The 2007-9 recession for morons

[Undesired Walrus]

Can someone explain, in layman terms, what exactly caused the recent recession? I can't be the only one who feels like they have no idea what the hell economists jabber on about, but I often feel like the only one.

[drkitten]

Can someone explain, in layman terms, what exactly caused the recent recession? I can't be the only one who feels like they have no idea what the hell economists jabber on about, but I often feel like the only one.

Banks made bad business decisions, based on bad assumptions (mostly about housing prices).
When those assumptions turned out to be false, they lost a lot of money and panicked -- and stopped lending money at all, even to good customers. This is/was the "credit crunch."

With easy, cheap credit cut off, a lot of businesses started losing money. (You can't sell houses or cars if people can't get loans to buy them; you can't afford to build houses or cars if they won't sell.) They started cutting down on spending and also started laying people off. And, of course, the people who were laid off or who had lost money on their houses also started cutting down on spending.

When everyone cuts down on spending, that's a pretty good definition of a recession.

[BeAChooser]

Title is wrong. The recession isn't over yet. As to what caused it, ask the folks who ran Fannie and Freddie, and who chose not to regulate them. In fact, ask the folks that just did this ... http://www.reuters.com/article/idUSTRE5BN2ZI20091224 . democrats, one and all. :D

[kevinquinnyo]

There was a housing bubble.

A positive feedback loop was created in the market, of houses being built and purchased on speculation, which in turn led to more houses being built, until at some point the market was flooded, and in retrospect overvalued.

The result was a huge loss of wealth.

The reason it happened is because, as Dr. Kitten alluded to, lending institutions were giving out loans like candy, without doing their diligence.

Why were they doing this?

The reason is because there is a global pool of wealth that seeks safe investment, and up until recently, hedge funds, pension funds, investors, and other large sources of money that needs a home, (to make interest) had few options. In the past, these pools of money would find a home in government bonds (generally regarded as a very safe investment) or other safe methods of investment, that produce a relatively low, but reliable cash flow.

But a new form of investment was invented with the mortgage-backed security. The basic idea, is that you take a whole bunch of mortgages, of varying risk to default, and group them together, to hedge against risk. (very much like an insurance company can hedge risk by having a very large group of people with varying risk).

The premise being that real estate values, historically, especially in the United States, seemed to always go up, on the whole.

So, an MBS can be thought of as buying stock (it's actually more of a bond) in a bunch of people's mortgages.

Because this was seen as a safe investment, the global pool of money couldn't get enough of these MBS's, so lending institutions, given the demand, and seemingly endless payoff, created more mortgages. When they started to run out of legitimate homebuyers, they started giving mortgages to anyone with a face.

You can see how the positive feedback loop got out of control...


One of the main reasons behind the reasons, was the very low interest rate in place at the time. Alan Greenspan has actually admitted to being a part of the problem.

Of course, bubbles in markets are not new, and will likely always occur. It's very difficult to tell, during a bubble, what portion of wealth is 'real,' and what portion is based on speculation and positive feedback.

I'm leaving out a LOT of info, particularly I didn't make the distinction between the big sister of MBS's, called CDOs. (Collateralized Debt Obligations).

If you want to watch some really cool video lessons on MBSs and the entire credit crisis/Housing Bubble, check this (http://www.youtube.com/user/khanacademy#g/c/945E4F0ED131E4D1) out.

The link is from Salman Khan, of the Khan Academy. Really great stuff.

And don't worry, if I remember correctly, the first couple of videos in that playlist treat you as if you know absolutely nothing, so you can watch them or skip them if you need to.

[r0ast_p0tat0es]

"Too many houses in the USA" was the proximate cause, but the system lends itself to these problems.

This is how a pyramid scheme works:

The initial mark makes one payment - let's say it's $1000. In a classic pyramid scheme, he then has to convince another two people to make the same payment. Those people in turn each have to convince two others, who then convince two others themselves. At this point the initial mark can leave with his promised return - $8000 - and everyone in the scheme moves up one level - the scheme keeps providing returns for its initial investors, provided it keeps expanding. However, when it all comes crashing down - which it inevitably must do - roughly 88% of all people who bought into it will be left with a deficit.

This is how the economy works:

Joe Sixpack makes a deposit of $1000 capital in a bank. As banks are only required to keep a small fraction of their reserves on hand at any time, this $1000 deposit allows the bank to dish out loans worth $10 000 to other people. i.e. The bank just created $9000 of fiat currency from nothing.

As long as everyone they gave a loan to is capable of meeting their monthly payments, the bank can maintain their fractional reserve, and thus keep their investors happy.

