Introduction: with the lending of subprime mortgages en masse

Introduction:

 

The 2008, 2009, 2010 recession has had its
impact felt across the globe, effecting the economies of many countries for
years to come, and has now been dubbed the ‘Great Recession’. Beginning with
the lending of subprime mortgages en masse in the US housing market became a full-blown
recession by the end 2007. There is an old saying that says when the US catches
a cold, the rest of the world sneezes. This was proven true as large economies
such as Japan and the European Union jointly went into a recession by mid-2008.
2009 was the first time since the Second World War that the world entered into
a recession, an unfavorable turn of events from the positive, booming of the
economy between 2002-2007.

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Causes:

 

Money Markets

 

When Americas housing market began its turn
for the worse, a chain reaction exposed how fragile the financial system was.
Mortgage backed securities plummeted in value, assuming they had any value to
begin with. It became increasingly difficult to sell assets at almost any
price, as no one was willing to take any investment risk, so investors began to
hold their cash instead of investing in the markets. Trust, the glue that holds
all financial systems together began to deteriorate. Banks began to question
the viability of their counterparties in 2007.

Chains of debt between lenders and
investors were vulnerable to failing to one small link in the chain breaking.
AIG, an American insurance giant, forced to dissolve under the weight of
credit-risk protection they had sold, days after the bankruptcy of the Lehman
Brothers, a large global bank. The entire financial system was exposed to have
been built upon a foundation of betting on themselves with borrowed money,
something that worked in the past when the economy was strong, but proved
catastrophic when it was failing. The major banks had not set aside enough
capital to absorb losses and thus was the beginning of the largest collapse of
the American economy of our generation.

 

The role of AIG – the biggest insurance
company in the world

 

AIG was selling insurances for products of
the financial market, not only typical health insurances. The most important
product they provided insurance for were credit default swaps (CDS’s). These
worked in a way where AIG would insure an investor’s CDO, the investor would pay
a quarterly premium to AIG. AIG would pay the investor out his losses in case
of default.

AIG not only sold CDS to protect the owners
of CDO’s, but also sold them to speculators to wager against the CDO’s they did
not own. They were able to issue and sell mass quantities of them as there was
no legislation in place or regulations requiring CDS to put money aside in case
of default. When the CDO’s began to fail, it became apparent AIG could not
protect their investors and could not pay their duties. When AIG went bankrupt,
the insurance policies they had issued defaulted.

 

Central banks

 

The central bankers did not keep economic
imbalances in check and did not exercise proper oversight of the large
financial institutions. The government made no effort to curb or slow down the
housing bubble. They could have raised interest rates, lowered the maximum
loan-to-value ratio on a mortgage that was available, or passed legislation to force
the major banks to keep more capital on hand in case of mass insolvency. Banks operated
with minimal equity, leaving them susceptible if anything were to go wrong.
From the mid-1990s, they were more frequently allowed to use internal models to
assess risk, essentially allowing themselves to create their own capital
requirements. A major error the government made was allowing the Lehman
Brothers to go bankrupt, causing mass panic in the financial market. Upon the
collapse of the Lehman Bros., nobody trusted anybody and therefore would not
lend. Companies began to hold their cash and assets and froze spending, as they
could not rely on being able to borrow money to purchase supplies or pay
salaries of employees. The decision by the Government to not intervene and
allow Lehman to bankrupt ending up causing more government intervention later
on. Tons of companies needed bailing out by regulators to curb the subsequent
panic.

 

 

Role of US subprime mortgages

 

In the years leading up to the crisis, banks
took part in irresponsible mortgage lending, loaning money to ‘subprime’
borrowers with bad credit who struggled to repay them, en masse.

