Literature Review
Exploring the Great Recession Causes and Effects from Financial Regulation
Yashaswi Sunkara
Commonwealth Governor’s School
Culminating 11/12
Mr. Thompson, Mr. Dugas, Mrs. Lopez-Sibel
2022-2023
Financial Regulation Effects from the Great Recession: A Literature Review
Research Question
How has the financial regulation from the US Government affected the economy as a result of the 2007-2009 Great Recession?
Rationale
There are multiple reasons why I have chosen a research question like this one. I am interested in learning more about the economy of the United States and its history. I believe that understanding more about the 2007-2009 Great Recession is important, especially considering that it's been more than 10 years and because economists and researchers have been able to conduct substantiated research on the topic, which makes it ideal for the purpose of culminating research and finding sources. I think that this topic will enable me to communicate with experts and mentors in the field, which is interesting to me. The laws, regulations, and history that I have researched have been really interesting.
Intro
The Financial Crisis of 2007-2009, more commonly known as the Great Recession, was the economic recession since the Great Depression of the 1930s. A recession in the economy is when a general decline in economic activity with measures like stock market performance, business cycles, and decreased Gross Geometric Product (GDP), among other factors. Legendary investor and CEO of conglomerate Berkshire Hathaway, Warren Buffett, called the great recession the “economic pearl harbor” due to the severity of the time period and because something like that has a very small chance of reoccurring. After the Pearl Harbor attacks, the United States took immediate action in World War II, and this was a similar case since the entire world was in turmoil over realizing just how far financial institutions took things. It is crucial to understand how banks work and how the housing bubble “popped” to see the bigger picture. Apart from banks suffering due to extremely weak, risky, and unstable practices of lending, people across the nation lost their jobs with the values of their homes depreciating from weak credit lending. Throughout this research project, I delve into the different effects of the recession and understand what type of legislation was passed to ensure something like this will never happen again in US History.
Causes of the Great Recession
The causes of what exactly caused the Great Recession cannot be drawn to one single thing since it was a multitude of actions and practices that compound on one another to set off the time of economic turmoil. During the Great Depression, in 1933, legislators introduced the Glass-Steagall Act, which, simply put, separated commercial banking from investment banking. According to Heakal (2021), “This mixing of commercial and investment banking was considered to be too risky and speculative and widely considered to be a culprit that led to the Great Depression.” This act was effectively repealed in 1999 under the Gramm-Leach-Bliley Act, and this was under the concern that banks needed to diversity in order to reduce risks and limiting banks to either investment or commercial banking were, in fact, holding them back. Economists argue that the Gramm-Leach-Bliley Act led to financial institutions evolving much larger than before, where they can be both commercial and investment banks. Banks grew in size rapidly through the acquisition of smaller banks, which resulted in enormous corporations dubbed “Too Big to Fail”. This a very fitting phrase that sums up many banks during the Great Recession. An expert on U.S. and world economies, Amadeo (2013) states, “‘Too big to fail’ is a phrase used to describe a company that's so entwined in the global economy that its failure would be catastrophic. ‘Big’ doesn't refer to the size of the company, but rather its involvement across multiple economies.”
Apart from the repealing of the Glass-Steagall Act, the weak lending practices of these financial institutions led to the creation of “sub-prime loans.” When banks compete to get higher interest rates on the loans that they give out, they lend to more people with weaker credit scores even though they loaned to low-credited borrowers. At the time, even with a very bad credit history, little to no income, and no assets could still get loans. Such sub-prime loans were so common and widespread that lenders called them “NINJA loans, which stands for "no income, no job, and no assets (Field 2021)”. This is only the first part of the problem that (Field, 2021) points out. Even though lenders are making money off of high-interest rates from the risky loans, they discovered that they could capitalize off of securitizing subprime loans. “Through securitization, subprime lenders bundled loans together and sold them to investment banks, which, in turn, sold them to investors around the world as mortgage-backed securities (MBS).” Now there is the sub-prime lender making money, and the investment banks decided to once again securitize by repackaging the mortgage-backed securities and selling them as something called collateralized debt obligations (CDOs). Many institutions around the world decided to borrow money to purchase these collateralized debt obligations. The idea behind this was that if you had enough different tranches of different loans, and enough different loans, the odds of all of them going bad at once were expected to be rather low, even if a lot of them were sub-prime. In the early 2000s, the housing market was increasing at an astonishing rate, and these practices worked well. Suddenly in 2007, the housing market stopped rising and started to fall, which led to the subprime mortgage market being: extraordinarily risky. According to Christopher Palmer, a professor of finance at UC Berkeley, “subprime mortgages originated in 2006–2007 were roughly three times more likely to default within three years of origination than mortgages originated in 2003–2004 (Palmer, 2015).” Why was this the case? It is implied that sub-prime lenders are more likely to default on mortgages by not being able to pay, but why was 2006-2007 more likely? Through Palmers’ analytics using nonlinear instrumental variables, he was able to conclude that “later cohorts defaulted at higher rates in large part because house price declines left them more likely to have negative equity (Palmer 2015). In support of Palmers’ research, the US Department of Treasury reports that in mid-2004, the federal funds rate was 1.25%. By mid-2006, the interest rate was 5.25%. This domino reaction led the banks and lending institutions to question how much these securities were worth. Considered“toxic”, the toxic sub-prime mortgage, toxic CDOs, the negative equity of homeowners, and scrambling banks were factors in causing the recession. The Stock Market Crash of 2008 led to the entire system collapsing upon the banks, which led to government intervention which we will be exploring.
