Question

Great recession in 2008 experienced the burst of housing market bubble, which led financial market crisis.

You were hired as a chief economic advisor in a major corporate, and they would like to know more about macroeconomic conditions in 2008.

Your responded one of followings;

1. Aggregate demand fell in 2008. Here are the reasons; Unemployment and lower income, resulting from a drop in consumer spending and investment, meant governments took in less in tax revenue. This caused government spending to drop.
2. The Great Recession was caused by the Fed’s policy which created artificially low interest rates, and Government housing policy which encouraged bad mortgages.
3. Recovery was slow because of productivity decrease from 2005, and policy uncertainty in 2008.
4. Aggregate demand fell in 2008 because the Fed policy was not expansionary enough.

Explain your response based on the economic theory that you are subscribing (eg.  Real business cycle theory, Keynesian, Austrian, Monetarists etc.).

Answer 1

Mortgage crisis. Credit crisis. Bank collapse. Government bailout. Phrases like these frequently appeared in the headlines throughout the fall of 2008, a period in which the major financial markets lost more than 30% of their value. This period also ranks among the most horrific in U.S. financial market history. Those who lived through these events will likely never forget the turmoil.

So what happened, exactly, and why? Read on to learn how the explosive growth of the subprime mortgage market, which began in 1999, played a significant role in setting the stage for the turmoil that would unfold just nine years later in 2008 when both the stock market and housing market crashed.

KEY TAKEAWAYS

• The stock market and housing crash of 2008 had its origins in the unprecedented growth of the subprime mortgage market beginning in 1999.
• U.S. government-sponsored mortgage lenders Fannie Mae and Freddie Mac made home loans accessible to borrowers who had low credit scores and a higher risk of defaulting on loans.
• These borrowers were called "subprime borrowers" and were allowed to take out adjustable-rate mortgages, which would start out with low monthly payments that would become much larger after a few years.
• Financial firms sold these subprime loans to large commercial investors in pools of mortgages known as mortgage-backed securities (MBS).
• By the fall of 2008, borrowers were defaulting on subprime mortgages in high numbers, causing turmoil in the financial markets, the collapse of the stock market, and the ensuing global Great Recession.

Unprecedented Growth and Consumer Debt

Subprime mortgages are mortgages targeted at borrowers with less-than-perfect credit and less-than-adequate savings. An increase in subprime borrowing began in 1999 as the Federal National Mortgage Association (widely referred to as Fannie Mae) began a concerted effort to make home loans more accessible to those with lower credit and savings than lenders typically required.

The idea was to help everyone attain the American dream of homeownership. Since these borrowers were considered high-risk, their mortgages had unconventional terms that reflected that risk, such as higher interest rates and variable payments. While many saw great prosperity as the subprime market began to explode, others began to see red flags and potential danger for the economy.

Bob Prechter, the founder of Elliott Wave International, consistently argued that the out-of-control mortgage market was a threat to the U.S. economy as the whole industry was dependent on ever-increasing property values. As of 2002, government-sponsored mortgage lenders Fannie Mae and Freddie Mac had extended more than $3 trillion worth of mortgage credit. In his 2002 book Conquer the Crash, Prechter stated, "confidence is the only thing holding up this giant house of cards."

The role of Fannie and Freddie is to repurchase mortgages from the lenders who originated them and make money when mortgage notes are paid. Thus, ever-increasing mortgage default rates led to a crippling decrease in revenue for these two companies.