Just like a classic pyramid scheme, the economy itself needs infinite growth in order to function. With regards to the last recession in particular, it was depending on infinite growth in the housing sector - people just had to keep emerging from the mud like Urukai in The Lord of The Rings, checkbook in hand to buy up houses in suburbia until the end of time.

Of course there is not an infinite supply of buyers. To maintain the bubble, banks lowered their standards for granting housing loans. People couldn't pay them back. With no new money coming in, the whole thing collapsed like a house of cards.

Or at least it would have, except unlike illegal pyramid schemes, the economy has a "central" banking system funded by the state. That's a nice way of saying that instead of sending the people responsible to jail for many years, like we do with ordinary pyramid schemesters, the taxpayer got to bail them out and keep them rich.

As long as our economy is based on the fantasy of infinite growth, recessions will continue to happen. Pretty soon, the system will collapse entirely, as the resources our economy depends on are rapidly becoming depleted.

[kevinquinnyo]

[...]

As long as our economy is based on the fantasy of infinite growth, recessions will continue to happen. Pretty soon, the system will collapse entirely, as the resources our economy depends on are rapidly becoming depleted.

Disagree. Why so pessimistic?

We will always find ways to create wealth and have an economy. In fact, having less natural resources, means there is even more need for an economy. This is because economics is essentially the study of the allocation of limited resources with alternative uses.

Only if there were somehow infinite resources, would there be no need for an economy.

[corplinx]

The thing to remember is that the recession was pretty mild until the oil bubble. The oil bubble was an immediate drag on the economy as gas prices rose. The oil bubble made companies and consumers stop spending money, creating more layoffs/foreclosures and thus making the existing mortage/foreclosure issue worse.

The credit markets freezing soon afterward is probably a nice tipping point of the stock market drop.

[drkitten]

This is how the economy works:

Joe Sixpack makes a deposit of $1000 capital in a bank. As banks are only required to keep a small fraction of their reserves on hand at any time, this $1000 deposit allows the bank to dish out loans worth $10 000 to other people. i.e. The bank just created $9000 of fiat currency from nothing.

As long as everyone they gave a loan to is capable of meeting their monthly payments, the bank can maintain their fractional reserve, and thus keep their investors happy.

Just like a classic pyramid scheme, the economy itself needs infinite growth in order to function.

This is simply wrong.

Bankers aren't idiots and expect a certain level of default on their loans. That's why they charge interest; if they expect that 5% of their loans will go south (and it costs them 1% to administer the loan), they'll charge 10% interest. 1% of that covers costs, 5% covers the loans that default (which can be used to maintain fractional reserves), and 4% becomes a healthy profit margin, some of which can go to expansion and making fractional reserves larger.

If the borrower has enough collateral, you don't even need much interest. If I expect to be able to sell your stamp collection for $300,000 in the case of a default, I can get away with only charging you 5% for a $200,000 loan if it's secured by your stamp collection. (Again, that's 1% servicing fee and a 4% profit -- if you default, hey, I collect $100,000 (33%) in profit, instead. I can live with that. In fact, I'd probably prefer that you defaulted.)

So you don't need infinite growth and it's nothing like a pyramid scheme.

The problem with the last/current recession was simply that banks misjudged both the risks and the value of the collateral. If it turns out that your $300,000 stamp collection can only be sold for $50,000, then my decision to lend to you wasn't so smart after all. And if instead of a 5% chance of default, it turns out that 25% of my loans default, then I'm going to be eating a lot more losses than I otherwise would.

So the problem isn't/wasn't structural. It's not a scam, just some widespread bad business decisions.

[skeptical]

No discussion of the recession would be complete without mentioning Default Credit Swaps (CDS). This is just a fancy term for insurance on a debt. It allows you to transfer the risk of a debt to someone else by paying a premium, just like insurance on a car or house.

A short but good intro is here: http://www.youtube.com/watch?v=DdEI6PkGZK8

The entire global financial system was infested with a web of these private, unregulated contracts, and it very nearly brought the entire system down. If you want to know why you kept hearing "we have to keep AIG from failing", its because AIG insured a large number of these bad debts, and if they went down they were going to bring a very large number of other institutions with it. And those institutions had their own insurance on other debts at other banks, which would mean those bad debts would cause still more failures and so forth.

[JihadJane]

So the problem isn't/wasn't structural. It's not a scam, just some widespread bad business decisions.

Ha ha! See no fraud, hear no fraud, speak no fraud.

Limits imposed by finite resources (particularly energy) are killing humanity's runaway, ecosystem-destroying, cancerous growth paradigm, hopefully.

[drkitten]

Ha ha! See no fraud, hear no fraud, speak no fraud.

