What Triggered the Recession?

Group Project Individual Research Paper

By: Monica Kempski

 The United States of America is known as the “land of opportunity.” Throughout history, millions
and millions of United States citizens have yearned to achieve the “American Dream,” which involves a
steady income, excess money to spend, and a big house. However, a recession may foil these dreams
and aspirations for countless Americans. Currently, the nation is hurting because of unwise investments
in the housing market, which led to a spiral of macroeconomic issues resulting in the downturn of the
economy. Recently, the United States of America entered a recession in 2007. Why this happened is an
important question to address so that America may not make this mistake again.

The origin of this recession is the real estate explosion in the 1970s. At this time, the country
was economically successful, and people had discretionary money to spend. Financial capitalists also
had great lending power. However, non-financial corporations were well-off enough that they did not
borrow from the financial capitalists. As a result, the financial capitalists looked for others to borrow
from, turning to the citizens searching to improve their living space. Here, they promoted the idea of
actually owning a home instead of an apartment, like their parents had generations before (Moseley).

In result of vast discretionary incomes, the majority of the population started buying homes
instead of lower-costing apartments. Thus, the people yielded to the lender’s wishes. The sale of homes
even expanded to the purchases of vacation homes for retirees. With all of this demand for housing,
demand of housing was less than supply. Thus, a shortage was created that drove up prices of real
estate (Morris, and McGann,238).

Despite the higher prices, the banks offered benefits to first time buyers. These tax advantages
and lower interest rates allowed people to purchase more expensive homes than their budget would
normally allow (Beck, 185). Therefore, the banks and the people practically ignored their incomes and
took out loans to help pay their mortgages. During this time, the bank’s lending to households increased
from 1970 to 2006 by thirty to fifty percent. Then, by 2006, the total value of mortgages tripled from
1998. All of these numbers enlarged the ratio of household debt to disposable income. It increased from
sixty percent in the 1970s to one-hundred percent in 2000. But this growth was not over. In 2007, it
increased to a massive 140 percent (Moseley).

By the new century, the financial capitalists had no credit-worthy workers to meet the criteria
for a “prime” mortgage; but, they still had more money to lend out to the people. Thus, the “subprime”
mortgage was created to give mortgages to lower-income less creditable workers (Moseley).
 To take advantage of the people and to get more money, the loaners created a system to
deceive people into taking these “subprime” loans. These loans put aside down payments, gave
adjustable mortgage rates (thus allowing them to pay less on opening rates), made more interest rates if
the borrower couldn’t afford the reduced rate, and created mortgage lender fees. In result, the
borrower would pay the interest on the first payment in addition to the loan interest; thus, monthly
payments would double or even triple for families (Morris, and McGann, 241).

An additional problem arose in 2006. During this year, housing prices stopped increasing. After
that, prices fell by twenty-five percent. Housing sales also fell due to this increase in price (see graph).
Even if a person tried to re-sell his home, it would be worth less than what he had bought it for. Thus, he
lost money from his original investment. Because of this, when it was time to reset mortgage rates,
people could not refinance (Moseley).

As a result, borrowers with low equity in their homes quickly reached a conclusion that it was
better to cease mortgage payments and let the bank reposes the house rather than struggle paying back
borrowed money that was no longer supported by property value. The banks in turn lost vast amounts
of money! The funds from the original sale price of the house went to the seller of the property. The
difference between the sale price paid and current property value represented the amount of
unrecoverable money or loss sustained by the bank. Multiply this scenario over hundreds or even
thousands of properties and the banking industry losses added up to the billions of dollars.

Because of this gigantic increase in monthly payments from loans and the fall of housing prices,
the people could not pay back their loans to the banks. In panic of losing any more money, the banks
responded by not giving out any more loans. Thus, cash flow halted and the banks began to go bankrupt
(Arunaj). One such disaster was Fannie Mae. This enterprise is government-sponsored that “seeks to
provide liquidity, stability, and affordability to the U.S. housing and mortgage ("FannieMae"). Hence, the
government had failed.

The government agency of the Federal Reserve Board failed to fix the mortgage issue in 2007. In
June, they forced banks to stop abusing the borrowers. However, this only applied to the banks, and not
to the non-bank lenders. These non-bank lenders accounted for the majority of the subprime loans, so
the regulation did not help the situation. Then in December, they released a set of conventions that
commanded banks to get extensive financial data from their borrowers. This process was for the
purpose of measuring the borrower’s ability to pay off their loans, so that they could avoid lending to
doubtful borrowers. However, as described above, it was too late (Morris, and McGann 249).

According to Keynesian macroeconomics, a nation may enter recession when there is a fall in
aggregate demand. This includes the consumer spending, investments, government spending, and net
exports of a country. If any of these values fall, there will be a fall in Real Gross Domestic Product, or
GDP. In 2007, consumer consumption fell for the first time in twenty years, at 6.4% (Chandra). It was the
largest decline since 1950. This was due the housing debt, making the consumers fear to spend their
money on goods and luxuries. At the heart of the mortgage crisis in 2008, the GDP fell by two percent,
and then five percent in 2009 (Guha, Handout 5). Because of the two consecutive quarters of falling
production (GDP), one can conclude that the nation entered a recession. In addition, the household debt
equaled GDP in 2007 (Palley). In saying so, there was no discretionary income; again, meaning that no
one has extra money to spend on consumer goods because that portion of family funds go to financing
the household debt.

This recession is unfortunately a vicious cycle. Because of taking on housing debt in

unreasonable amounts, people are consuming less because they have less money to spend. Less
available discretionary income triggers a drop in demand for goods and services. Inventories begin to
build. Companies cut back on production and therefore don’t produce as much, thus declining
economic output. In effect, workers get laid off (cyclical unemployment) which in turn leads to a
recession. Can the nation pull out of a recession? Only with careful government policies, less
government intervention, and the reliance on self-correcting free market forces will the capitalistic
economy get back on track. Hopefully the citizens and government of the United States can learn from
their unwise mortgage practices and avoid or minimize the negative effects of another recession.