reserve continued to lower interest rates, reaching a low of 1% in June 2003. This only made it easier for banks to issue risky loans.
The repeal of the Glass-Steagall Act during the previous decade made it possible for banks to combine these mortgages into collateralized debt obligations, which they then sold to investors. In order to promote...
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investments, the Securities and Exchange Commission (SEC) relaxed federal investment regulations. This allowed investment banks to leverage these packages many times over.
However, when interest rates rose, many subprime borrowers found themselves unable to afford their mortgage payments and defaulted. In early 2007, subprime lenders found that they were not receiving enough payments from borrowers and many filed for bankruptcy. With over one trillion dollars in securities backed by failing subprime mortgages, investment banks faced the prospect of losing everything. This led to sharp drops across the stock market.
The federal government responded quickly to the crisis. When cuts by the federal reserve to the discount and funds rate proved ineffective, the government was forced to enact legislation to address the impending recession. Congress passed the National Economic Stabilization Act in October 2008. This act created 700 billion dollars which were used to buy failing securities. This is considered by many to be a bailout of the big banks and is controversial. Some say it rewards investment banks for taking risks with the economy. At any rate, it was enough to stem the tide of the recession.
In February 2009, the American Recovery and Reinvestment Act was passed, which implemented sweeping spending and tax cuts. This included billions of dollars to help homeowners avoid defaulting on their mortgages. At the same time, the federal reserve lowered interest rates once again. Taken together, this avoided further defaults on mortgages and restabilized the economy.
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