Essay Example on Great Recession: Causes and Impact

The great recession was the period between December 2007 to June 2009, which majorly saw the 2008 financial crisis (Sraders, 2019). It was associated with reduced GDP rates, worst employment rates, and economic disaster. The leading cause of the great recession was the housing bubble, which in return, devastated the US and European economy. At that time, GDP fell by 4.3% while the unemployment rate rose steeply from 5% to 10 % in October 2009 (Sraders, 2019). As highlighted in 'The Big Short' movie, where the subprime mortgage crisis was caused by banks and financial institutions disbursing high- risk mortgages and also granted people with low credit score mortgages. The housing market started booming since banks were loaning high-risk candidates so that they would fill up risky securities that they had sold to investors. Many institutions and individuals put more effort into these risky bond investments because of their AAA ratings that were causing the housing demand to increase, making it hard to secure a mortgage loan (Sraders, 2019). The homeowners could not pay their mortgages since refinancing or selling homes was not a feasible option for paying off these mortgages. Many businesses closed down, banks could not lend more, and thus house prices fell considerably. The housing bubble burst such that people couldn't pay their debts. This collapse of the housing market was very catastrophic to the global economy to date.

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Through the movie "Big Short," it is clear that the housing bubble had a massive and catastrophic impact on the global economy at large. People lost jobs, long time standing companies collapsed, banks were in a liquidity crisis, stock markets crashed, people lost homes while governments were in overdrive.

Credit Default Swap (CDS) played a significant role in the great recession in the United State's Economy. A CDS is a credit derivative contract between counterparties where the buyer makes periodic payments to the seller and later gets a payoff of the security's premium and the future interests if an underlying financial instrument defaults (Bangay,2016). Credit default swaps act as insurance security against a potential default. Although the housing bubble occurred, CDS played a role in the financial crisis since the banks had to give back the total premium and all future interest payments to the three investor groups, which had invested billions of money in the housing bubble bet that came to pass.

Collateralized debt obligations Were also a significant contributor in the impending housing bubble, which in return led to the great recession. A Collateralized debt obligation is a financial tool that banks use to repackage individual loans into a product sold to investors in the secondary market (Bangay,2016). Economically, the banks sell CDOs to move the default risk to investors and get more liquidity. In the case of "big short," the personal loans were the mortgages where the banks used them as mortgage-backed securities (MBS). Unfortunately, the extra liquidity by the CDOs created the housing bubble where housing prices rose steeply, and people bought homes for reselling, people took more loans while the banks gave more unsecured loans ("Northwestern Business Review," 2016). The Opaqueness of CDOs led to a market panic in the year 2007, where banks realized they could not price the assets and products they were holding (Bangay,2016). Banks cut off lending since they did not want more CDOs in the balance sheet. MBS went south with the housing prices going down while people were unable to pay their loans. The fall housing market crash resulted in the great recession, which was fatal to the economy.

Prospect theory has been evident in the 'Big Short,' and it was majorly one of the contributors to the great recession after the housing bubble. Prospect theory is a behavioral model in economics that determines how people make decisions between alternatives relating to uncertainty and risks (Zimmerman, 2016). People dislike losses and therefore go to an extreme of avoiding losses by alternatively taking risks. In the case of the housing bubble and recession, banks feared losses that would come in hand with defaulted loans and, in return, sold them to investors in the secondary market was CDOs (Zimmerman, 2016). The bank's main aim was to transfer the risks of default losses and face uncertainty. It went south after the financial institutions got overwhelmed with the fact that they could no longer place value on the assets and products they had.

Conclusion

Although Michael Burry predicted the housing bubble, it is complicated to identify a housing bubble until it pops. Through the movie 'Big Short,' it is evident how the struggle of risks transfers through CDOs, a corrupted housing market, borrowing more than one is worth, and lending of loans to people who are not creditworthy can ruinously affect the economy just like the housing bubble led to the financial crisis.

References

Bangay, T. (2016). The economies of The Big Short, Explained. Retrieve from https://www.ecnmy.org/engage/the-big-short/

Northwestern Business Review. (2016). What the big Short Teaches Us About the 2007-2008 Financial Crisis? Retrieved from https://northwesternbusinessreview.org/what-the-big-short-teaches-us-about-the-2007-08-financial-crisis-9cb30793ad92

Sraders, A. (2019). What was the Great Recession? History, Causes, and Consequences. Retrieved from https://www.thestreet.com/politics/what-was-the-great-recession-14664025

Zimmerman, A. (2016). 3 Essential Financial Lessons From 'The Big Short.': How Behavioral Economics Shape the Financial Decisions We Make. Retrieved from https://www.inc.com/angelina-zimmerman/3-essential-financial-lessons-from-the-big-short.html