Recession – How did we Get Here?

There are several factors that have played significant roles in the birth of the current economic crisis. At its very core, the sub-prime mortgage meltdown was a major catalyst. To give you a brief history of how it all began, let's first explain just what a sub-prime mortgage is. Simply put, it's an adjustable-rate mortgage (ARM) that was offered to individuals with generally weak credit ratings. The brokers that offered these mortgages received commissions on every sale, thus feeding the impetus to entice and cajole buyers into purchasing homes, whether they could actually afford them or not. Attractive, low front-end payments were basis of their sales pitch.

During this housing boom, predatory lenders sold homes to individuals with little regard to their FICO scores, offering homebuyers interest rates that were so low they were, in a word, 'irresistible.' What transpired next was that the lenders would package and sell those mortgages to investors both here and abroad. However, unbeknownst to the many buyers, within a relatively short period of time after purchase the interest rate of the ARM adjusted – upward, of course – and increased the loan's monthly payment. Interest rates on the mortgages increased to a point that many homeowners could not meet those higher payments. Needless to say, foreclosures ensued, prices of existing homes declined, and the housing market eventually collapsed.

According to foreclosuredataonline.com, the sub-prime mortgage problem became serious when in June of 2007 two Bear Stearns hedge funds collapsed. This had a rapid effect on other parts of the financial markets worldwide, which reached the crisis level in August-September of 2008 and temporarily froze the money market sector, which is critically important to banking and financial operations.

As sub-prime mortgages began to reset in droves resulting in waves of foreclosures, housing prices inevitably declined. Because of the way these loans and Collateralized Debt Obligations (CDOs) were globally distributed, the whole system was dealt a crucial destabilizing blow. (It should be noted that a single CDO package might contain as many as 100 sub-prime mortgage loans.) As the defaults continued, the worldwide CDOs took a major hit and the entire structure collapsed like the house of cards it actually was.

Paul Krugman, an economist and Nobel Prize winner, noted that the innovations of recent years – the alphabet soup of CDOs, SIVs (Structured Investment Vehicles), RMBSs (Residential Mortgage-Backed Securities), and ABCPs (Asset-Backed Commercial Paper) – were all sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead (aside from making their creators a ton of money, none of which had to be repaid when it all went bust) was spread confusion, luring investors into taking on more risk than they realized.

Why was this allowed to happen? At a foundational level, the problem may have been an ideological one – policymakers, committed to the view that the market is always right, simply ignored the warning signs. The bottom line is that policymakers left the financial industry free to innovate without real oversight or restraint, and what it did was innovate itself, and the rest of the world, into virtual chaos.