The Great Recession

How Did the Great Recession Start?

by Gabriela Schneider

The recent financial crisis plays a crucial role in The Way West as the cause of many of the problems the central characters face. Mom is going bankrupt and facing a foreclosure on her house because of a second mortgage—probably subprime—that she took out before the collapse. Later in the play, we hear about the effects the recession has had on the neighborhood where mom lives: the city can no longer afford to keep the parks open, and the neighbors on both sides of Mom’s house have been evicted. While the pioneers in Mom’s stories faced exhaustion, starvation, and hostile Native Americans, the main villain in her and her daughters’ lives is the economy.

An empty house in Las Vegas

A brief explanation of the main factors that got Mom, and the rest of America, into this mess

The housing bubble: In general, a speculative bubble happens when prices rise much higher than the intrinsic worth of the items being sold, until prices get so high that people simply stop buying. Prices drop precipitously after demand stops growing; that’s when the bubble pops. The recent housing bubble refers to the rapid increase in housing prices nationwide between 2002 and 2007. One well-known symptom of the bubble was the sudden popularity of “flipping”—buying real estate properties and quickly reselling them for a profit.

This graph shows the median and average sale prices of homes sold in the US from 1963 to 2011. The rapid rise and collapse of the bubble can be seen near the right edge of the graph.

Bad mortgages: Subprime mortgages are mortgage loans made to subprime borrowers; that is, people with weak credit histories, who are more likely to default on the loan or struggle to make payments on time. While the housing bubble was growing, banks were issuing more subprime loans then ever before, and coming up with new types of loans that made homeownership more accessible but often at the cost of failing to properly screen the buyers. Traditional mortgages have a fixed interest rate and a thirty-year term, and require verification of the potential buyer’s income and assets. Many of the loans offered to subprime borrowers did not require such verification, and they often featured adjustable interest rates that started out lower than the traditional fixed rates but could later be changed at the lender’s discretion.

"U.S. Home Ownership and Subprime Origination Share" by Farcaster at en.wikipedia. Licensed under CC BY-SA 3.0 via Wikimedia Commons - http://commons.wikimedia.org/wiki/File:U.S._Home_Ownership_and_Subprime_Origination_Share.png#/media/File:U.S._Home_Ownership_and_Subprime_Origination_Share.png

Mortgage-backed securities: Instead of buying shares in a company and receiving a portion of its profits, investors in a mortgage-backed security (MBS) own shares in a group of several hundred mortgages. Since each share includes a small part of each mortgage, it is less risky than actually lending money directly to one person, and in theory the number of mortgages in the pool balances out the likelihood that any one of them will default. However, because the subprime mortgage situation was so unprecedented, the ratings agencies that determine how safe investments are tended to underestimate the danger, and mortgage-backed securities made up of subprime mortgages were considered very safe investments when in fact they were not.

This chart attempts to explain the complicated machinations behind mortgage-backed securities and CDOs.

How the stock market and the housing market got so tangled up: Wall Street and Main Street may seem like two separate worlds at times, but the different sectors of the economy are all interconnected. The reason the housing bubble and its collapse had such a profound effect on the entire economy was the “food chain” linking the homebuyers with subprime mortgage debt to the investment bankers selling shares in that debt. In between were many levels of bankers, brokers, and investors who were involved in turning unwise home loans into a very popular form of investment. The more popular mortgage-backed securities became on Wall Street, the more the investors encouraged the lenders to find more people to take out mortgages, and so lenders kept making it easier for people to qualify for loans they couldn’t really afford. Once the bubble popped, property values began to decrease, defaults and foreclosures became increasingly common, and the chain reaction started to move in the opposite direction. When homeowners couldn’t make their payments, people all along the chain lost money. Many subprime lenders went bankrupt, and the large investment banks that had been trading in mortgage-backed securities were also vulnerable to collapse.

Timeline of the causes and effects of the crash and the history behind it

  • October, 1929: Wall Street crash marks the beginning of the Great Depression, a decade of economic downturn, poverty, and unemployment in the United States and worldwide.
  • 1933-38: President Franklin D. Roosevelt and Congress enact the New Deal in response to the Great Depression, promoting the “3 R’s” of Relief (short-term help for the poor and unemployed), Recovery (long-term efforts to restore prosperity), and Reform (new regulations to prevent a crash from happening again). Many of the programs created by the New Deal are still in existence today, such as Social Security and the Federal Deposit Insurance Corporation (FDIC).
  • 1938: Federal National Mortgage Association (Fannie Mae) is founded as part of the New Deal. Its purpose is to buy up mortgage debt from smaller lenders, leaving them with more cash available to make loans and thereby enabling more Americans to get mortgages.
  • late 1940s—early 1970s: Postwar economic boom. Suburban population explodes. Home ownership cemented as part of the American Dream.
  • 1970: US government creates the Federal Home Loan Mortgage Corporation (Freddie Mac), a counterpart of Fannie Mae. Fannie and Freddie have the ambiguous status of “government-sponsored enterprises”—not part of the government, but public corporations with an implicit guarantee of government bailout if they fail.
  • 1970s: Fannie and Freddie start to issue mortgage-backed securities. These are pools of many mortgages in which investors can buy shares. Regular banks begin to do the same, and mortgage-backed securities become an established type of investment.
  • 2001-2005: The housing bubble: homes are rapidly increasing in value and more people are buying homes than ever before. The US government works to make home ownership more accessible to minorities and low-income families, and people increasingly view real estate as an investment that will never lose value.
  • As the bubble grows, banks and other lenders introduce less strict requirements for mortgage applications and begin lending to many people who would formerly not have qualified; these are known as subprime mortgages.
  • At the same time, mortgage-backed securities become extremely popular as an investment. This fuels the demand for mortgage borrowers, which promotes subprime lending practices and inflates the housing bubble even more. Many mortgage-backed securities are rated as very safe investments even though they contain subprime loans.
  • 2004: US homeownership rate peaks at 69% (this is the percentage of homes that are occupied by their owners).
  • Fall 2005: Housing prices peak and start to decline—the bubble bursts.
  • 2006-2007: Subprime mortgage industry collapses. Defaults and foreclosures increase and many subprime lenders go bankrupt.
  • January 2008: The subprime mortgage crisis hits Wall Street. As more and more people default on their mortgages, the values of the securities based on those mortgages drop, triggering a financial crisis—a state in which everyone wants to sell and no one wants to buy—which spreads throughout the stock market and the banking system.
  • 2008: The effects of the crash are felt worldwide in the global credit crisis. At every level, from individuals to national governments, it is suddenly much more difficult to borrow money.
  • 2007-2009: The US experiences a recession, usually defined as at least two consecutive quarters in which the Gross Domestic Product (GDP) declines. A depression is a long and severe recession, but there is no universally accepted cutoff between the two. Economists have been known to joke that “when your neighbor loses their job, it’s a recession; when you lose your job, that’s a depression.”
  • September 2008: Federal takeover of Fannie Mae and Freddie Mac, fulfilling the implicit guarantee that the government would prevent both companies from failing.
  • October 2008: First government bailout of banks considered “too big to fail.” US Treasury purchases failing assets, including mortgage-backed securities, to prevent major banks from going out of business.
  • 2008-2009: The US Government passes two stimulus packages to stabilize the economy.
  • 2010: Foreclosure rate peaks and starts to decline.
  • 2011-present: Economic recovery continues, but has not reached pre-recession levels. The post-bubble economy is increasingly interpreted as a “new normal,” and many Americans begin to adjust to a lower standard of living.