The U.S. Financial Crisis of 2007-2010

Abstract

Scholars, economists, and leaders continue to compare the 2007–2010 recession to the Great Depression of the 1930s. It is clear that the 2007–2010 financial crisis had a profound impact on a number of key industrial sectors as well as individual consumers. This paper will an overview of the root causes of the financial crisis and discuss the efforts to foster a long-term recovery.

Overview

Not long after the start of the Great Depression, famed economist John Maynard Keynes was asked by a reporter if any event like it had occurred before. "Yes," he answered, "it was called the Dark Ages, and it lasted 400 years." While the Great Depression did not last nearly as long as the Dark Ages, it did have an indelible impact on American history. The Depression changed the relationship between the government and the free market, leading President Franklin D. Roosevelt to adopt Keynes's ideal of government intervention in a time of crisis. It also forced upon Americans the notion of self-subsistence, as all family members sought work wherever it could be found, regardless of the location of a job or its suitability, in order to survive and rebuild from the economic collapse.

The Great Depression remains one of the most significant events in modern US history. Since it came to an end during World War II, political leaders in the decades that followed took great steps to implement measures to protect against a recurrence. Entrepreneurs also took great pains to safeguard their businesses in the event of another Depression. Even those whose lives are more than two generations removed from the Depression look back on it in fear, comparing any economic downturn to that devastating period.

In 2007, the global economy began to suffer a series of events that led to a staggering economic recession that many dubbed the worst economic period since the Depression. This recession brought corporate and financial industry giants to the brink of failure, resulting in millions of job layoffs and foreclosures for countless businesses and homeowners. While scholars, economists, and leaders continue to compare this recession with the Great Depression, it is clear that the relatively short recession of 2007–2010 had a profound impact on a number of key industrial sectors as well as consumers themselves. This paper will look at the root causes of the financial crisis and discuss the efforts to foster a long-term recovery.

Further Insights

Depression or Recession? The Great Depression was indeed one of the most significant periods of economic stagnation in modern history. Between 1929 and 1933, the gross domestic product (GDP) of the United States declined by 30 percent. In the view of many, there were many smaller depressions that took place before the Wall Street collapse of 1929. Within this school of economic thought, a depression was simply a period in which a downturn in economic activity occurred. However, the Great Depression was an iconic event, so widespread and devastating that many felt it simply deserved its place in history—any "smaller depression" that occurred after this period would therefore be dubbed a "recession" (Moffat, 2010). More concretely, however, some economists have defined a depression as a period in which a country's GDP declines by more than 10 percent or a period of contracting GDP that lasts for more than three years.

There is very little universal agreement on the difference between a recession and a depression. A common definition of a recession is a period in which a country's GDP is in a period of decline over two or more consecutive quarters, although this definition is considered somewhat simplistic, as it does not consider unemployment rates or consumer confidence. What is agreed upon is that the Great Depression, in light of its severity, is typically the benchmark by which subsequent recessions are gauged (Moffat, 2010).

By 2007, the state and the national economies had largely returned to a state of reasonable growth after several years of stagnancy that lasted between 2001 and 2004. However, a number of factors that went largely unnoticed or ignored during this recovery helped lay the groundwork for another recession, one that would draw comparisons to the most significant recession in modern history. During the global financial crisis of 2007–2010, the GDP of the United States shrank by 0.3 percent in 2008 and by 3.1 percent in 2009, qualifying it as a recession but not as a depression.

The Housing Bubble. In the spring of 2005, the chair of the US Federal Reserve, Alan Greenspan—whose nearly twenty years in the position gave him significant credibility among political leaders—acknowledged that there was a change in the housing landscape. However, he stopped short of saying there was cause for concern, saying instead that some housing markets had become "frothy" (Freeman, 2005). Others, however, expressed concern that this "froth" was in fact a housing bubble.

A housing bubble in essence is an unexpected increase in the valuations of residential real estate until they reach unsustainable levels. Housing bubbles typically lead to a point at which home values exceed incomes and employment growth, in addition to other economic factors. When a housing bubble "deflates"—a process that is typically gradual and not explosive—it can even result in negative equity for the homeowner (a mortgage debt that exceeds the value of the property).

