The Great Recession by Peter Mikel

The current economic crisis affecting the United States (and the rest of the world) has many causes which include: market fluctuations, government regulation and deregulation, political pressure, excess spending, and the desire to achieve the “American Dream.” The timeline of events can be summarized briefly as follows: The housing market crash led to the exposure of the sub-prime mortgage crisis which, in turn, caused several major banks in the United States and Europe to fail. The failure of these banks caused a large reduction of available credit. The lack of credit then created a great liquidity crisis. This caused major downturns in the stock market and more bank failures. Throw in a jump in oil prices, an inflated US dollar, some accounting scandals, and the result is a world class recession.

A recession in economics, as defined by David O’Conner and Christopher Faille in their book Basic Economics, is “an extended decline in general business activity, typically two consecutive quarters of falling real gross national product”(234). The falling quarters are usually preceded by several slow growth quarters. Recessions are one of several recurring events caused by fluctuations in our economy. Economic re-alignments include depressions, inflationary times, high growth periods, as well as recessions. Recessions are normal patterns of our modern economic system and have occurred since the founding of the United States. According to the website Recession.org, the first recession, known as the Panic of 1797, lasted three years. The economy has suffered through twenty recessions since 1797 and is at the beginning of its twenty-first.

Although market fluctuations are normal, each economic change is associated with one or more factors. The trigger for the current financial chaos was the fall of the housing market in December of 2007. The housing market crash started in the normal fashion, as a boom in the preceding years. Property values began increasing at levels not seen in the past, and borrowers were able to qualify for mortgages that exceeded the previously allowed income ratios with reduced credit ratings. The home builders, seizing on the new markets, began to build. The United State’s Census Bureau statistics show this trend continued from 1996 to 2005. Homes sales began to drop by the end of the first quarter in 2006, and by fall of 2007 the number of properties for sale exceeded the market demand.

The surplus of homes on the market occurs for several reasons: the borrowers who are under-qualified are beginning to have financial issues and sellers are trying to cash in on the large profit due to the unfounded increases in property equity. In addition, the builders, not paying attention to the market, continue building. These factors led to 1.8 million homes sitting empty before those involved looked up the street and saw the glut of “For Sale” signs (United States). The price of real estate fell, making it more difficult for people to refinance. The United States Census Bureau statistics indicate the lowest number of housing starts since 1959. Construction companies scaled back production and laid workers off, causing the same responses in the building materials industries. The foreclosure rates began to increase.

If the trigger is the housing market crash, the silver bullet is the sub-prime mortgage crisis. The federal government, through its policies, created the foundations for the sub-prime fiasco. The term “sub-prime” refers to a borrower that is not “prime.” These are borrowers who might be less likely to repay a loan (O’Conner and Faille 236). In the past, lenders made fewer sub-prime loans due to the increased risk. This began to change in 1977 with the Community Reinvestment Act (CRE). The government wanted to prevent unfair or biased lending practices and help middle to lower income families achieve the American dream of home ownership. According to Kavous Ardalan in his article “Community Reinvestment Act: Review of Empirical Evidence,” the CRA did not punish lenders who chose not to make sub-prime loans. However, they put them on a watch list. This was the first step toward the government telling the mortgage lenders to whom to make loans as well how to make loans. The next step came in 1992, with the Federal Housing and Financial Safety Soundness Act, it required the two quasi-government agencies, Federal Home Loan Mortgage Corporation (FHLMC), also known as Freddie Mac, and Federal National MortgageAssociation (FNMA), known as Fannie Mae, to be regulated by the Department of Housing and Urban Development (HUD). They were also required to designate a percentage of the loans they purchased to be allocated to affordable housing. Lending was, then, no longer financially based; it was now also politically motivated.

Sub-prime lending was now mandatory for Freddie Mac and Fannie Mae, which were originally designed to purchase and securitize mortgages so that funds would be available for home lending institutions. To “securitize” mortgages means large blocks of loans are grouped together, a process referred to as “bundling,” to create a security that can be sold to financial brokers as investments. The investments created were originally highly rated, safe investments. This changed as the number of sub-prime mortgages increased and, ergo foreclosure rates increased. In September 2008, when the Federal Government took control of FHLMC and FNMA, they held almost fifty percent of the mortgages in the United States, of which there are approximately thirty percent were sub-prime. It is this situation that William Pool, President of the Federal Reserve Bank in St. Louis, refers to when he states that the government sponsored enterprises (Freddie Mac and Fannie Mae) need more oversight (Poole 154).

The banking and financial industry failures were precipitated by government deregulation. During the Great Depression the Glass-Steagall Act of 1933 was passed. Also known as the Banking Act of 1933, it separated the commercial banking from the securities industries. The need for this separation was due to conflict of interest and fraud which led to the failure of banks during the 1930s. The Banking Act of 1933 was repealed in 1999. The reasoning was that US banks were not able to compete with banks outside of the US that offered a “full range” of financial services.

As a result, financial institutions, including banks, investment firms, brokerage agencies and insurance companies became “one stop shopping” financial services companies. Each area was regulated, but there was not an entity that watched the big picture. The repeal of the Banking Act caused a boom for the financial industries, as companies could move into markets that were previously unavailable to them. The following scenario played out innumerable times over the last ten years: a financial institution makes a loan with “new improved” standards for qualifications and “new improved” loan programs like adjustable rate mortgages (also called ARMs). The company profits from the loan origination and disregards the quality of the note, since it is going to be re-sold to another investment firm or to Freddie Mac or Fannie Mae. The sub-prime, high risk loans will be off its books. The company then uses the profits to buy loan-based securities for its investment side portfolios. In the article, “The Only Real Mistakes…Are the Ones We Don’t Learn from,” Louis Grumet believes it may be time to re-instate a version of the Glass-Steagall Act. Many financial gurus, bankers, investment analysts, and real estate professionals thought these markets would continue to climb despite the common sense and the lessons taught by history.

When the foreclosure rates began to increase, the companies that heavily invested in the mortgage securities began to have liquidity problems. The cash flow problem was caused from two sides: (1) the mortgage securities values began to decrease, and (2) the short term credit money was not available from other sources. The short term money lent between financial companies was not available since there was insufficient collateral, due to the de-valuation of the mortgage securities. The mortgage securities quickly turned from asset to liability. They became known as “toxic assets” with good reason; if a firm had these former assets, it was dead to the financial world.

The housing market crash, as well as the sub-prime mortgage problem, would not have occurred, or would not have been as catastrophic, if the American consumer had shown restraint. Many people, failing to look at their spending habits, chose to blame others for their own lack of financial discipline. Scapegoats include politicians (Democrats and Republicans), bankers and stockbrokers. The financial corporations did not force buyers to buy a house or refinance their mortgage with adjustable rate mortgages. The ARMs make up eighty percent of the sub-prime mortgages made in the last three years. The stockbrokers did not force consumers to maintain an average credit card balance of $8,000. It is not our elected officials’ fault that the average American spent six percent more than their annual salary during the previous six years as Economist Howard Davidowitz explains during his interview by Aaron Task. If one cannot or does not make a mortgage payment, it is ultimately the responsibility of the borrower.

Citations