Free Essay: Impact of the Economic Recession in 2007-2009

Published: 2019-09-11 06:01:28
Free Essay: Impact of the Economic Recession in 2007-2009
Categories: Economics Finance
Pages: 7
Wordcount: 1822 words
16 min read

Economies had experienced crises since the Great Depression in the 1930s but the 2007/9 recession was one of the most severe economic shocks on the global economy. In what began as a small problem within the investment banking sector, the crisis spread to other areas of the economy bringing many economies to almost a standstill. Research findings show that the crisis originated from the year 2004 when the economy experienced asset price bubbles which continued until the year 2007 when the mentioned prices reached unsustainable levels, resulting in the catastrophic collapse of the mortgage market. According to Allen and Carletti (2009), banking crises are often preceded by asset price bubbles and booms in credit advancements into the economy. Allen and Carletti assertion is consistent the studies of Reinhart, Rogoff and Savastano (2003) who found out that financial crises are occasioned by the fall in the intrinsic value of assists in the real estate market. The financial crisis began as a liquidity crunch in September 2007, spreading to other sectors of the economy within a period of three months.

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As noted earlier, the cause of the crisis can be traced to the persistent rise of prices in the real estate market that eventually lead to the destruction of self-sustaining forces in the real estate market. Fundamentally, the recession was occasioned by excessive leverage at various levels of the economy; customers, financial institutions, businesses, and government agencies. The mentioned persons borrowed excessively money that was mostly tied to the real estate securities leading widespread default as a result of the great fall of the mortgage prices in 2007.Allen and Carletti found out that failure of regulators to control excessive leverage, excessive private borrowing, trading in exotic products by financial institutions, quick-profit goals by financial players were some of the conditions that predisposed the country to the recession. These findings are in agreement with the US Senate Levi-Corburn Report, which concluded that regulatory failure, fraudulent trading, and over-borrowing, were the primary factors that contributed to the outbreak of the crisis (Kolb, 2010). In this paper, the impact of the 2007/9 on the financial and auto manufacturing sectors as well as policy implications of the crisis will be investigated.

The decline in the share prices in stock market tied to the mortgage investment was one of the earliest casualties of the economy. The plummeting housing prices occasioned the fall in the real estate industry. In their paper on economic crises, Reinhart and Rogoff (2009) found out that some of the results of the financial crisis were the drop in the housing prices and the fall in equity prices. Averagely, housing prices experience a drop of 35% which is often spread over a six-year period during financial crises. Similarly, the prices of shares experience a drop of 55% on average for more than two years from the time of the crisis. In regards to the 2007/9 recession, the housing bubble had a significant influence on the drop of securities tied to the real estate industry. The booming credit encouraged the ownership of homes and the development of real estate since the industry was experiencing tremendous growth before the crisis period. These developments lead to massive borrowing from prospective private homeowners and real estate developers as of the persistent rise in the prices such assets. Subprime borrowers accessed credit facilities in anticipation of the continued rise in housing prices. The prices of houses increased averagely by 10% since 2004 due to massive investments by homebuyers, Wall Street investment houses, mortgage lenders, and insurers. When the real estate became unsustainable in 2007, the housing prices plummeted to a record low, making the securities tied to the mortgage industry appears unattractive. The mentioned events translated to drop of customer confidence of the real estate investment, leading to massive withdrawals from mortgage-tied securities. Dow Jones Industrial Average, for instance, dropped by 54% from the year 2007 to 2009.

During the build-up to the crisis, banks made substantial money from lending to the real estate development. The attractiveness of the housing market made some banks to advance credit excessively with the anticipation of reaping big from the burgeoning industry. These banks collapsed when the industry experienced economic shocks as a result of the significant drop in the housing prices. According to Kolb (2010), a total of 176 commercial banks collapsed. Notably, financial services Lehman Brothers filed for bankruptcy protection in September 2008 following excessive liquidity. The failure to secure eventually led to the liquidation of the ending its 158-year existence. Research findings of Craig and Spector (2010) show that repo market played a significant role in the investment banks demise in 2008.The bank engaged in the raising cash to fund operations using nontraditional securities. The bank was also under financial strain as it runs out of securities to that would use as collateral in procuring short-terms that were meant to ensure it survived the crisis. It is important to note that most of the companys assets were tied to mortgages, explaining the substantial decline engineered by the sharp drop in mortgage prices. Fraudulent business practices such as falsification of balance sheet items to secure funding from the repo market also contributed to the crashing of the institution. Allen & Carletti (2009) observed that the demise of Lehman Brothers sent disruptive consequences into the market that changed the lending practices. Their findings indicate that lenders shrunk their credit, causing a liquidity crisis.

