Question

The past can offer us an opportunity to understand and fine tune our understanding of the present and future. Using either the text book or other readings.

    Discuss the key factors that led to the Great Recession of 2007.

    Explain why these key factors are important to future financial market.

    Provide an example of how the Great Recession has shaped today’s financial market.

Answer 1

Discuss the key factors that led to the Great Recession of 2007.

Great Recession, economic recession that was precipitated in the United States by the financial crisis of 2007–08 and quickly spread to other countries. Beginning in late 2007 and lasting until mid-2009, it was the longest and deepest economic downturn in many countries, including the United States, since the Great Depression (1929–c. 1939).

The financial crisis, a severe contraction of liquidity in global financial markets, began in 2007 as a result of the bursting of the U.S. housing bubble. From 2001 successive decreases in the prime rate (the interest rate that banks charge their “prime,” or low-risk, customers) had enabled banks to issue mortgage loans at lower interest rates to millions of customers who normally would not have qualified for them (see subprime mortgage; subprime lending), and the ensuing purchases greatly increased demand for new housing, pushing home prices ever higher. When interest rates finally began to climb in 2005, demand for housing, even among well-qualified borrowers, declined, causing home prices to fall. Partly because of the higher interest rates, most subprime borrowers, the great majority of whom held adjustable-rate mortgages (ARMs), could no longer afford their loan payments. Nor could they save themselves, as they formerly could, by borrowing against the increased value of their homes or by selling their homes at a profit. (Indeed, many borrowers, both prime and subprime, found themselves “underwater,” meaning that they owed more on their mortgage loans than their homes were worth.) As the number of foreclosures increased, banks ceased lending to subprime customers, which further reduced demand and prices.

As the subprime mortgage market collapsed, many banks found themselves in serious trouble, because a significant portion of their assets had taken the form of subprime loans or bonds created from subprime loans together with less-risky forms of consumer debt (see mortgage-backed security; MBS). In part because the underlying subprime loans in any given MBS were difficult to track, even for the institution that owned them, banks began to doubt each other’s solvency, leading to an interbank credit freeze, which impaired the ability of any bank to extend credit even to financially healthy customers, including businesses. Accordingly, businesses were forced to reduce their expenses and investments, leading to widespread job losses, which predictably reduced demand for their products, because many of their former customers were now unemployed or underemployed. As the portfolios of even prestigious banks and investment firms were revealed to be largely fictional, based on nearly worthless (“toxic”) assets, many such institutions applied for government bailouts, sought mergers with healthier firms, or declared bankruptcy. Other major businesses whose products were generally sold with consumer loans suffered significant losses. The car companies General Motors and Chrysler, for example, declared bankruptcy in 2009 and were forced to accept partial government ownership through bailout programs. During all of this, consumer confidence in the economy was understandably reduced, leading most Americans to curtail their spending in anticipation of harder times ahead, a trend that dealt another blow to business health. All these factors combined to produce and prolong a deep recession in the United States. From the beginning of the recession in December 2007 to its official end in June 2009, real gross domestic product (GDP)—i.e., GDP as adjusted for inflation or deflation—declined by 4.3 percent, and unemployment increased from 5 percent to 9.5 percent, peaking at 10 percent in October 2009.

As millions of people lost their homes, jobs, and savings, the poverty rate in the United States increased, from 12.5 percent in 2007 to more than 15 percent in 2010. In the opinion of some experts, a greater increase in poverty was averted only by federal legislation, the 2009 American Recovery and Reinvestment Act (ARRA), which provided funds to create and preserve jobs and to extend or expand unemployment insurance and other safety net programs, including food stamps. Notwithstanding those measures, during 2007–10 poverty among both children and young adults (those aged 18–24) reached about 22 percent, representing increases of 4 percent and 4.7 percent, respectively. Much wealth was lost as U.S. stock prices—represented by the S&P 500 index—fell by 57 percent between 2007 and 2009 (by 2013 the S&P had recovered that loss, and it soon greatly exceeded its 2007 peak). Altogether, between late 2007 and early 2009, American households lost an estimated $16 trillion in net worth; one quarter of households lost at least 75 percent of their net worth, and more than half lost at least 25 percent. Households headed by younger adults, particularly by persons born in the 1980s, lost the most wealth, measured as a percentage of what had been accumulated by earlier generations in similar age groups. They also took the longest time to recover, and some of them still had not recovered even 10 years after the end of the recession. In 2010 the wealth of the median household headed by a person born in the 1980s was nearly 25 percent below what earlier generations of the same age group had accumulated; the shortfall increased to 41 percent in 2013 and remained at more than 34 percent as late as 2016. Those setbacks led some economists to speak of a “lost generation” of young persons who, because of the Great Recession, would remain poorer than earlier generations for the rest of their lives.