The roots of this housing bubble extend back to a 2001–2004 recession and recovery period. The Federal Reserve ("the Fed") recommended that interest rates remain low in order to stimulate spending, as most consumers opted to minimize spending until the crisis was over. Some observers argue that these rates should have been increased after a short period, rather than held low for several years.

Subprime Lending. While the low interest rates almost certainly played a role in spurring home buying, it is believed that a major culprit was subprime lending. This practice entailed offering fixed-rate mortgages to individuals who could afford monthly payments but had poor credit histories. Because it offered growth to the housing industry, subprime lending was even endorsed by the government-backed Fannie Mae and Freddie Mac, the two corporations charged with purchasing and securitizing mortgages for lending institutions (Lynch, 2010). This approach satisfied many political leaders, who were under pressure (and who therefore applied pressure to the relevant agencies) to enable low-income Americans to purchase homes.

As subprime lending became more and more popular in 2004, the housing bubble began to grow. Lenders offered interest-only mortgages and other creative packages to entice lower-income people to buy homes. They also loosened their credit standards, which further broadened the market. Lenders, according to one real estate analyst, became more concerned with the quantity rather than quality of the mortgages they secured (Burry, 2010). To lower the risks, the lenders would then sell them on Wall Street as mortgage-backed securities. Meanwhile, the government (including Alan Greenspan and Fed officials) openly encouraged Americans to take advantage of record-low interest rates and buy a home. Such pronounced endorsements sent buyers to legitimate lenders, but it fostered increased cases of mortgage fraud as well (Burry, 2010).

In 2008, the housing bubble began to collapse upon itself. Homeowners, many of whom were coerced into thinking they could afford their mortgages, could not keep up with monthly payments or increases due to adjustable rate mortgages, especially as the economy began to slow. In Florida, a state with a traditionally vibrant real estate market, more than one-fifth of the state's mortgages were either ninety or more days behind in payment or were in foreclosure in 2009. The state's population dropped by 57,000 people (it normally grew by 200,000 to 400,000 people annually), and fewer state tax revenues sent the state budget into a $3.5 billion deficit ("Paradise," 2010, p. 5). According to RealtyTrac’s Midyear 200 Metropolitan Foreclosure Market Report, for the first half of 2010, Miami recorded the highest number of foreclosures out of the top metro cities in the country, with 94,466 properties filing (Harmon, 2010).

The collapse of the housing bubble had an enormous impact on the American economy. It created record numbers of foreclosures, increased unemployment, and tore at the fabric of state infrastructures. It also created chaos in the heart of the business world—the financial sector.

The Collapse of the Financial Industry. The fact that subprime lending was so widespread was exacerbated by the fact that a large number of major financial institutions were heavily invested in the practice, and that the Fed, which regulates many of those major lenders, did not intervene. Speaking to a 2007 Fed conference in Chicago, Greenspan's successor, Ben Bernanke, told attendees that subprime lending did not pose a risk to the country's major financial institutions. However, five of the ten major institutions heavily invested in subprime lending were banks that were overseen by the Fed (Applebaum & Cho, 2009). Among them were Citigroup and Wachovia, both of which either invested heavily in subprime lending or purchased lenders that engaged largely in such practice.

Of course, what attracted these major institutions to subprime lending was the perceived profitability involved. As mentioned earlier, lenders were more concerned with booking large quantities rather than high-quality mortgages. Such numbers, regardless of the risks, served as indicators of the lender's success. When Lehman Brothers began engaging in subprime lending in 2006, one of its major competitors, Merrill Lynch, looked to acquire a similar subprime lender, New Century Mortgage. Meanwhile, mid-sized mortgage lenders such as Washington Mutual and Countrywide aggressively competed with one another over who could book what one analyst called "the flimsiest mortgages" (Dickey, 2010). One year later, Merrill Lynch and Countrywide were acquired by Bank of America, Lehman Brothers filed for bankruptcy, and Washington Mutual was acquired by Chase.

