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What Was the Great Recession? Key Takeaways The Great Recession refers to the economic downturn from to after the bursting of the U. The Great Recession was the most severe economic recession in the United States since the Great Depression of the s. In response to the Great Recession, unprecedented fiscal, monetary, and regulatory policy was unleashed by federal authorities, which some, but not all, credit with the subsequent recovery.
Important The Dodd-Frank Act enacted in by President Barack Obama gave the government control of failing financial institutions and the ability to establish consumer protections against predatory lending. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation.
This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Terms The Great Moderation The Great Moderation was a period of decreased macroeconomic volatility in the United States from the mids to the financial crisis in Learn About the European Sovereign Debt Crisis The European debt crisis refers to the struggle faced by Eurozone countries in paying off debts they had accumulated over decades.
It began in and peaked between and Economic Stimulus Economic stimulus refers to attempts by governments or government agencies to financially kickstart growth during a difficult economic period. In a working paper, Fligstein and co-author Alexander Roehrkasse doctoral candidate at UC Berkeley 3 examine the causes of fraud in the mortgage securitization industry during the financial crisis.
Fraudulent activity leading up to the market crash was widespread: mortgage originators commonly deceived borrowers about loan terms and eligibility requirements, in some cases concealing information about the loan like add-ons or balloon payments. Banks that created mortgage-backed securities often misrepresented the quality of loans. For example, a suit by the Justice Department and the U.
The authors look at predatory lending in mortgage originating markets and securities fraud in the mortgage-backed security issuance and underwriting markets. After constructing an original dataset from the 60 largest firms in these markets, they document the regulatory settlements from alleged instances of predatory lending and mortgage-backed securities fraud from until Fraudulent activity began as early as when conventional mortgages became scarce.
Several firms entered the mortgage marketplace and increased competition, while at the same time, the pool of viable mortgagors and refinancers began to decline rapidly. To increase the pool, the authors argue that large firms encouraged their originators to engage in predatory lending, often finding borrowers who would take on risky nonconventional loans with high interest rates that would benefit the banks. In other words, banks pursued a new market of mortgages—in the form of nonconventional loans—by finding borrowers who would take on riskier loans.
This allowed financial institutions to continue increasing profits at a time when conventional mortgages were scarce. Moreover, because large firms like Lehman Brothers and Bear Stearns were engaged in multiple sectors of the MBS market, they had high incentives to misrepresent the quality of their mortgages and securities at every point along the lending process, from originating and issuing to underwriting the loan. Fligstein and Roehrkasse make the case that the integrated structure of financial firms into multiple sectors of the MBS industry, alongside the marketplace dynamics of increased scarcity and competition for new mortgages, led firms to engage in fraud.
FOMC members set monetary policy and have partial authority to regulate the U. Fligstein and his colleagues find that FOMC members were prevented from seeing the oncoming crisis by their own assumptions about how the economy works using the framework of macroeconomics. Their analysis of meeting transcripts reveal that as housing prices were quickly rising, FOMC members repeatedly downplayed the seriousness of the housing bubble.
Even after Lehman Brothers collapsed in September , the committee showed little recognition that a serious economic downturn was underway. The authors argue that the committee relied on the framework of macroeconomics to mitigate the seriousness of the oncoming crisis, and to justify that markets were working rationally.
They note that most of the committee members had PhDs in Economics, and therefore shared a set of assumptions about how the economy works and relied on common tools to monitor and regulate market anomalies. The meeting transcripts show that the FOMC tried to explain the rise and fall of housing prices in terms of fundamental issues of supply and demand, which was an inadequate frame to recognize the complexity of the changes taking place throughout the entire economy.
FOMC members saw the price fluctuations in the housing market as separate from what was happening in the financial market, and assumed that the overall economic impact of the housing bubble would be limited in scope, even after Lehman Brothers filed for bankruptcy. These topics were often discussed separately in FOMC meetings rather than connected in a coherent narrative.
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.
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Key Points The subprime mortgage crisis in signaled the beginning of the Great Recession. Because they were confident that home mortgages were sound collateral for MBS, banks and other financial corporations invested in these in the form of derivatives. To feed the rapid rise in demand for derivatives, many interest-only loans were cobbled and made available to even subprime borrowers or those who lacked creditworthiness.
Subprime borrowers started defaulting when the housing bubble burst at the same time the Fed raised rates in Derivatives based on subprime mortgages lost value.
Lehman Brothers declared bankruptcy. The stock market crashed in In fact, the loan verification process was so lax at the time that it drew its own nickname: NINJA loans, which stands for "no income, no job, and no assets. Because subprime mortgages were granted to people who previously couldn't qualify for conventional mortgages , it opened the market to a flood of new homebuyers. Easy housing credit resulted in the higher demand for homes. This contributed to the run-up in housing prices, which led to the rapid formation and eventual bursting of the s housing bubble.
While interest rates at the time were low , subprime mortgages were adjustable-rate mortgages, which charged low, affordable payments initially, followed by higher payments in the years thereafter.
The result? Borrowers who were already on shaky financial footing stood a good chance of not being able to make payments when the interest rate rose in the years following. In the rush to take advantage of a hot market and low interest rates, many homebuyers took on loans without knowing the risks involved.
But the common wisdom held that subprime loans were safe since real estate prices were sure to keep rising. Along with issuing mortgages, lenders found another way to make money off of the real estate industry: By packaging subprime mortgage loans and reselling them in a process called securitization.
Through securitization, subprime lenders bundled loans together and sold them to investment banks, which, in turn, sold them to investors around the world as mortgage-backed securities MBS. Eventually, investment banks started repackaging and selling mortgage-backed securities on the secondary market as collateralized debt obligations CDOs.
These financial instruments combined multiple loans of varying quality into one product, divided into segments, or tranches, each with its own risk levels suitable for different types of investors.
The theory, backed by elaborate Wall Street mathematical models, was that the variety of different mortgages reduced the CDOs' risk. The reality, however, was that a lot of the tranches contained mortgages of poor quality, which would drag down returns of the entire portfolio. Investment banks and institutional investors around the world borrowed significant sums at low short-term rates to buy CDOs.
And because the financial markets seemed stable on the whole, investors felt secure about taking on more debt. To make matters even more complicated, banks used credit default swaps CDS , another financial derivative, to insure against defaults on CDOs.
Banks and hedge funds started buying and selling swaps on CDOs in unregulated transactions. Also, because CDS transactions didn't show up on institutions' balance sheets, investors couldn't assess the actual risks these enterprises had assumed. Like corporate bonds and other forms of debt, MBS and CDOs required the blessing of credit rating agencies in order to be marketed.
These agencies placed AAA ratings — usually reserved for the safest investments — on many securities, even though they contained a healthy share of risky mortgages. It's worth noting that credit rating agencies are supposed to be independent. But an inherent conflict of interest seems to have existed since the banks issuing the securities were the ones paying the agencies to rate them.
After staying low throughout the early s, interest rates began to rise starting in in response to an overheating economy and fears of inflation. In mid, the federal funds rate was 1. By mid, the interest rate was 5. By mid, home prices were peaking and the market was slowing down. When supply started to outpace demand, home prices spiraled.
The combination of high interest rates and falling home prices made it extremely difficult for buyers to make payments on their homes.
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