Economics
There are a number of different causes for the most recent recession in the United States. The was instability in the banking industry, which was brought about mismanagement of mortgage assets. This paper will investigate this cause in particular, although there were other causes as well.
The housing bubble was created when, fueled by easy access to cheap loans, housing . These prices increased rapidly in part because the financial institutions that underwrote the mortgages were able to offload that debt onto other investors. They did this by packaging that debt into instruments that were known as collateralized debt obligations (CDOs). These rare derivative instruments were used by financial institutions to hedge loan risk, by spreading that risk around the financial services industry. Loans were packaged, and these complex bundles of loans were typically seen to be low risk. They were not, however, and when the housing market collapsed these CDOs were spread throughout the U.S. economy. As a result, not only did the financial institutions that wrote the bad mortgages face the risk of those bad mortgages, but so did every financial institution that bought into the risk through the CDO (Wigan, 2007).
With the risk of the entire housing market spread around not only the U.S. banking system but a number of other banking systems, the end of the housing market bubble meant the onset of recession. There was a lack of planning, however. As early as 2005, some analysts were predicting a major recession as the result of the end of the housing bubble (AP, 2005). However, the actual scenario was worse than was predicted at the time, and this was because of the CDOs. The recession may have been inevitable, but it was made more severe when the actual risk level of the CDOs became apparent.
The CDOs were found to be more risky than originally believed, and as a result of this they became illiquid — nobody wanted to buy them. So the banks that held them had to suffer the effects when they defaulted on their payments. One such bank was Lehman Brothers, but there were many others. These institutions began to collapse, putting the entire financial system at risk. The government was forced to orchestrate a bailout for the system, adding to the deficit, and the banking system began to withdraw from credit markets.
With the banking system on life support and there not being any credit available to businesses that wanted to borrow to invest, the economy began to falter severely. With no investment, a weak banking system, and one of the major drivers of economic growth (the housing market) all but eliminated from the economy, the conditions were ripe for a major recession. Businesses began to lay off workers in anticipation of reduced demand. This in turn put more people out of work and scared more businesses into layoffs. At this point, in late 2008 and early 2009, the recession was in full swing. The unemployment rate was headed way up and GDP down.
There were a number of different culprits, but certainly the collapse of the banking system ensured that not only would we have a recession but that it would be a bad one. This collapse occurred only because mortgage lenders were able to spread the risk associated with their loans across the entire banking system. The problem, of course, is that the worst case scenario occurred with the housing bubble and those CDOs became worthless. The link between the housing bubble, the CDOs and the collapse of the banking system is where the causes of the last recession lay.
Works Cited:
AP. (2005). Housing bubble’s burst could and cause a recession, experts say. North County Times. Retrieved November 28, 2012 from http://www.nctimes.com/business/housing-bubble-s-burst-could-cost-million-jobs-and-cause/article_ca387065-86dd-519a-98d2-9e5d35d30055.html
Wigan, D. (2007). Derivatives market may hold key to U.S. recession. Reuters. Retrieved November 28, 2012 from http://www.reuters.
