Many factors directly and indirectly serve as the causes of the Great Recession that started in 2008 with the US subprime mortgage crisis. The major causes of the initial subprime mortgage crisis and the following recession include lax lending standards contributing to the real-estate bubbles that have since burst; U.S. government housing policies; and limited regulation of non-depository financial institutions. Once the recession began, various responses were attempted with different degrees of success. These included fiscal policies of governments; monetary policies of central banks; measures designed to help indebted consumers refinance their mortgage debt; and inconsistent approaches used by nations to bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.
Overview
The immediate or proximate cause of the crisis in 2008 was the failure or risk of failure at major financial institutions globally, starting with the rescue of investment bank Bear Stearns in March 2008 and the failure of Lehman Brothers in September 2008. Many of these institutions had invested in risky securities that lost much or all of their value when U.S. and European housing bubbles began to deflate during the 2007–2009 period, depending on the country. Further, many institutions had become dependent on short-term (overnight) funding markets subject to disruption.
Many institutions lowered credit standards to continue feeding the global demand for mortgage securities, generating huge profits that their investors shared. They also shared the risk. When the bubbles developed, household debt levels rose sharply after the year 2000 globally. Households became dependent on being able to refinance their mortgages. Further, U.S. households often had adjustable rate mortgages, which had lower initial interest rates and payments that later rose. When global credit markets essentially stopped funding mortgage-related investments in the 2007–2008 period, U.S. homeowners were no longer able to refinance and defaulted in record numbers, leading to the collapse of securities backed by these mortgages that now pervaded the system.
The fall in asset prices (such as subprime mortgage-backed securities) during 2007 and 2008 caused the equivalent of a bank run on the U.S., which includes investment banks and other non-depository financial entities. This system had grown to rival the depository system in scale yet was not subject to the same regulatory safeguards. Struggling banks in the U.S. and Europe cut back lending causing a credit crunch. Consumers and some governments were no longer able to borrow and spend at pre-crisis levels. Businesses also cut back their investments as demand faltered and reduced their workforces. Higher unemployment due to the recession made it more difficult for consumers and countries to honor their obligations. This caused financial institution losses to surge, deepening the credit crunch, thereby creating an adverse feedback loop.
Federal Reserve Chair Ben Bernanke testified in September 2010 regarding the causes of the crisis. He wrote that there were shocks or triggers (i.e., particular events that touched off the crisis) and vulnerabilities (i.e., structural weaknesses in the financial system, regulation and supervision) that amplified the shocks. Examples of triggers included: losses on subprime mortgage securities that began in 2007 and a run on the shadow banking system that began in mid-2007, which adversely affected the functioning of money markets. Examples of vulnerabilities in the private sector included: financial institution dependence on unstable sources of short-term funding such as repurchase agreements or Repos; deficiencies in corporate risk management; excessive use of leverage (borrowing to invest); and inappropriate usage of derivatives as a tool for taking excessive risks. Examples of vulnerabilities in the public sector included: statutory gaps and conflicts between regulators; ineffective use of regulatory authority; and ineffective crisis management capabilities. Bernanke also discussed "Too big to fail" institutions, monetary policy, and trade deficits.
Economists surveyed by the University of Chicago rated the factors that caused the crisis in order of importance. The results included: 1) Flawed financial sector regulation and supervision; 2) Underestimating risks in financial engineering (e.g., CDOs); 3) Mortgage fraud and bad incentives; 4) Short-term funding decisions and corresponding runs in those markets (e.g., repo); and 5) Credit rating agency failures.
