Understanding the Great Recession

The great recession occurred between the years 2007 and 2009. It was characterized by a collapse in the housing sector and a compromised stability of the banking sector. A recession is a condition of reduced economic activities that is characterized by low purchasing power among citizens. The demand falls due to the low purchasing power leading to a cyclic of events that deteriorates the economy. The 2008 Great Recession also referred to as the Global Financial Crisis started in the American housing sector that in turn crippled the financial sector.  The wave of declining profitability in the housing and the financial sector then spreads to major economies in Europe due to high linkage between the European economies and the United States economy.  People view the crisis as a 2007 problem and fail to examine the root of the problem.  Some people think that the crisis was caused by selfish bankers who were seeking to maximize returns by offering risky loans. Other believes that it was caused by subprime mortgage lenders who could not leverage   risks. It is essential to examine the specific factors that contributed to the problem and how it circulated to the entire globe.

The Great recession started back in the year 2000 when there was a false signal in the housing market regarding increase in house prices.  This signal emanated from the move by the Federal Reserve to reduce the interest rate from 6.5% in the year 2000 to 1% in the year 2003. Home owners speculated that the persistent reduction of interest rate would translate into an increase in housing demand. As a result there was a boom in the housing sector where home builders increased their building capacity with an aim of meeting the anticipated high demand.  When factors held constant, a decrease in the interest rate should lead to an increase in the demand for houses since loans become more affordable thus increasing the people’s ability to access affordable loans for buying houses.  The decreasing interest rate experienced between the year 2000 and 2003 was however not a true reflection of the housing market.   Another indicator that convinced home builders of a profitable future is the move by the Congress to make amendments to encourage banks to offer mortgages to low income buyers who would not ordinarily qualify for mortgages. This move encouraged low income earners to take mortgages. The sub-prime mortgages given to the low income earners are considered the main and the immediate cause of the financial crisis.  The low income earners are risky clients since their chances of defaulting is high.  Bankers therefore charged a premium to make compensation for the high risk.   In the year 2004, the government began increasing the interest rate to counter the increasing inflation rate.  As a result, the low income borrowers could not meet the debt obligation that led to massive defaulting across the housing sector. The increasing interest rate also made the housing prices to fall.   This trend led to foreclosure as mortgage owners realized that they owed more to mortgage sellers than the actual value of their homes.  In the year 2007 there were changes in the accounting system where financial institutions were required to write down losses before they occur. This regulation led to collapse of some financial institutions as the losses lead to a decline in capital at an alarming rate. The new accounting requirements had major impacts in the financial sector since even the largest financial institutions registered major losses. The crisis spread to other countries making European banks to register huge losses .

References

Hillsdale College.(2014).The Great Recession Explained in 3 Minutes | Hillsdale College Econ                 101 https://www.youtube.com/watch?v=Dz_7ikEc26w

 

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