That's right. All of those are simple consequences of the fact that 'is no fraud.'

[Debunker]

Can someone explain, in layman terms, what exactly caused the recent recession? I can't be the only one who feels like they have no idea what the hell economists jabber on about, but I often feel like the only one.

War in Iraq?

[JihadJane]

That's right. All of those are simple consequences of the fact that 'is no fraud.'


Yes, just some widespread bad business decisions...

All perfectly innocent...

:hypnotize

[JihadJane]

The best way to rob a bank is to own one:

'Obama Administration Involved In Mass Coverup'

VIDEO: 28:18

"Bill Moyers interviews William K Black, white collar crime expert and one of the central figures involved in exposing the S&L scandal in the 1980s. Black alleges that the top bankers, indeed most of the financial community, were involved in fraud or the facilitation of fraud, and that the Bush administration and now the Obama administration were and are involved in a coverup."

http://video.google.co.uk/videoplay?docid=1639422077439069408&hl=en#

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~

@ Undesired Walrus

What's makes you think the recession ended in 2009?

[JihadJane]

FBI: “an epidemic of mortgage fraud”.


**Danny Schechter: "...the media has framed this only as a business story, not as a crime story."



** VIDEO, 10 minutes: Danny Schechter talking on The Real News Network (http://therealnews.com/t2/index.php?option=com_content&task=view&id=31&Itemid=74&jumival=4702&updaterx=2010-01-11+01%3A46%3A09)about the financial meltdown as a crime story and his new film Plunder - Investigating Our Economic Calamity (http://therealnews.com/t2/index.php?option=com_content&task=view&id=31&Itemid=74&jumival=4702&updaterx=2010-01-11+01%3A46%3A09)

[paiute]

This American Life had an episode about the recent and rapid increase in the global
"pool" of money and how that money chasing a higher return than the Fed was going to provide distorted the mortgage market in a bad way.

http://www.thisamericanlife.org/Radio_Episode.aspx?episode=355

[metzomagic]

No discussion of the recession would be complete without mentioning Default Credit Swaps (CDS). This is just a fancy term for insurance on a debt. It allows you to transfer the risk of a debt to someone else by paying a premium, just like insurance on a car or house.

I think skeptical has nailed this one. Not only was the bad debt being repackaged and insured, it was being sold on to other institutions further down the food chain, almost like a commodity. Incisive article about this here (from a source you wouldn't normally expect):

http://www.rollingstone.com/politics/story/26793903/the_big_takeover/1

Read that, and you get some appreciation for the *scale* this was happening on :-\

[Jaggy Bunnet]

If the borrower has enough collateral, you don't even need much interest. If I expect to be able to sell your stamp collection for $300,000 in the case of a default, I can get away with only charging you 5% for a $200,000 loan if it's secured by your stamp collection. (Again, that's 1% servicing fee and a 4% profit -- if you default, hey, I collect $100,000 (33%) in profit, instead. I can live with that. In fact, I'd probably prefer that you defaulted.)

This is (at least as far as the UK is concerned) wrong. If you default, I take your stamp collection and sell it. If I get back more than the amount you owe me, plus costs, I return the surplus to you. There is zero possibility of a profit arising because the security exceeds the debt.

[Jaggy Bunnet]

Banks made bad business decisions, based on bad assumptions (mostly about housing prices).
When those assumptions turned out to be false, they lost a lot of money and panicked -- and stopped lending money at all, even to good customers. This is/was the "credit crunch."

Again, from a UK perspective, the point was not that banks stopped lending money because they panicked, but because they had no cash to lend.

UK banks typically raised less from deposits than they lent in loans. The difference was borrowed on the wholesale markets, typically on relatively short term loans. While the wholesale market was willing to lend, this was fine. Once the wholesale markets got worried about whether the banks could repay, they stopped lending, leading to an acute shortage of cash in the banking system - meaning the banks stopped making new loans, not because they would not be profitable but because they did not have cash to lend.

[GlennB]

No discussion of the recession would be complete without mentioning Default Credit Swaps (CDS). This is just a fancy term for insurance on a debt. It allows you to transfer the risk of a debt to someone else by paying a premium, just like insurance on a car or house.

A short but good intro is here: http://www.youtube.com/watch?v=DdEI6PkGZK8

The entire global financial system was infested with a web of these private, unregulated contracts, and it very nearly brought the entire system down. If you want to know why you kept hearing "we have to keep AIG from failing", its because AIG insured a large number of these bad debts, and if they went down they were going to bring a very large number of other institutions with it. And those institutions had their own insurance on other debts at other banks, which would mean those bad debts would cause still more failures and so forth.