Losses of wealth and speed of recovery also varied considerably by socioeconomic class prior to the downturn, with the wealthiest groups suffering the least (in percentage terms) and recovering the soonest. For such reasons, it is generally agreed that the Great Recession worsened inequality of wealth in the United States, which had already been significant. According to one study, during the first two years after the official end of the recession, from 2009 to 2011, the aggregate net worth of the richest 7 percent of households increased by 28 percent while that of the lower 93 percent declined by 4 percent. The richest 7 percent thus increased their share of the nation’s total wealth from 56 percent to 63 percent. Another study found that between 2010 and 2013 the aggregate net worth of the richest 1 percent of Americans increased by 7.8 percent, representing an increase of 1.4 percent in their share of the nation’s total wealth (from 33.9 percent to 35.3 percent).

As the financial crisis spread from the United States to other countries, particularly in western Europe (where several major banks had invested heavily in American MBSs), so too did the recession. Most industrialized countries experienced economic slowdowns of varying severity (notable exceptions were China, India, and Indonesia), and many responded with stimulus packages similar to the ARRA. In some countries the recession had serious political repercussions. In Iceland, which was particularly hard-hit by the financial crisis and suffered a severe recession, the government collapsed, and the country’s three largest banks were nationalized. In Latvia, which, along with the other Baltic countries, was also affected by the financial crisis, the country’s GDP shrank by more than 25 percent in 2008–09, and unemployment reached 22 percent during the same period. Meanwhile, Spain, Greece, Ireland, Italy, and Portugal suffered sovereign debt crises that required intervention by the European Union, the European Central Bank, and the International Monetary Fund (IMF) and resulted in the imposition of painful austerity measures. In all the countries affected by the Great Recession, recovery was slow and uneven, and the broader social consequences of the downturn—including, in the United States, lower fertility rates, historically high levels of student debt, and diminished job prospects among young adults—were expected to linger for many years.

Explain why these key factors are important to future financial market.

Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

Underlying assets include physical commodities or other financial instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.

Futures—also called futures contracts—allow traders to lock in a price of the underlying asset or commodity. These contracts have expirations dates and set prices that are known up front. Futures are identified by their expiration month. For example, a December gold futures contract expires in December. The term futures tend to represent the overall market. However, there are many types of futures contracts available for trading including:

• Commodity futures such as in crude oil, natural gas, corn, and wheat
• Stock index futures such as the S&P 500 Index
• Currency futures including those for the euro and the British pound
• Precious metal futures for gold and silver
• U.S. Treasury futures for bonds and other products

It's important to note the distinction between options and futures. Options contracts give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of the contract.

The futures markets typically use high leverage. Leverage means that the trader does not need to put up 100% of the contract's value amount when entering into a trade. Instead, the broker would require an initial margin amount, which consists of a fraction of the total contract value. The amount held by the broker can vary depending on the size of the contract, the creditworthiness of the investor, and the broker's terms and conditions.

The exchange where the future trades will determine if the contract is for physical delivery or if it can be cash settled. A corporation may enter into a physical delivery contract to lock in—hedge—the price of a commodity they need for production. However, most futures contracts are from traders who speculate on the trade. These contracts are closed out or netted—the difference in the original trade and closing trade price—and are cash settled.

Futures Speculation

A futures contract allows a trader to speculate on the direction of movement of a commodity's price.

If a trader bought a futures contract and the price of the commodity rose and was trading above the original contract price at expiration, then they would have a profit. Before expiration, the buy trade—long position—would be offset or unwound with a sell trade for the same amount at the current price effectively closing the long position. The difference between the prices of the two contracts would be cash settled in the investor's brokerage account, and no physical product will change hands. However, the trader could also lose if the commodity's price was lower than the purchase price specified in the futures contract.

Speculators can also take a short or sell speculative position if they predict the price of the underlying asset will fall. If the price does decline, the trader will take an offsetting position to close the contract. Again, the net difference would be settled at the expiration of the contract. An investor would realize a gain if the underlying asset's price was below the contract price and a loss if the current price was above the contract price.

It's important to note that trading on margin allows for a much larger position than the amount held by the brokerage account. As a result, margin investing can amplify gains, but it can also magnify losses. Imagine a trader who has a $5,000 broker account balance and is in a trade for a $50,000 position in crude oil. Should the price of oil move against their trade, they can incur losses that far exceed the account's $5,000 initial margin amount. In this case, the broker would make a margin call requiring additional funds be deposited to cover the market losses.

Futures Hedging

Futures can be used to hedge the price movement of the underlying asset. Here, the goal is to prevent losses from potentially unfavorable price changes rather than to speculate. Many companies that enter hedges are using—or in many cases producing—the underlying asset.

For example, a corn farmer can use futures to lock in a specific price for selling their corn crop. By doing so, they reduce their risk and guarantee they will receive the fixed price. If the price of corn decreased, the company would have a gain on the hedge to offset losses from selling the corn at the market. With such a gain and loss offsetting each other, the hedging effectively locks in an acceptable market price.