The Worst Economic Crisis Since The Great Depression

The global financial crisis of 2007-2008 is considered the worst economic crisis since the Great Depression. It is critical to study the factors that brought the global economy to its knees and from which we are still feeling the effects today. In order that the past will not be repeated, we must study the political decisions during that time, the risky practices by various institutions, the greed of the financial marketplace, and the housing bubble that many calculated would never burst. These are some of the causes that led to financial ruin for so many people in the United States and across the globe. In this paper we will discuss the multiple causes and how they contributed to the financial crisis, as well as how we recovered from the crisis, and how to prevent it from occurring again.

Though difficult to determine which came first, “the chicken or the egg,” many experts believe uncontrolled financial innovation and corruption began with the deregulation of the financial industry in 1999. In response to the Great Depression, “The Glass-Steagall Act of 1933 separated retail banking from investment banking. Separation of the two prohibited retail banks from taking risky investments with depositors’ funds. Glass-Steagall did not allow investment banks to have a controlling interest in retail banks. They had to find a different source of money that was not from the depositors’ accounts. The purpose of Glass-Steagall was to permanently end dangerous bank practices that created bank runs.” (Amadeo, 2018, para. 1-4,10). However, many bank lobbyists felt that because of the regulations, American banks were not competitive against foreign firms. With mounting pressure and bi-partisan support the Glass-Steagall Act was repealed by the Gramm-Leach-Bliley Act. Though the repeal opened relationships between retail and investment banks, transactions were still to be monitored and supervised by the Federal Reserve. Though some Wall Street banks didn’t want to deal with the oversight of the Feds, others did take advantage of a new sector to make profit in and trading opened up on a global scale with many investments from overseas markets. These investment banks later became known as “too big to fail” because they would eventually be bailed out by the United States government in that their demise would create catastrophic consequences to the global economy.

With restrictions lifted and banks looking to make more profit from loans, the housing market (with its false security of ever-rising returns) was a perfect environment for investors. New opportunities for banks to make larger profits coincided with a boom in the housing market and a push by the government for everyone to live the American dream of home ownership. A real estate bubble was forming. A real estate bubble is when housing prices grow above average. Locations with desirable living qualities increased the demand for homes, for example, the nice weather in places like Florida and Arizona affected such state’s housing market. Real estate speculation was created from rising home prices and people began to see their homes as a piggy bank. Strict lending requirements were completely forgotten, and interest rates dropped. The government encouraged broad home ownership and influenced banks to lower their lending requirements and rates. This created a home buying frenzy and raised prices 50-100%. About 56% of homes bought during this time period, were from people that normally would not be able to afford it. These kinds of buyers are referred to as subprime borrowers, those who took advantage of the large loans that the banks were giving out, knowing that they may not be able to fully pay them back.

Because of the increase in demand in the housing markets, investors began to buy homes as well. People began to start flipping houses for thousands of dollars in a short amount of time. The demand for homes was much higher than the supply. This was until housing companies increased their supply, resulting in too many homes being built and not enough homeowners looking to buy. This then caused the price of homes to drop dramatically. Homeowners were unable to move or get away because the value of their homes dropped below the value of their mortgage debt. In the U.S, 8.8 million people’s homes were affected. Foreclosure soon began to hit these homes, which left people homeless. About 1.3 million homes foreclosed, forcing the homeowners to leave their house, with less value then they had when they had purchased it. This collapse caused many investment companies who got involved in the housing market, to lose financial value as well. The large financial institutions that had invested in subprime loans lost billions, resulting in several of them to claim bankruptcy.

Housing was usually referred to as a sure investment, but after years of rising home prices and many Americans stretching their dollar to pay for expensive mortgages, home owners were defaulting on their loans and the wheels were set into motion for the fall of mortgage-backed securities. The housing market crash was the slight breeze that brought down a very precarious house of cards. As banks stopped profiting from the loans they gave (either directly or indirectly,) the banks began to trust no one to pay them back and stopped making loans to businesses. The problem was that the businesses needed the loans to regulate their cash flow. Without the loans from the banks, businesses shut down adversely affecting the entire United States financial sector and financial markets overseas. Many companies that relied on credit for their business suffered as well. Eventually, American auto industry companies like Ford, General Motors, and Chrysler faced potential insolvency which put their futures at risk and would eventually lead to an automotive bailout in 2008.

Another important cog in the wheel for the cause of the financial crisis were the credit rating agencies. “These agencies are roundly criticized for not only failing to warn investors of the dangers of investing in many of the mortgage-backed securities at the epicenter of the financial crisis, but benefiting by not pointing out deficiencies.” (Krantz, 2013, para. 1). Much too influenced by the profit they were making from the investment banks, these agencies gave high ratings to sketchy bundled securities which helped the investment banks sell them to investors. Without their approved ratings, many of these mortgage-backed securities would have been unsalable and the deceptive practices of the banks to investors within the global economy may have been halted. The agencies, blinded by profit and supposed certainty in the improbability that housing prices would fall, became lax and unreliable in their scrutiny of the mortgage-backed securities. They failed in accurately analyzing and disclosing the risks for default of the subprime borrowers, therefore, deceiving and not protecting investors. What is interesting to note, the three big global credit ratings have never really accepted blame or admitted to financial corruption in their part of the crisis citing that the practice of ratings is built on calculated “opinions” and that rating decisions were decided by committees and not individual analysts. However, lawsuits against, and billion dollar settlements paid out by the agencies, as well as regulatory U.S. legislation (Dodd-Frank), and modern skepticism across the globe, illustrate otherwise.

The executive branch and Congress had to fiercely address the threat of catastrophic global and U.S. economic failure not seen since the Great Depression. The Emergency Economic Stabilization Act was signed into law by President George Bush to help bring the economy back to a stable state. The act restored liquidity to financial and credit markets. The act also authorized the Treasury Secretary to purchase 700 billion dollars worth of mortgage-backed securities and other troubled assets from the banks. The U.S. markets for credit and capital were no longer frozen and the cost of borrowing for households and businesses was reduced.

Retried national economist, Joel Havemann, describes the effects of the crisis. “Share prices plunged throughout the world—the Dow Jones Industrial Average in the U.S. lost 33.8% of its value in 2008—and by the end of the year, a deep recession had enveloped most of the globe. In December 2007, The National Bureau of Economic Research, a private group recognized as the official arbiter of such an economic event, determined that a recession had begun in the United States.” (Havemann, n.d., para. 1). Compared to other countries, the United States took the largest loss of the crisis, and repercus-sions are still felt today with effects of the crisis adding significantly to our national debt. But as stated above, many would say the U.S. is where it all began and therefore, as a leading economy, the U.S. had a moral and obligatory responsibility to the rest of the world. Let’s hope we learn critical and valuable lessons from the actions of the past. Just as the financial crisis would have been triple the outcome of the Great Depression, our failure to not change could mean a future recession much greater and possibly unsalvageable then that of 2008.

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