As the crisis wore on, Indy Mac also collapsed. The country-wide mortgage lender had a lot its loans tied to the housing market when the crisis began. What caused the collapse? According to Kolb (2010), the mortgage lenders failure was occasioned by its aggressive growth strategy based on the massive origination of nontraditional loan products and its huge concentration of credit in the housing business in the markets of California and Florida. Statistics show that in the year 2006, the company originated more than $90 worth of mortgages. The concentration of its investments in high-risk securities prompted the liquidity crisis. The collapse of the housing market triggered panic that caused massive withdrawals, crippling the liquidity of the institution. Findings of the Office of Thrift Supervision showed that the bank made excessive lending to subprime borrowers and floated some of the prudential guidelines in making investments in risky assets. Although the regulator noted some of the issues before the collapse, the company could not avert the crisis as the prices in the housing market had plummeted, constraining its fortunes in the real estate market (Kolb, 2010). Also, the subprime borrowers failed to repay their loans exacerbating the liquidity challenges. In light of the crisis, Scharfstein (2010) argued that advancing vast sums of money into the real estate sector pushes the prices together with personal debt. The rising of personal debt was higher than the incomes of the borrowers thus the inability to make the loan repayments. Like the Lehman Brothers, there was a violation of business ethics in dealings as insufficient underwriting and selling of securities that gave little benefit to the customers were rampant.

The increase in personal debt resulted in financial difficulties for mortgage owners. The strained incomes led to huge defaults in loan repayments. The lenders instituted foreclosures that led to homelessness for many families across the US. At least one in every 49 properties in the US went into foreclosure in the year 2009, and 2010 2.9 million mortgage investments were filed for foreclosure. The period before the financial crisis the economic environment allowed mortgage owners to refinance or sell their homes during difficult financial strain to repay their loans. But the situation was unfavorable during the crisis because the prices in housing drastically, making the mentioned option unviable. The figures from the US Department of Housing and Urban Development (2009) indicate that homelessness increased in both cities and rural areas. The department estimated that by September 2008, 664,000 people were homeless in the US. The homeless in shelters and on the streets showed an increase from the previous year and the concentration of these homeless people was noted highest in the cities of Los Angeles, New York, and Detroit. In the mentioned month, the number of people entering the New York City homeless shelters increased by 40%.Massachusetts also reported a 32-percent increase in the number of families in state-sponsored shelters from the from November 2007 to November 2008(US Department of Housing and Urban Development)

Following the collapse of Lehman Brothers, many financial institutions began reassessing the credit profiles of borrowers and tightened lending regulations. Studies conducted by Ivashina & Scharfstein (2010) found out that the collapse of Lehman Brothers and Washington Mutual increased credit line draw downs. The findings of the research also indicated that new loans to borrowers dropped by 47% during the fourth quarter of 2008 vis-a-vis the third quarter of the same year. The investigation into the fall in lending immediately before the crisis shows that new loans to large borrowers fell by 79% relative to the second quarter of the year 2007.Ivashina and Scharfstein further find that the fall of Lehman Brothers affected the banks that syndicated loans with the institution. Borrowers who made credit line draw downs during the crisis aggravated the situation since the banks feared for their liquidity. This problem was further compounded by the short-term financing of the banks rather than insured deposits which increased credit line draw downs. These studies are consistent with the findings of Berrospide and Meisenzahl (2015) that showed that the collapse of Lehman Brothers reduced the cash flows of firms, resulting in the decline of the aggregate liquidity and increased credit line draw downs. These happenings did not allow banks to and borrowers to engage in conventional credit-line withdrawals due to the liquidity panic from firms. Traditionally, banks and borrowers made prearranged credit lines to sustain investment spending during liquidity shocks.

Although the effects of the financial crisis were not widespread across the insurance sector, some institutions that were highly interconnected with the financial system were affected. These consequences touched on specific segments of the insurance industry. According to Liedtke and Schanz (2010), the pressure was on the asset portfolios of life insurance that were tied to the mortgage sector and guarantees, and securities of mortgage institutions. The financial risks seemed to affect reinsurance companies who took large risks that were interconnected with the mortgage and the banking business. American International Group (AIG), for instance, experienced liquidity problems due to its interconnectedness with the financial system. The findings of Government Accountability Office (2009) indicated that AIG was not insolvent but experienced liquidity problems due to its engagement in trading of non-insurance products. The insurance company received shocks on its AIG Financial Products unit which carried activities that entailed securities lending related with the mortgage market.

The financial crisis affected manufacturing businesses across the United States. According to Mimoun (2010), most lending institutions feared the risks of default due to the shrinking incomes of peopl...

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