Question

Briefly discuss the factors that caused the recession of \(2007-2009 .\)

Short answer

The recession of 2007-2009 was primarily caused by the bursting of the housing bubble, risky financial practices and instruments, and the resultant credit freeze.

Step-by-step solution

Housing Bubble and its Bursting

One of the main causes of the recession was the bursting of the housing bubble. Banks were lending to individuals who could not afford mortgages, causing a surge in house prices. When these individuals defaulted on their loans, house prices fell drastically, leading to a crisis in the mortgage industry and a sharp decline in the value of mortgage-backed securities held by many financial institutions.

Financial Instruments and Practices

Banks and other financial institutions had been engaged in the practice of securitization, turning mortgages and other debts into securities that could be sold to investors. Additionally, many financial institutions had taken on too much risk with complex financial products like collateralized debt obligations (CDOs) and credit default swaps (CDSs). When the housing market collapsed, the value of these securities plummeted, leading to huge losses.

Credit Freeze

As a result of massive losses on bad loans and risky securities, many financial institutions faced potential insolvency. This led to a freeze in lending (credit crunch), which further deepened the recession. Companies found it difficult to borrow money, resulting in cutbacks and layoffs.

Key concepts

Housing Bubble

The housing bubble was at the heart of the 2007-2009 recession. A bubble, in this context, refers to a market phenomenon characterized by an inflating value of assets beyond their intrinsic worth. The housing bubble occurred when house prices surged rapidly due to high demand, speculative buying, and easy lending practices.

Many banks relaxed their lending standards, offering loans to individuals with low creditworthiness, often referred to as subprime mortgages. These borrowers frequently found themselves unable to meet their mortgage payments. This pushed house prices too high and eventually, when borrowers defaulted, led to the bubble bursting.

A deluge of foreclosures put downward pressure on house prices, causing them to fall dramatically. As a result, mortgage-backed securities—a type of financial instrument—lost value. This sparked a crisis in financial institutions as their holdings decreased significantly in value.

Financial Instruments

Prior to the recession, banks had been engaged in practices of turning mortgages and other types of debt into financial instruments that could be sold to investors. This process is known as securitization.

These financial instruments, such as mortgage-backed securities (MBS), collateralized debt obligations (CDOs), and credit default swaps (CDSs) became popular. They allowed banks to clear their balance sheets and gain liquidity by selling off the risk associated with these debts.

Many of these products were complex and opaque. Banks and investors often underestimated the risk involved. When the housing bubble burst, and people defaulted on their mortgages, the value of these securities plummeted. Financial institutions that held large amounts of these instruments faced enormous losses, contributing heavily to the financial crisis.

Credit Freeze

The bursting of the housing bubble and the collapse of financial instruments led to a crisis in confidence among financial institutions. This caused a credit freeze, also known as a credit crunch.

Faced with heavy losses, banks became hesitant to lend to each other and to businesses. The perceived risk of default was too high. Traditional sources of funding dried up almost overnight. As lending evaporated, businesses struggled to secure capital for day-to-day operations.

The economy relies on credit to facilitate growth and innovation. A credit freeze leads to a contraction in spending and investment. As companies cut back on expenses, many were forced to lay off workers, contributing to rising unemployment and further deepening the recession.