Nebulous Accounting: The Case of AIG. Seemingly adding insult to injury were the rewards the banks gave to their senior personnel for amassing such a large quantity of subprime mortgages. American International Group (AIG) was one of the businesses at the center of this firestorm. In 2009, AIG was starting to feel the effects of the subprime crisis after its financial products division had invested aggressively in the subprime market. The company lost $40 billion in 2008 alone because of its dealings in this arena. The federal government, however, was determined not to let a giant like AIG fail—the company was a major cog in the global economy and many feared that its collapse would have devastating effects on other worldwide economies. To prevent collapse, the government intervened, infusing AIG with about $200 billion through the Troubled Assets Relief Program (TARP). This bailout was designed to enable AIG to recoup its losses and regain its footing as it phased out of subprime lending. The money was not exactly free, however; the government now owned most of AIG and required strict and transparent accounting (Saporito, 2009).

This accounting uncovered an issue that became one of the biggest political firestorms during the 2007–2010 recession. In many cases, subprime lenders were accused of "pumping up" sales figures on mortgages, as doing so entitled key executives to more significant bonuses (Davidson, Wiseman & Waggoner, 2010). One of the most visible of these alleged activities was manifest once again in AIG. In March 2009, AIG reported that it had paid approximately $165 million in retention bonuses to executives. These individuals were at the helm of the subprime endeavor and were being rewarded for securing such volumes of mortgages ("Obama tries," 2009).

This infuriated President Barack Obama and congressional leaders on both sides of the aisle, with the public clamoring for some sort of retaliatory action. President Obama and Secretary of the Treasury Timothy Geithner demanded that AIG halt the bonuses, but their demands were largely ineffective. The executives were contractually obligated to receive the bonuses, according to the new AIG chief executive. In light of the potential lawsuits, forcing the executives to return the money was likely to cost more to the government than the bonuses themselves ("Obama tries," 2009).

To the further consternation of the government and the general public, routine reporting in 2010 revealed that AIG had classified about $2.3 billion in repurchase agreements (financial arrangements whereby a party offers securities such as stock as collateral for short-term cash) as sales transactions before these bonuses were paid out. In late 2008, AIG leadership had demanded higher levels of collateral to enter into such agreements, particularly in light of the fiscal climate. Because the collateral requirements were greater than in previous arrangements, such transactions would be seen as a sale. Although AIG flatly denied that the repurchase agreement inclusion was used for the bonus arrangement, critics quickly seized upon the information as more evidence of the apparent nefarious behavior of financial institutions that contributed to the fiscal crisis (Gallu, 2010).

Such accounting seemed reminiscent of other examples of perceived improper accounting measures leading up to and during the crisis. For example, in 2008, New Century was placed under the microscope for very similar circumstances when that company used allegedly inflated sales figures to pay out its bonuses (Reckard, 2008).

In 2014, former AIG executive Hank Greenberg filed a lawsuit with the US Court of Federal Claims, arguing that the government’s 2008 bailout of his former company was an unlawful seizure of the company’s shareholders’ private property. In 2015, a judge in the United States Court of Federal Claim found the government's bailout terms to be excessively harsh but awarded no damages to Greenberg, as the company would have been bankrupted without the government's bailout, leaving the company's shareholders with nothing.

Issues

The Road to Recovery. The US financial crisis of 2007–2010 was one of the most impactful economic events since the Great Depression. The recession itself, which lasted eighteen months, was one of the longest post-Depression recessions in history. During the crisis (which persisted after the recession came to an end), the economy simply staggered. The country's peak-to-trough decline in real GDP was more than 4 percent and monthly job losses were as high as 750,000. The unemployment rate peaked at 10 percent in October 2009. The government's intervention in the near collapse of the financial industry, coupled with steady, low interest rates and a continued commitment to stimulate jobs have helped the economy turn around in some ways. President Obama also signed the American Recovery and Reinvestment Act in 2009 to help create jobs and cut taxes to stabilize the middle class. The GDP was 2.2 percent annual growth rate in 2012 and the economy was adding about 125,000 jobs per month in 2010 and was up to 200,000 in late 2013. By August 2016, the unemployment rate had declined to 4.9 percent, although this figure remained above the prerecession unemployment rate, which was 4.4 percent in early 2007, and wages remained stagnant.