Narratives
There are several "narratives" attempting to place the causes of the crisis into context, with overlapping elements. Five such narratives include: There was the equivalent of a bank run on the shadow banking system, which includes investment banks and other non-depository financial entities. This system had grown to rival the depository system in scale yet was not subject to the same regulatory safeguards. The economy was being driven by a housing bubble. When it burst, private residential investment (i.e., housing construction) fell by nearly 4%. GDP and consumption enabled by bubble-generated housing wealth also slowed. This created a gap in annual demand (GDP) of nearly $1 trillion. Government was unwilling to make up for this private sector shortfall. Record levels of household debt accumulated in the decades preceding the crisis resulted in a "balance sheet recession" once housing prices began falling in 2006. Consumers began paying down debt, which reduces their consumption, slowing down the economy for an extended period while debt levels are reduced. Government policies that encouraged home ownership even for those who could not afford it, contributing to lax lending standards, unsustainable housing price increases, and indebtedness. The financial turmoil induced an increase in money demand (precautionary hoarding). This increase in money demand triggered a corresponding decline in commodity demand.Stefan Homburg (2015) What Caused the Great Recession? Review of Economics 66 (1), pp. 1–12. IDEAS. One narrative describing the causes of the crisis begins with the significant increase in savings available for investment during the 2000–2007 period when the global pool of fixed-income securities increased from approximately $36 trillion in 2000 to $80 trillion by 2007. This "Giant Pool of Money" increased as savings from high-growth developing nations entered global capital markets. Investors searching for higher yields than those offered by U.S. Treasury bonds sought alternatives globally.
The temptation offered by such readily available savings overwhelmed the policy and regulatory control mechanisms in country after country, as lenders and borrowers put these savings to use, generating bubble after bubble across the globe.
When these bubbles burst, causing asset prices (e.g., housing and commercial property) to decline, the liabilities owed to global investors remained at full price, generating questions regarding the solvency of consumers, governments, and banking systems. The effect of this debt overhang is to slow consumption and therefore economic growth and is referred to as a "balance sheet recession" or debt-deflation.
Housing market
The U.S. housing bubble and foreclosures
Between 1997 and 2006, the price of the typical American house increased by 124%. During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006. This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation.
By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the US. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default. During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007. As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure.
The Economist described the issue this way: "No part of the financial crisis has received so much attention, with so little to show for it, as the tidal wave of home foreclosures sweeping over America. Government programmes have been ineffectual, and private efforts not much better." Up to 9 million homes were at risk of entering foreclosure over the 2009–2011 period, versus one million in a typical year. At roughly U.S. $50,000 per foreclosure according to a 2006 study by the Chicago Federal Reserve Bank, 9 million foreclosures represents $450 billion in losses.
Subprime lending
In addition to easy credit conditions, there is evidence that both competitive pressures and some government regulations contributed to an increase in the amount of subprime lending during the years preceding the crisis. Major U.S. investment banks and, to a lesser extent, government-sponsored enterprises like Fannie Mae played an important role in the expansion of higher-risk lending.AEI-The Last Trillion Dollar Commitment
The term subprime refers to the credit quality of particular borrowers, who have weakened credit histories at a greater risk of loan default than prime borrowers. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding.
Subprime mortgages remained below 10% of all mortgage originations until 2004, when they spiked to nearly 20% and remained there through the 2005–2006 peak of the United States housing bubble.Harvard Report-State of the Nation's Housing 2008 Report A proximate event to this increase was the April 2004 decision by the U.S. Securities and Exchange Commission (SEC) to relax the net capital rule, which encouraged the largest five investment banks to dramatically increase their financial leverage and aggressively expand their issuance of mortgage-backed securities. Subprime mortgage payment delinquency rates remained in the 10–15% range from 1998 to 2006, then began to increase rapidly, rising to 25% by early 2008.
Mortgage underwriting In addition to considering higher-risk borrowers, lenders offered increasingly risky loan options and borrowing incentives. Mortgage underwriting standards declined gradually during the boom period, particularly from 2004 to 2007.Michael Simkovic, Competition and Crisis in Mortgage Securitization The use of automated loan approvals let loans be made without appropriate review and documentation. In 2007, 40% of all subprime loans resulted from automated underwriting. The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay. Mortgage fraud by lenders and borrowers increased enormously. Adverse selection in low-to-no documentation loans can account for a substantial fraction of losses on home foreclosures between 2007 and 2012.