What Happened During the Great Recession?
Key Points – What Happened During the Great Recession?
- What Happened During the Great Recession?
- What Led to the Great Recession
- Learning from the Dot-Com and Housing Market Bubbles
- Assessing the Impact of the Great Recession
- 7-Minute Read | 10-Minute Listen
What Happened During the Great Recession?
The stock market is in a free-fall and Wall Street is in a full-blown panic. Fear has consumed the American public, as many Americans have never experienced such a catastrophic financial failure. What does this mean for them, their jobs, and their families? The real answer is … nobody knows, but they’re about to find out very, VERY soon.
The year is 2007, and this is … THE GREAT RECESSION.
Why the Great Recession Remains Relevant
For the first episode of our video essay series, we’re going to be revisiting a moment in American history that shook the nation to its core. Economic uncertainty is something Americans are no stranger to these days. The world seemingly grows more unpredictable by the second. So, in the face of uncertainty, we look to our history as a beacon of hope for which we remember the times our Nation overcame adversity.
Today, we’re going to explore one of the biggest financial catastrophes in our lifetime. December will mark 18 years since the Great Recession began.1 We’ll explore what it was, why it happened, break down terminology, and take you on a journey through time. We’ll be utilizing the mountain of research conducted by academic scholars and interviews from professionals in the financial industry through this tale, because in this house we ALWAYS cite our sources. And while the world of finance can be scary at times, just remember … it doesn’t have to be.
How Did the Great Recession Happen?
To set the stage for the Great Recession, we first must look at some of the factors that explain how such a failure could ever happen in the first place. Well, fortunately (for us), we don’t have to look very far. To quote one of our advisors, Shane Barber, who wrote an article on this topic in 2022.
“Nothing happens in a vacuum and actions have consequences. The Great Recession from 2007 to 2009 was no exception. It was also direct result of behaviors that stemmed from the bursting of the Dot-Com Bubble.”
With that being said, let’s set the stage for the Great Recession by looking where some of the roots lay, starting with … the Dot-Com Bubble.
Revisiting the Dot-Com Bubble
For those unfamiliar with the two terms, we’ll break it down for you. First, the bubble. A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets.2 This fast inflation is followed by a quick decrease in value, or a contraction, that is sometimes referred to as a “crash” or a “bubble burst.”
Dot-Com is in reference to the nature/industry of this particular bubble that was created by heavy speculation in internet-based businesses.3 Hence the name “Dot-Com” after their web addresses. This event officially kicked off with the climb of the NASDAQ by a staggering 582% from January 1995 to March 2000 and the subsequent 75% fall from that March to October 2002.4
We know what the Dot-Com Bubble is now, but what are some of the factors that helped form the bubble? Well, there are several, so we’ll do our best to cover as many as possible. If you’re interested in digging through the weeds, check out this research paper by Cesar Delossantos.5 The theme of his research centers around deregulation, venture capital, and a severe overestimation of earnings.
Deregulation
Delossantos’ research found a strong correlation coefficient of 0.4 between the average Initial Public Offerings that included a Discounted Share Program (DSP) and the average underpricing between 1996-2000. He cited the deregulation of the Glass-Steagall Act as a primary contributor to underwriting issues that ensued.6 Delossantos noted that commercial banks became involved in investment banking, which resulted to instances in which they advised clients to make investment decisions that were in the best financial interests of the banks. This frequently led to underpricing or overpricing en masse depending on the status of the company.
The study also found a moderate link between IPOs and Direct Stock Purchase Plans. The increased amount of DSSPs created a lower stock price when the companies would go public. This was an issue because the Glass-Steagall Act was deregulated.
Commercial banks and investment banks used to be separate, but after the de-regs and this newfound freedom banks were able to advise companies, sell their stock, and invest in them which created a HUGE conflict of interest. A bank could promote investments that they had major holdings in, which would benefit them, but not always the client.
In simpler terms, imagine if you went to a store that sold products AND gave shopping advice. If that store started recommending products it profits from the most, even if they’re not the ones that are best for YOU, do you see how that can be a problem? That’s how deregulation contributed to the Dot-Com Bubble. It essentially messed with how IPOs were priced.
Venture Capital
Venture capital firms played a role as well. They dumped millions of dollars into a website startup regardless of profitability and built the brand up, causing the company stock price to skyrocket. From banks pushing these companies onto the bold new frontier of the internet, the forefront of portfolios, and venture capital rushing to get in on the ground floor of a lucrative investment opportunity, the reality is that most of the value was artificially inflated for many of these companies.
When the bubble finally burst, several went out of business.7 Only a few were left standing, and they are now titans of their industry.8
After the Dot-Com bubble burst, the S&P 500 and the NASDAQ came tumbling down. The experience left a bad taste in the mouth of some investors, so they sought to place their assets elsewhere. “But where?” you may ask. Well, to borrow a quote from one of my favorite TV shows: “Buy Land AJ, because God ain’t making any more of it.9”
The Rise of Real Estate
At this point, interest rates had bottomed out at 1% due to the burst of the Dot-Com Bubble. The housing market was positioned to skyrocket, but remember that what goes up, must come down.
Real estate has been generally touted as a notoriously safe investment. After feeling the sting of the Dot-Com Bubble, some investors were interested in something more tangible. From house flipping, rental properties, and everything in-between, the real estate market was booming.10
Let’s circle back to Shane’s article to review some eye-popping statistics about the real estate market from this era. He pointed out that prior to 2000, the annual pace of existing home sales was between 4.5 and 5 million homes.11 By 2005, it eclipsed 7 million. Sales of new homes nearly doubled from 793,000 in June 2000 to 1.389 million in June of 2005. This all sounds great, but as we just learned, what goes up, must come down. A new bubble had formed, and by the year 2007, the real estate market was ready to pop.
