Key takeaways
- The Great Recession was spurred on by a toxic combination of banks offering mortgages to unqualified people and mortgage-backed securities.
- Congress passed the Dodd-Frank Act in 2010 to ensure the same causes would not harm the economy again.
- High inflation is the main factor that leading us toward another recession, many experts say it won’t be nearly as bad as 2008.
The 2008 recession was a tragic time for many Americans. Not only did so many of us lose our jobs, many of us also lost our homes and our life savings. It took years to recover, and some never have. The recession also left long-term scars on those of us who experienced significant losses.
Today, there is talk of another recession. Let's look at the Great Recession of 2008 and see if the next recession will be anything like that.
What Caused the 2008 Recession?
Multiple dominoes played a role in the fall of the U.S. economy in 2008, but it started with the reduction of the federal funds rate. This led to a red-hot housing market, which in turn, became a big housing market bubble that would eventually pop.
In the two years following the September 11 terrorist attacks in 2001, the Federal Reserve slashed the federal funds rate, reaching 1% by July 2003. This pushed large sums of money into the economy, banks made it easier than ever to borrow money.
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As a result, many consumers took out loans to buy homes they weren't qualified to purchase. This caused home prices to spike as lenders offered NINJA loans, or no income, no job applications for mortgages. Borrowers without jobs were buying homes even though they had no income. The lax lending standards also allowed large amounts of mortgage fraud, specifically for derelict homes.
In many cases, these loans were either adjustable-rate loans (where the interest rate was fixed for a period of time before adjusting) or interest-only loans. The interest-only loans allowed borrowers to pay only the monthly interest payment and nothing towards the principal amount. Both of these products allowed more people to qualify for mortgages.
Lenders engaged in selling these types of loans to qualified — and unqualified — borrowers because they were turning the mortgages into securities for investors to purchase on the secondary market. This allowed lenders to get the mortgage off their books and have zero risk of defaults.
Just about all traditionally qualified borrowers looking for a home had already purchased one, leaving lenders looking for more borrowers. That led to an explosion in the subprime mortgage market, lenders were loaning to just about anyone who applied. This was done to package more subprime mortgage-backed securities and collateralized debt obligations for investors to purchase.
A decision by the Securities and Exchange Commission (SEC) to relax net capital requirements for five investment banks morphed into another domino that eventually fell with Goldman Sachs, Lehman Brothers and Bear Stearns. These banks leveraged their initial investments by unsafe amounts, leaving them vulnerable to adverse events.
In response to a fast-growing economy, the Federal Reserve started to increase the federal funds rate back up in 2004, reaching 5.25% by July 2007. Homeownership peaked, and the once hidden cracks quickly surfaced. Those with adjustable-rate mortgages saw their monthly payment hit an amount that they could not afford, so they invariably began to miss payments.
With fewer buyers, home prices started to fall. Thousands of homeowners went underwater on the value of their homes, meaning they owed more than their home was worth. The fall in home prices accelerated, and the secondary market’s buying of bundled mortgages ran into issues because investors realized the underlying mortgages were low quality mortgages for unqualified borrowers.
Bear Stearns halted redemption from three of its hedge funds, and Merrill Lynch seized $800 million from the funds. Financial institutions started to look at subprime loan securities and desperately searched for a solution.
This was the final domino to fall that led to the eventual bankruptcy of Lehman Brothers and a bailout of Bear Stearns in 2008. There were over 3 million foreclosure filings, and around 2.6 million jobs were lost in 2008. By the end of 2009, more than 15 million people were unemployed. About 500 banks failed as well. In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed to prevent a repeat of what happened in 2008.
How long did the recession officially last?
The recession lasted 18 months and was officially over by June 2009. However, the effects on the overall economy were felt for much longer. The unemployment rate did not return to pre-recession levels until 2014, and it took until 2016 for median household incomes to recover.
Impact on the stock market
The stock market crash that heralded the arrival of the recession occurred on September 29, 2008. The Dow Jones Industrial Average dropped 777.68 points by the time of closing. This was the largest drop in its history, even compared to the Wall Street crash of the 1920s that started the Great Depression. The decline was caused by the rejection of a bill meant to rescue banks struggling from their own risky lending practices.
The Dow started the day at 11,139.62 and ended it at 10,365.45. The drop wiped out $1.2 trillion in value from the U.S. stock market and led to a ripple effect on exchanges around the globe. All major stock indexes suffered a severe loss in value. Investors sold off their stocks in large numbers as a no-confidence vote in the financial industry's ability to recover from bad decisions made by players both big and small.
Overall, the Dow Jones Industrial Average lost more than 50% of its value, and it wasn’t until March of 2013 that the Dow fully recovered.
Expectations for possible recession today
Turn on the news, and there is talk of a pending recession due to high inflation and rising interest rates. The stimulus efforts made by the federal government to keep the economy going during the pandemic had the direct result of putting a lot of cash into the economy. Add to this supply chain issues, increasing prices, and the economy has been slowing. Some experts say we are already in a recession, while others say a recession is likely in 2023.
Most experts agree that this recession will not be as severe as the one experienced in 2008. For starters, the health of the U.S. consumer is much better today than in the early 2000s. Additionally, banks are in much better financial shape as well.
The housing market overall is in a different place, where higher prices have been caused by a shortage of new homes being built, not by the selling of mortgages to people who cannot afford to purchase a home.
What triggered most of the fear in 2008 was the failure of many large financial institutions and the sale of low-quality mortgage-backed securities. Today, there are stricter laws regarding bank liquidity and selling mortgage-backed securities.
The two outstanding question: when will the recession become official and how long will it last?
The bottom line
While no one wants to experience a recession, the reality is they are a part of the economic cycle. The good news is that the 2008 recession was more severe than most recessions, and many economists are predicting that the next recession will be mild by comparison.
Still, it is important to look back and understand the causes and impacts the recession of 2008 had, as many people —especially our youngest generations — have not experienced a recession firsthand.
Given the milder outcomes expected for our next, pending recession most experienced investors recommend keeping most, if not all of one’s available investment dollars, in the market. Instead of investing in any one security, it’s best to diversify. Q.ai takes the guesswork out of investing.
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