In this week’s essay, the Great Recession of 2008 will be analyzed. The duration and severity will be specified along with the root cause. Three individuals, firms, or agencies will be identified that may have contributed the most to the recession and why. The economic actions or controls the US used to fight the 2008 recession will be explained and how effective they were and any actions the US failed to take fighting this recession. Finally, the role of moral hazard will be explained in the recession and the recovery.
The United States suffered the Great Recession of 2008 from Quarter IV of December 2007 to Quarter II of June 2009, which was 18 months (NBER, 2014). The higher level of severity is why the recession obtained the Great before its name. Employment dropped 6.7 percent and consumption was 5.4 percent which is very high compared to other post war recessions. This Great Recession of 2008 is also considered Great because the economy how long the economy has been taking to recover, which was uncommonly long (States News Service, 2017). Usually the economy gets back on track quickly, but the Recession of 2008 took longer.
The root causes of the 2008 recession were the housing prices that declined, the financial system was invested in the housing-related assets and mortgage-backed securities, and the shadow banking system that invested in the housing assets was very vulnerable to bank runs (State News Service, 2017). People were buying houses that they could not afford, and those home loans were considered high-risk to those with risky credit. They were even sold interest only loans, so they could be approved. The Community Reinvestment Act (CRA) had been in place and it helped to increase home ownership. But most of the higher loans were made by lenders not covered by the CRA, and 60 percent of the higher priced mortgages were middle income and upper income borrowers. Fannie Mae and Freddie Mac were created to lower costs of home borrowing by encouraging development of securitized mortgage market. It expanded lending to low quality borrowers and helping to raise home ownership rate. Since they were government-sponsored entities (GSEs), there was no risk and the interest rate was low on the debt. The GSEs market shares declined. When the banks were experiencing the crisis, they did not want to loan any money out at all (S
Credit rating agencies, Congress, and banks contributed the most towards the recession. The Credit Rating Agencies were known as Moody’s Investor Service (Moody’s), Standard and Poor’s Rating Services (S &P), and Fitch Ratings, Ltd. (Fitch). They acted recklessly in the housing market. They were not regulated (Lynch, 2009). Subprime home loans had higher interest yield and could be sold to investors easier as long as they received AAA which was the highest grade from the CRA. The banks did not hold on to these debt obligations before offloading them to investors. Investment banks had a choice and they chose to violate their internal standards instead of saying no to the mortgages (Murray et al., 2017, p. 176). In just two months their AAA rated bonds fell to junk. CRA is regulated by Securities and Exchange Commission (SEC), so it can be said that the SEC failed, but the CRA showed that they had conflicts of interest, incentives that caused issues, and moral hazard (Murray et al., 2017, p. 178). Most of the borrowers did not have written verification of their incomes and got adjustable rate loans.
Congress failed because they pushed Fannie Mae and Freddie Mac and created them. They were to lower the costs of home borrowing to people with risky credit, so homeownership could be higher. They were supposed to be guaranteed not to go bankrupt. A guarantee by the federal government. They borrowed funds at low rates because of federal guarantee and bought high yielding mortgages and mortgage backed securities. Then, Freddie Mac stated they would stop buying subprime mortgage-backed securities. There were risks, miscalculations, and less than par accounting practices, and manipulation of earnings to get bigger bonuses (States New Service, 2009). The GSEs market shares declined. The Treasury Department had to step in with $400 billion to keep them going.
Banks failed because they knew what was going on, but still chose to try to make money on the loans that they knew they should not be loaning. They also failed to deny these home owners out of greed and making more money for themselves.
The US enacted stimulus programs and different types of tax cuts and government spending. The Economic Stimulus Act of 2008 and American Recovery and Reinvestment Act of 2009 (ARRA) were used to help get things back on track. The ARRA was a fiscal stimulus of “$800 billion, the largest in American history” (Klein & Staal, 2017). It was to promote economic recovery. According to Klein and Staal (2017), it had a positive effect on gross state products and they reviewed pre-recession Medicaid spending level to compare. Some states may have been hit harder than others. They used gross domestic product (GDP) on the state level and gross state product (GSP) for the measure of economic activity. The Economic Stimulus Act of 2008 was disbursed as tax rebates in the amount of over $100 billion. They wanted to reverse the effects of the recession. The money made the difference between struggle and survival for some and while it did help, it did not give enough of a push that everyone was looking for. Some businesses were able to hire people with the money.
