1. Introduction
A recession is defined by the National Bureau of Economic Research (NBER) as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales”. While there are typically many factors that make a contribution to an economy slipping into recession, the ultimate cause can be traced back to inflation.
While the many different reasons for inflation may be poles apart, the result of a rise in the prices of goods and services is a decline in economic activity. The most recent recession in the United States was a ...view middle of the document...
The alarm that was felt in the market was because investors feared that the Federal Reserve Chairman would inflate interest rates at the central bank in order to slow down the economy, which is exactly what the founders of the Federal Reserve did in 1928 (Hetzel 2009).
Financial panics are often attributed to the inevitable collapse of asset speculation. As an asset experiences growing returns in a bull market, it typically becomes over valued and irrational exuberance is felt amongst investors. A major contributor to The Great Recession was brought about precisely because of this nature of investor greed.
The euphoria that was emanating after the early 2000’s minor recession had investors in a frenzied state. Although previous crises have occurred rather frequently, this fact was easily forgotten during these boom years (Verick & Islam 2010). The bubble that was being created revolved around the housing market. Home prices were increasing incessantly, which led to speculation of an ever-growing asset, real estate.
Because of the aura that real estate would appreciate indefinitely, an overwhelming number of U.S. citizens were purchasing homes that were out of their budget and most times already over-priced. This over-extension of credit can be traced back to the Clinton administration, which instituted stated income loans where the borrower was not required to
provide proof of their ability to pay the debt they were requesting. Fannie Mae also reduced the required down payment on a home in order to provide mortgages to more residents, but in turn charged a significantly higher interest rate to borrowers who lacked a strong credit history.
Out of this particular housing market speculation sprung credit-default swaps (CDSs). A CDS is an insurance policy on the default risk of a corporate bond or loan. Banks in the U.S. began packaging mortgage backed securities and selling them to investors. Goldman Sachs was one of the top traders of mortgage backed securities that led to this period of economic crisis, and is currently being sued by several different entities including the United States Government. The suits claim that Goldman Sachs knowingly sold mortgage backed securities that it knew to be junk without disclosing all information about them.
In 2007, the housing bubble finally burst, which caused an incredible rate of defaults on subprime mortgages. With homes being foreclosed upon and home prices deteriorating, the mortgage backed securities that were in the market went defunct with the burst. The CDSs that were outstanding made it impossible for most firms to pay their debts, since they were responsible for the loss of value that was incurred.
3. The Financial Crash
By August of 2008, there were $63 trillion of outstanding CDSs, when the United States GDP in 2008 was only about $14 trillion (Bodie 2010). At this point in time, AIG alone had more than $400 billion of CDS contracts on subprime mortgages. ...
