Our economy is a learning experience. Economists differ on what helps or harms it. But some things stand out. For example, inflation is very destructive and is controlled by the Fed. The Great Depression has been studied endlessly.
The Great Depression and the Great Recession of 2007, have at least one thing in common: Financial institution risk taking. A great world economy can be destroyed by recklessness.
Unlike banks, financial institutions connected with the stock market have/had less regulation, and could loan greater percentages of their deposits than banks. Both banks and other financial lenders, created mortgages that were "sub-prime" to say the least. Many were illegal, and financially unsupportable. People were going to lose their homes because they couldn't pay these mortgages. They did, big time.
The housing market was on fire, and it looked like the only path was up. Investors who had been put off by the dot.com bust of 2001, saw mortgage paper as a safe haven, and the rush to buy mortgage investments shot the price of stock way up - a bubble. But what is on fire usually burns itself out.
When too many of these mortgage investments went bad because people couldn't pay them and the homes were not worth nearly the amount of the loans, things went very bad for investors. The investment community had "credit default swap" guarantees for the bad paper, but they didn't expect anything of this size to happen, and they couldn't guarantee (pay up) the bundles of bad mortgages.
The big financial institutions that held these bad loan bundles, didn't have enough money on reserve to cover losses. As the fire burned them down, this caused a rethinking about risk around the globe, because the entire world was doing similar things, and everyone owned everyone's bad paper.
The Federal Reserve created some new rules. The large investment companies became banks, so they could be regulated under a stricter set of rules that would prevent another collapse from risky investments. This also helped save them.
The Fed also decided that banks were also over-leveraged - they were loaning too much of the money they had on deposit. So they tightened up that rule - banks could loan a smaller percentage of the funds they had on deposit. And they could only make less risky loans.
The effect of the Fed action was to prevent another collapse, but it also cooled off the economy. Since banks could loan less of their money, and the loans had to be less risky, small businesses and people had difficulty getting money for business expansion and mortgages. It was felt that the system would rebound in a few years, like maybe 3 or 4.
The mortgage foreclosure crisis didn't peak even until 2012. Consumers quit buying. Hardly a single person in the US, and around the world, didn't feel the economic impact of the recession, and everyone was scared to spend money. Many banks closed, and many small businesses went out of business.
Small business employs over 60% of the US employees. As the economy fell, they laid off employees, as did larger corporations, and everyone stopped hiring, and cut hours. Everyone made less or found themselves without income. As a result, more people couldn't make their house payments, deepening the foreclosure crisis, and putting more banks out of business.
There was no market for abandoned homes, partly because most people who had purchased homes in the last few years owed more on them than they could sell them for, if they could be sold at all. Credit qualifications ruled most people out, and the banks had very little money to loan. Banks stopped making most mortgage loans.
Unemployment surged in the US and in other countries. The entire world economy fell due to recklessness on "Wall Street."
The only thing that has rebounded healthily is the stock market and financial institutions, and many corporations. These are setting records.
Why is that? In the next article we'll look at how the overall economy works, and what is going wrong.
The Perfect Storm of Economic Problems - Part 5