The risky mortgages were passed on to the
big banks who turned them into what were supposed to be low-risk securities by
pooling them together in large numbers. This only works when the risks of the
loans are uncorrelated, but being all mortgage loans to predominantly subprime
lenders, the risks were highly correlated. Starting in 2006, America began its
decline into a nationwide housing market slump, where homes across the country
began to drop in value

The pooled mortgages were used to as
collateral for pooled assets called Collateralized Debt Obligations or (CDO’s),
which were separated into sections based on how safe from defaulting they were.
Investors bought the safer CDO’s as they trusted the ratings that were assigned
to them by agencies like Moody’s and S&P’s. Those agencies were paid by the
banks that created the CDO’s and thus were too generous in assessing them with
triple-A credit ratings.

Investors felt comfortable investing into
these securitized products as they appeared relatively safe and it was a time
when interest rates were low, and they were providing higher returns.

The low interest rates incentivized banks,
hedge funds and investors to seek our other investments that albeit may have
been riskier, but offered higher returns. The low interest rates also allowed
investors to borrow and use the excess cash to invest further, based on the
assumption that the returns would exceed the costs of borrowing.

Ultimately, there was far too much money lent
out to investors at low interest rates, along with the millions of subprime
mortgages, which was a defining factor in what became the 2008-2010 recession.

 

Getting off track: How Government Actions
and Interventions Caused, Prolonged, and Worsened the Financial Crisis by John
B. Taylor. Hoover Institution Press. 2013

 

 

 

Impact on Canada’s economy, US economy
(GDP, unemployment, inflation),

 

The financial crises had several negative
impacts on the local and global economy, banks, financial institutions,
individual households and businesses.

Many major banks suffered serious losses
and some forced into bankruptcy. Many banks lost large amounts of capital as
consumers lost faith in them and pulled their money out of their accounts,
resulting in a shortage of funds.

Because of the loose laws and regulations
that were in place, which were partly responsible for the collapse of the
economy, many financial institutions today are subject to stricter
requirements.

Furthermore, the financial crisis affected
households as consumers’ confidence in the financial institutions fell, and
thus people saved more and consumed less. Because of reduced consumptions by
households, the profits of many firms decreased and thus they began to lay
people off, increasing unemployment. Households had less disposable income and many
homes had to sign up for unemployment and food stamps, using more resources the
government did not have at the time.

Some statistics about the impact the
recession had on the U.S. economy are as follows.

U.S households lost an average of $5,800 in
income due to the reduction in economic growth during the period of time
between September 2008 and the end of 2009.

The federal government spent on average
$2,050 per U.S. household to mitigate the damage of the financial crisis.

The average household lost nearly $100,000
in declining stock and home values between July 2008 and March 2009.

The U.S. lost an estimated $648 billion due
to slowed economic growth.

The U.S. lost $7.4 trillion in stock wealth
from July 2008 to March 2009.

5.5 million American jobs were lost due to
slower economic growth.

 

The impact on the
world economy

 

The United States economy was estimated to
have shrunk by 2.7 percent in 2009. The most severely affected were
middle-incomes countries, especially in Central and Eastern Europe and the
Commonwealth of Independent States. The primary causes being the combination of
the major financial institutions being heavily reluctant to loan, and the
domestic imbalances such as the housing bubble and a large number of households
and businesses with account deficits. Due to its links with the United States,
most of Latin America fell into a deep recession itself. Mexico was hit the
hardest, their economy contracted by 7.1 percent in 2009 alone. Most low-income
countries avoided a recession, but suffered seriously slowed growth, which
nonetheless had a negative impact for poverty going forward. Based on the ILO’s
Global Employment Trends, the number of registered unemployed persons was
estimated at 212 million in 2009, 34 million more than the number estimated in
2007 before the recession had truly taken place. China and India have notably
continued to grow strongly during the crisis, as they have large emerging economies,
which are supported by domestic demand and government spending. Japan’s
economy, the world’s second largest, is deteriorating at its worst pace since
the oil crisis of the 1970s, hurt by shrinking exports and anemic spending at
home. The U.K. government provided $88 billion to buy banks completely or
partially and promised to guarantee $438 billion in bank loans.