Wasn't it also the case that these were then 'leveraged' way beyond the total actual losses that might have been incurred by real defaulting loans. That is, they became a gambling medium?

[drkitten]

Again, from a UK perspective, the point was not that banks stopped lending money because they panicked, but because they had no cash to lend.

UK banks typically raised less from deposits than they lent in loans. The difference was borrowed on the wholesale markets, typically on relatively short term loans.

Really? The UK doesn't practice fractional-reserve banking? How.... quaint.

[Jaggy Bunnet]

Really? The UK doesn't practice fractional-reserve banking? How.... quaint.

Certainly does, but you still need cash.

[skeptical]

Wasn't it also the case that these were then 'leveraged' way beyond the total actual losses that might have been incurred by real defaulting loans. That is, they became a gambling medium?

Yes, that indeed seems to be the case. A poster earlier in the thread mentioned the Rolling Stone article, I concur with them that it is well worth the read. I don't recall where I first came across it as I don't normally read RS, but I forwarded the link to all my friends and family (no idea who read it or didn't) because it was my first real "holy crap" moment when I realized just how insidiously crazy the world economic system had gotten.

To say it was gambling is an understatement, it was more like a legalized pyramid scheme where the last bank was going to get it in the shorts. The problem was, there was no "last bank", it was "all banks", or at least all the big ones. They were all in hoc up to their necks on large numbers of bad housing loans predicated on the principle of infinite upside in the housing market.

This may sound like I am spinning this to make it seem worse than it was, but as far as I can tell it really was this bad, maybe even worse. The fact is, to my knowledge there are still lots of CDS style arrangements out there, and no one really knows how many there are because these are all private transactions completely unregulated by any govt body.

For those who want a free market with little regulation, there you go. You don't get any more free than zero.

[The Don]

IMO a key element to the collapse was financial institutions ability to securitise blocks of loans and as a result move them off the balance sheet. Consequently they were able to lend much larger multiples of their capital than would otherwise be the case. When loans started defaulting, the value of the securitised loan assets were impossible to determine and effectively dropped to zero (because no-one was willing to buy them). The banks then had no capital to lend.

Those institutions which still had cash hoarded it against possible future losses and as a result the wholesale money markets dried up (and the margins required soared).

[Eddie Dane]

If this doesn't clear it up, nothing will.

The credit crisis explained. (http://www.youtube.com/view_play_list?p=823872ACFE6369A2&search_query=credit+crisis+explained) :D

[Corsair 115]

My impression would be that the problem boils down to the U.S. having allowed its financial system to become the equivalent of a giant Ponzi scheme.

[Meadmaker]

Can someone explain, in layman terms, what exactly caused the recent recession? I can't be the only one who feels like they have no idea what the hell economists jabber on about, but I often feel like the only one.

So, have the previous explanations helped?

One thing everyone agrees about is that housing prices were unrealistically high, but everyone, from families to banks to investors who purchased bonds that were based on mortgages, were treating their home values as if they were money. The sudden realization that people didn't have as much money as had been suspected caused a whole lot of trouble.

I don't think the oil prices have been given enough credit. In addition to popping the bubble, they changed spending patterns. Detroit had a lot of capacity to build trucks and vans that suddenly were not in demand. That sudden change in demand can cause recessions.

Other industries were similarly affected. Travel businesses found they couldn't draw as many customers as they had to raise prices to cover energy costs. Restaurants and entertainment went out of business as people poured previously discretionary income into their gas tanks. Retailers were hit from all sides. Lower discretionary income reduced sales. Increased shipping costs raised overhead. Furthermore, a lot of people, suddenly conscious of the price of gas, took fewer trips to shopping areas, resulting in lower impulse buying rates. Even now, these effects continue. Those $2.75 cent gas prices look small compared to last summer, but they are larger than they ever were in the past, and they continue to have effects on spending, and industries are still having a difficult time adjusting.

[Travis]

I should point out that it wasn't so much a surplus in housing as it was a surplus in certain types of housing. There were far more 3,800+ sq/ft $450,000+ homes built, especially here in California, than there was any reasonable amount of true demand for. In hard hit cities like Modesto and Stockton these types of homes are where the majority of the mortgage defaults occurred.

[Toke]

I had the impression that the rise in oil and grain prices were due to people trying to find somewhere else that mortgages backed papers to store their money.

[daenku32]

My impression would be that the problem boils down to the U.S. having allowed its financial system to become the equivalent of a giant Ponzi scheme.

The sad part is that US is primarily just a combination of financial institutions, TGI Friday's, and pro sports. And that's just about it. All the wealth in this country is tied up in institutions.