What Made the Housing Market Bubble Unique?
This new bubble was a bit different though, so let’s break it down.
The housing market bubble was fueled by several factors, including the availability of subprime mortgages, which were loans given to borrowers with poor credit histories.12 These loans often had adjustable interest rates that started low but could increase significantly over time.
As housing prices continued to rise, many people took out these risky loans, believing that the value of their homes would keep increasing. However, when housing prices began to fall, many borrowers found themselves unable to afford their mortgage payments, leading to a wave of foreclosures.
Consequences of a Credit Crunch
The financial institutions that had issued these subprime mortgages were also heavily invested in mortgage-backed securities, which were bundles of loans sold to investors. When the housing market collapsed, the value of these securities plummeted, causing massive losses for banks and other financial institutions. This led to what’s called a credit crunch, where banks were unwilling or unable to lend money, which made the economic downturn even worse. Why is that you may ask? Let’s talk about the effects of a credit crunch.13
Typically, the main effect of a credit crunch is a lengthy recession or a long recovery that stems from the diminished credit supply. Along with tightening credit standards, lenders might raise interest rates amid a credit crunch to capture larger revenues from the lesser number of consumers who can borrow. Higher borrowing costs may impede the consumer’s ability to spend. That in turn can diminish business capital which could be allocated to expand operations and increase employment.
It depends on the business and consumer, but the results of a credit crunch can be more devastating than the rising cost of capital. If a business is incapable of borrowing, it can be difficult for the business to grow, much less stay open. When businesses cut back on their operations and/or lay off employees, workplace efficiency typically decreases and unemployment increases. Those are both leading recession signals.
Assessing the Impact of the Great Recession
The Great Recession officially began in December 2007 and lasted until June 2009.14 During this period, the U.S. economy experienced a significant contraction, with GDP falling by 4.3% and unemployment reaching a peak of 10%.15 The stock market also suffered heavily, with the S&P 500 losing more than half of its value.16
There are numerous stories from those who suffered through this financial crisis, just to name a few from Reddit.com.17
How Did the U.S. Government Respond to the Great Recession?
The impact of the Great Recession was felt worldwide, as global trade and investment slowed, leading to economic difficulties in many other countries.18
In response to the crisis, the U.S. government implemented several measures to stabilize the economy.
- The Federal Reserve lowered interest rates to near zero and launched a series of programs to provide liquidity to financial institutions and stimulate them.19
- Congress passed the Emergency Economic Stabilization Act, which included the Troubled Asset Relief Program (TARP) to purchase toxic assets from banks and other financial institutions. They had to do this because the banks were so overloaded with sub-prime loans and couldn’t function as safely. TARP freed the banks up to begin lending again.20
- Additionally, the American Recovery and Reinvestment Act was enacted to stimulate economic growth through government spending and tax cuts. The ARRA injected $787 billion into the economy through government spending on infrastructure, education, healthcare, and new clean energy initiatives. It cut taxes for individuals and businesses and the additional funds prevented essential public workers from being laid off. All these decisions were an effort to get the engine of the U.S. economy running again. It made sure people had jobs and money to spend.21
Lessons Learned from the Great Recession
It’s easy to talk enthusiastically about these recovery efforts now that we’re on the other side of this moment in history, but let’s be clear. The Great Recession was a nightmare for so many and despite these efforts, the recovery from the recession was slow and uneven.22 Many people lost their homes, jobs, and savings, and the effects of the crisis continued to be felt for years.
The lessons learned from the Great Recession were important ones and have led to changes in financial regulation and economic policy aimed at preventing a similar crisis in the future. The Great Recession serves as yet another reminder about the importance of history and learning from it. This is why we stress test financial plans against various economic conditions, especially events such as the Great Recession and Dot-Com Bubble.
Remember that it’s not only important to plan for the possibility of a prolonged market downturn taking place during your retirement, but that the timing of it matters as well. It’s important to understand the potential impact of retiring at the beginning of a prolonged market downturn. To learn more about how to plan for that possibility and why it’s important to revisit events like the Great Recession, start a conversation with our team below.
Resources Mentioned in This Article
- Navigating Economic Uncertainty: Special Market Update
- The Great Recession’s History Remains Relevant
- Dot-Com Bubble History Remains Relevant
- 10 Ways to Fight Inflation in Retirement
- The Federal Reserve’s Monetary Policies
- Stress Testing Your Financial Plan
- What If I Retire During a Recession?
- Sequence of Returns Risk and Why Timing Matters
Other Sources
[1] https://www.federalreservehistory.org/essays/great-recession-and-its-aftermath
[2] https://www.investopedia.com/terms/b/bubble.asp
[3] https://www.investopedia.com/terms/d/dotcom.asp
[4] https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/dotcom-bubble/
[5] https://www.scirp.org/journal/paperinformation?paperid=127628
[6] https://www.history.com/articles/glass-steagall-act
[7] https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/dotcom-bubble/
[9] https://youtu.be/55kK29kaduY
[11] https://fred.stlouisfed.org/graph/?graph_id=187068
[12] https://edition.cnn.com/2009/US/01/29/economic.crisis.explainer/index.html
[13] https://www.investopedia.com/terms/c/creditcrunch.asp
[14] https://www.history.com/articles/great-recession-timeline
[15, 16, 19] https://www.federalreservehistory.org/essays/great-recession-of-200709
[20] https://home.treasury.gov/data/troubled-asset-relief-program
[21] https://www.fcc.gov/general/american-recovery-and-reinvestment-act-2009
Investment advisory services offered through Modern Wealth Management, Inc., a Registered Investment Adviser.
The views expressed represent the opinion of Modern Wealth Management a Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.