The recovery process after this crisis has been incremental and tentative. Most experts and political leaders have expressed cautious optimism that the recovery will be sustained. The July 2010 passage of a financial industry regulatory overhaul has been lauded as a major step toward prevention of the missteps and risk-taking that undid this sector.

Several conditions demand continued caution in declaring the apparent recovery successful. The tremendous damage caused by the mortgage crisis, for example, took a number of years to repair, and although the housing market rebounded, long-term effects are unknown. In 2012, the US federal government settled with five major banks for $25 billion for their parts in the housing scandal, and it reached a large-scale agreement in 2013 with JP Morgan for $14 billion for the sale of fraudulent mortgages. The government offered programs such as the Home Affordable Refinance Program (HARP) to allow for homeowners to renegotiate their mortgages, but few people initially took part. The government originally planned for three to four million homeowners to refinance under such programs, but only about one-quarter took advantage by June 2010. In 2011, the Federal Housing Finance Agency made adjustments to HARP in the hope that more homeowners would take advantage of the program. Meanwhile, more than 300,000 foreclosures took place monthly between 2009 and 2010. With banks holding enormous stocks of foreclosed mortgages—some studies suggested that it would take eight years to clear this backlog if the prerecession rate of sales resumed—housing prices remained static, compounding the issue of negative equity ("Double-dip," 2010).

Adding to the slow return to normalcy in the US economy has been the credit environment. Lenders no longer offer flexible credit in the wake of the crisis, due both to the new cautionary mentality in financial institutions and the federal deficit, which was already high before the crisis and was exacerbated by financial institution bailouts, economic stimulus, and other programs. Small businesses, which account for about half of the jobs in the United States, stand to suffer the most because of this ongoing credit crunch ("How to measure," 2010). Lack of affordable credit continued to hamper businesses seeking to expand for many years after the recession. In 2014, more than five years after the recession officially ended, public spending as a portion of the country's GDP increased for the first time since the financial crisis, signalling that the economic recovery was beginning to take hold. However, the postrecession US economy has seen significant increases in income and wealth inequality, with the top 1 percent of income earners capturing more than half of the income gains in the first three years of the recovery, and many low- and middle-income families remain less wealthy than they were prior to the recession.

Conclusion

Although the historical significance of the Great Depression led to the "retirement" of the use of the term depression, the semantics of its replacement, recession, do little to ease the concerns of an economically vibrant society. In truth, there are a great many parallels that have been drawn between the Depression and the Great Recession of 2007. Among the similarities are massive unemployment, long-term fiscal stagnancy, and even a Keynesian approach to reversing such conditions—massive government intervention in the traditionally private business country.

The severe conditions wrought by the combination of the housing bubble and the mortgage crisis created ripples that spread throughout the global economy. Although most economists agree that the three-year US financial crisis was winding down by 2010, by 2016, unemployment and wages had not fully recovered to their prerecession levels.

Terms and Concepts

American International Group (AIG): A major US financial insurance institution that was the recipient of significant government bailout funds to prevent further and possibly global financial collapse.

American Recovery and Reinvestment Act: A 2009 law passed with the goal of creating new jobs, cutting taxes, investing in long-term economic growth, and providing funding for programs such as unemployment benefits.

Housing Bubble: An uncorrelated increase in the price of residential real estate which becomes unsustainable and can even result in negative equity for the homeowner.

Recession: An economic downturn period in which growth declines over a sustained period of time (often two or more quarters).

Repurchase Agreement: A financial arrangement whereby a party offers securities such as stock as collateral for short-term cash.

Subprime Lending: The practice of offering mortgages to individuals who are determined to be able to afford monthly payments despite poor credit histories or low incomes.

Troubled Assets Relief Program (TARP): A 2008 law that offered financial assistance to US financial institutions on the brink of collapse.

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Suggested Reading

Aliber, R. Z., & Kindleberge, C. P. (2015). Manics, panics, and crashes: A history of financial crises. 7th ed. New York: Palgrave.

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Demyanyk, Y. & Hasan, I. (2009). Financial crises and bank failures: A review of prediction methods. Omega, 35, 315–324.

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