The economy is better around May 2010, but the unemployment rate was 9.7% even though the ARRA has worked and helped with jobs. Since the unemployment reduces demand, due to companies laying off workers, people stop buying. Housing construction was low and business investments in structures like office buildings, factories, and shopping malls were falling. They could have done better with financial regulatory. The SEC was not regulating the CRAs and it seemed like the unregulated companies were doing whatever and that led to the earlier stock market crash 1929. They also did not protect the consumers that lost their homes or helped them refinance so that they could get rates that were proper and fixed that would allow them to pay their mortgages (Obama Whitehouse, 2010).
Well, one thing the US did not do was help the people that lost their homes. The Stimulus Package did help businesses hire workers.
Moral hazard refers to where a business or person will take more risks because they will not be liable for the costs that would result in them taking those risks (Murray, Manrai, and Manrai, 2017, p. 171). The financial institutions know that they are protected by insurance or the government and they may know more information than the other party involved in certain transactions like the lenders that gave out the loans and knew they should not. They took advantage knowing that homeowners could not afford homes and signed agreements that were misleading or one that they did not understand. Equity was also taken out of homes (Cushman, 2015, p. 9). Institutions knowing that they would be backed, and it would be easy money, granted these loans that never should have been loaned. George W. Bush intervened in the recession with the Troubled Asset Relief Program (TARP) which was a bailout for banks to keep them going as a monetary policy. Another moral play that Congress used was H.R. 1586, The Bonus Recoupment Bill, which was a response to the failure of AIG. The bill gave a 90% tax rate on the bonuses paid out by those that received TARP (Cushman, 2015, p. 15). The recession was caused by this moral hazard, so the companies did not have to take responsibility for the decisions they took those very high risks on and the CEOS received TARP to fix things, but it was still enough to give executives bonuses for what happened and no criminal action. “President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010” (Murray et al., 2017, p. 171). This made new rules for incentive compensation that limited money that could be given from TARP.
Even though the recession of 2008 lasted for 18 months, it still took a while for things to completely get back on track. Declining house prices, mortgage-backed securities were being invested in and lenders were more concerned about getting that higher yield than just saying no to the homeowners. Congress, CRA, and banks all played a part in the recession and it seems like it is based on greed. The ARRA and the Economic Stimulus Package of 2008 did help with jobs and help keep people afloat, but the unemployment was still high at 9.7%. The US failed to protect the homeowners when they lost their homes and the fact that the companies were practicing bad accounting practices, miscalculating, and just taking risks, just because they could helped lead to this recession.
Cushman, T. (2015). The Moral Economy of the Great Recession. Society, 52(1), 9–18. Retrieved from http://libweb.ben.edu/login?url=https://search.ebscohost.com/login.aspx?direct=true&db=s3h&AN=100710982&site=ehost-live&scope=site
Klein, B. & Staal, K. (2017). Was the American recovery and reinvestment act an economic stimulus? Int Adv Econ Res 23: 395.https://doi-org.libweb.ben.edu/10.1007/s11294-017-9655-7
Lynch, T (2009). Article: Deeply and Persistently Conflicted: Credit Rating Agencies in the Current Regulatory Environment. Case Western Reserve Law Review, 59, 227. Retrieved from https://advance-lexis-com.libweb.ben.edu/api/document?collection=analytical-materials&id=urn:contentItem:4WS2-MMY0-00CW-5121-00000-00&context=1516831.
Murray, N., Manrai, A. K., & Manrai, L. A. (2017). The financial services industry and society: The role of incentives/punishments, moral hazard, and conflicts of interests in the 2008 financial crisis. Journal of Economics, Finance & Administrative Science, 22(43), 168–190. https://doi-org.libweb.ben.edu/10.1108/JEFAS-02-2017-0027
National Bureau of Economic Research. (2014). US business cycle expansions and contractions. Retrieved from https://www.nber.org/cycles.html
Obama White House (2010). Treatment and prevention: ending the great recession and ensuring that it doesn’t happen again. Retrieved from https://obamawhitehouse.archives.gov/administration/eop/cea/speeches-testimony/treatment_and_prevention
Schiller, B., Hill, C., and Wall, S. (2013). The macro economy today (13th edition). New York City, NY: McGraw-Hill/Irwin
States News Service. (2009, October 22). Understanding great global contagion and recession. States News Service. Retrieved from Nexis Uni.
States News Service. (2017, February 7). The great recession: a macroeconomic earthquake why it happened, endured and wasn’t foreseen and how its changing theory. States News Service. Retrieved from Nexis Uni.