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The recession of 2007-2009 Report

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Updated: Jan 29th, 2020

Abstract The 21st Century experienced a financial crisis which followed the recession that began in December 2007 lasting up to June 2009. The objective of this paper is to explain the main cause of this crisis and its effect on the international financial system as well as the economies of the affected counties. It gives a background of the “boom and bust” of the housing bubble which was the major cause of the financial crisis as the house prices fell leading to loss of the security value.

Consequently, the financial institutions to which these securities belonged suffered great losses. The rate of unemployment increased to 10% in 2009 from 5% in 2008(“Bureau of labor statistics: unemployment rate” par 1). The federal funding interest rates dropped to zero (“FRBSF: crisis and response” par 4).

The gross domestic product on the other hand decreased by approximately 5.1% and the loss of payroll jobs was at about 6.1 %( “FRBSF: crisis and response” par 1). The Federal Reserve rates reduced to zero which was the lowest they point of measure for the rates. They depended on other programs to revive the economy including quantitative easing which was divided into three phases QE1, QE2 and QE3.

In addition, there were other monetary policies like Operation Twist and Trouble Assistance Program (TARP). The government resulted to tax cuts as well an increased government spending (“FRBSF: crisis and response” par 2). These monetary and fiscal policies seemed to have a positive impact on the economy with the GDP rose from 0.4% in the fourth quarter of 2012 to 2.5%in the first quarter of 2013. Introduction The international and the US financial system were threatened as a result of the 2007-2009 recession.

This paper examines the factors that led to the recession and provides a critical evaluation of the monetary and fiscal policy measures undertaken by policy makers. Section 2 analyses the factors that led to the recession. Section 3 describes the impact of the financial crisis on the economy. Section 4 focuses on monetary policy and fiscal policies undertaken by the FED and the government to resolve the crisis.

This fact is followed by Section 5 which evaluates the impact of these monetary and fiscal policies while Section 6 assesses the current state of the economy after the crisis. The final section presents the conclusion. Causes of the recession Commercial banks were the only financial institutions that gave mortgages in the 1970’s. These mortgages could not be resold as there was no secondary market in which to sell them.

Mortgages and other loans began to be securitized by banks to enable them to be sold in the secondary markets. The mortgages were grouped together to create mortgage-backed securities (MBS) then sold to investors (“FRBSF: crisis and response” par 1). However, the banks had a difficult time in reselling the mortgages because no investor was willing to risk purchasing them as they feared incurring losses when the borrower defaulted.

To deal with this problem, government sponsored enterprises (GSE) like the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) established in 1938 and 1970 respectively came into perspective. They acted as middlemen between the investors and the banks by purchasing the mortgages from the banks, securitized them, and then resold the MBS to investors. This fact enabled banks to earn more money which they could then use to give other loans.

More households were able to obtain loans hence increasing home ownership as well as the price of housing. By the year 2000, investment banks and other shadow banking systems were participating in the mortgage-backed securities business as they were more profitable than other securities.

The thriving housing business also attracted international business people who invested in the US real estate sector (“FRBSF: crisis and response” par 1). A recession hit the US in 2001 and was worsened by the September 11th terrorist attack .To tackle the recession, the FED reduced the federal fund rate from 3.0% to 2.5% the same year.

In 2002, lenders began issuing subprime lending which was the granting of loans to unworthy credit borrowers. These borrowers were then given adjustable rate mortgage (ARM) loans which required them to only state their income and were therefore not subjected to any credit assessment( “FRBSF: crisis and response” par 1). The ARM loans allowed the borrower to pay lower rates in the first two or three years after which they would be increased.

This easy access to credit increased the demand for home ownership and so the price of housing increased (“Federal reserve board” opinion on lending standards” par 2). In the event that the borrower could not pay, he was able to sell the house at a profit. In 2004, the FED realized that it had erred in overly reducing the taxes and to fix this it increased taxation (“FRBSF: crisis and response” par 3).

As a result, housing prices began to reduce in 2006 and the borrowers could not make any profit from the sale of their houses as the value of the mortgage-backed securities had also plummeted. Subprime mortgage borrowers started defaulting in their payments which led to the lender foreclosing on them and reselling the houses which led to the housing prices declining further. The financial firms that owned these securities suffered great losses.

Although the commercial banks were also affected, the investment banks like the Lehman Brothers and Bear Stearns were grievously affected. This fact is because they were highly leveraged meaning that a huge part of their operating money was “borrowed” money from the investors and the remaining small amount was theirs. GSEs were not spared either; Fannie Mae and Freddie Mac were ruined and therefore declared bankrupt. The financial market plummeted and the recession began.

The impact of the financial crisis on the US economy The financial crisis of 2007-2009 hit the US economy so “hard” that it left the stock market, employment rates, GDP and other sectors plummeting. In the 3rd quarter of 2008, the GDP was at 5.6% below its potential rank, while the rate of unemployment was at 10% in 2009 up from 5 % in 2008(“Federal reserve economic data” par 1). Approximately 8.8 million people were left jobless after the recession struck (“Bureau of labor statistics” par 1).

Housing prices went up by about 30% in the year 2008. Individuals close to 5.4 million gave up searching for employment and resulted to the Federal Disability Support. As the inflation continued, median household earnings went down to approximately $49,500 in 2010(Manuel 1). The stock market also plunged with Dow Jones Industrial Average declining by 20% to close at 6,763.29 on the 2nd of March 2009(“Yahoo finance:DJIA historical prices” par 1).

Monetary and fiscal policies The Federal Reserve undertook several measures in terms of monetary policies in order to stabilize the economy and minimize the damage to the financial system. The FED had lowered the federal funding rate to zero and could not lower it any further and opted for other means.

In March 2008, the FED gave financial firms including investment banks short term loans to enable them to run their daily operations. Primary dealers that stuck with mortgage-backed securities that had lost value were provided with treasury securities worth up to $200 million (“FRBSF: crisis and response” par 2).

Apart from providing liquidity, the FED facilitated the acquisition of collapsing investment banks like Bear sterns, Lehman Brothers, Government Sponsored Enterprises like Fannie Mae and Freddie Mac by the government to save the economy from further damages that came with investors’ withdrawal of funds(FRBSF: crisis and response” par 2).

In October, 2008, the Trouble Assistance Relief program was launched that saw the FED buying stock from financial institutions so as to provide the former with money. The FED also embarked on a program known as quantitative easing, a non-traditional monetary policy where by the FED directs money into the economy by purchasing commercial banks and other private financial institutions’ financial assets in a bid to improve the economy.

This quantitative easing was divided into three stages named QE1, QE2 and QE3.QE1 involved the easing of credit where the FED bought mortgage-backed securities and other debts from the banks and in exchange, the banks would be able to increase their reserves. After QE1 failed to revive the economy, QE2 was launched and FED began buying treasury securities hoping to stimulate demand.

Evaluation of monetary and fiscal policies The FED decided to provide financial institutions with funds to ease the credit market which had frozen and to reduce taxes so as to raise consumer spending as the two would have worsened the already strained financial system (“CNN money: Economy” par 1). Although the decision to save the collapsing investment banks was a tough one, the FED opted to bail them out instead of letting the economy plummet further.

The recession had left the government budget with a deficit due to the reduced tax returns but economists believe that the $825 billion stimulus package plunged the government into more debt as it had to result in borrowing to compensate for the extra expenditure. The borrowing would increase interest rates so as to fund the economy’s recovery. The increased government expenditure is also believed to reduce private expenditure by “crowding” them out (“Economy. Help: criticisms of fiscal policies” par1).

Current state of the economy The Gross Domestic Product (GDP) has increased from 0.4% in the 4th quarter of 2012 to 2.5% in the first quarter of 2013(“Bureau of economic analysis: US economy at a glance” par 1). The unemployment rate has decreased from 10% in 2009 to 7.5% in April, 2013.Payroll jobs have increased by 165,000 as of April, 2013(“Wells Fargo: economic forecast” par 1).

The recession of 2007-2009

Gross Domestic Product (GDP) Graph Source.

Conclusion

The 2007-2009 recession was not the first economic crisis in the world. Other crises have been experienced like The Great Depression of 1929-1933, the 1982 recession as well as the 2001 recession. Certain similarities can be made in all the said recessions. In both 1929 and 2007, there were long-term unemployment rates, rising inequality in the wealth gap and inflation rate.

However, certain differences exist. In 1929, the real estate market was not badly affected and the prime lending rate (PLR) did not go up like it did in 2007 and in 1929. The PRL rates in 1929 went up by about 20% while in 2007 they remained at 1% through the recession. The lessons that can be made from this crisis include enforcement of appropriate regulation on financial institutions as well as adherence to standard lending rates by major business firms.

Works Cited

Bureau of Economic Analysis. US Economy at a Glance: . 2013. Web.

Bureau of Labor Statistics. Unemployment rate. April 3. 2013. Web.

CNN Money. Economy. 2013.Web.

Economics Help. Criticisms of fiscal policies. April 4. 2013. Web.

Federal Reserve Board. . 2013. Web.

Federal Reserve Economic Data. Federal funds rate. 201. Web.

Federal Reserve Bank of San Francisco. FRBSF: Crisis and Response. 2013. Web.

Manuel, D. Dave Manuel.com. . 2013.Web.

Wells Fargo Securities. Economic forecast. 2013. Web.

Yahoo Finance. Dow Jones Industrial Average (DJIA); Historical prices. 2013. Web.

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