Legislation Passed as a Result of the Crisis
For this literature review, my research consisted of after-effects and not necessarily every government action during the crisis. The single most important piece of legislation whose main purpose was to reflect on the recession is the Dodd-Frank Act. The Dodd-Frank Act or more formerly known as the Dodd-Frank Wall Street Reform and Consumer Protection Act was aimed to reorganize the financial regulatory system and create new agencies like the Consumer Financial Protection Bureau, among other restrictions and additions to the federal reserve and government. To explore what exactly the Dodd-Frank was, and to explore the impact of the Dodd-Frank Act on financial stability and economic growth, Martin Neil Baily, Aaron Klein, and Justin Schardin wrote a peer-reviewed publication about the act. Written almost a decade after the financial crisis, the authors divide their rationale and analysis of the Dodd-Frank Act into five groupings: clear wins, clear losses, costly tradeoffs, unfinished business, and too soon to tell.
They distinguish each of these sections as such since, in clear wins, they discuss the regulations' highlights and benefits and discuss the implementation of these standards into the economy as we know it. In one of their clear wins, the authors expand upon what is the most important contribution of the Act:
“We argue that Dodd- Frank’s most valuable contributions have included higher prudential standards, including for capital; the new resolution authority that has manifested in the single- point- of- entry (SPOE) strategy; creating the CFPB; and subjecting derivatives transactions to greater transparency and oversight. Higher capital requirements make institutions more resilient to financial stress events and crises (Bailey et al., 2017).”
This is a very important section of their research since, without this part of the Act, it wouldn't be able to prevent another crash similar to that in 2008. In clear losses, they talk about the downsides to the act, like the restrictions on the Feds’ emergency lending authority and other laws that Congress had passed for the FDIC to get permission before allowing temporary liquidity guarantees. Costly trade-offs include some past laws like the Volcker Rule and the Lincoln amendment. Unfinished business is what the authors believe is still yet to come and needs progress like regulatory consolidation and more independence for the Financial Stability Oversight Council and the Office of Financial Research. Lastly, too soon to tell are requirements and standards for leverage ratios, capital buffers, stress testing, and liquidity requirements. In another higher-institution publication, Weinstein and his colleagues explore the effects of the Dodd-Frank Act and its macroeconomic effects exactly 5 years after Congress passed it.
The authors also talk about the Glass-Steagall Act, which was similar to another time of recession about how that repeal was a cause of the great financial crisis. “The US government and the Federal Reserve were under enormous pressure to provide liquidity to the financial system to prevent it from melting down and decided to bail out the banks at enormous cost. There was enormous pressure on the Federal Reserve and Treasury to invest trillions of dollars in bailing out the banks and the bankers. At the same time, the push for regulatory reform intensified (Weinstein 2015)” The Dodd-Frank Act attempted to increase the capital and monitor dangerous interconnections among financial institutions, and begin to bring the largest, most complex financial institutions. The act has been modified since to meet better the needs of returning to a regular status of the economy.
The Emergency Economic Stabilization Act (EESA) was a law passed by Congress in 2008 in response to the subprime mortgage crisis. It authorized the Treasury secretary to buy up to $700 billion of troubled assets and restore liquidity in financial markets. The EESA is important to my topic since it was the main piece of legislation/financial regulation that was passed from 2007-2009 during the crisis. “The EESA is widely credited with restoring stability and liquidity to the financial sector, unfreezing the markets for credit and capital, and lowering borrowing costs for households and businesses. This, in turn, helped restore confidence in the financial system and restart economic growth (Keaton 2011)” Without the Emergency Economic Stabilization Act, the markets would not have rebounded. It was a controversial act since it was expensive by being valued at such a steep price, but it was justified for the number of “too big to fail” banks collapsing. Everyone at that time knew that the US was in trouble since so many companies were collapsing so the government had no choice but to interfere and bail out some firms that were very important to the economy.
The Troubled Assets Relief Program or more commonly known as TARP, was one of the most important programs and actions that the government took to ensure a total economic collapse. The Emergency Economic Stability Act was a part of the official TARP. The true cost of the financial crisis is not only calculated by banks but also by the number of jobs lost, the health that vanished in a couple of months, the homes lost, and the struggles that almost every American faced in one way or another. Troubled Asset Relief Program’s “primary purpose of the government’s response was to arrest the economy’s free-fall and limit the recession’s devastation”. TARP prevented another Great Depression by stabilizing the markets “and restarting the markets that provide mortgage, auto, student, and business loans (Kehoe 2013)”. The US Department of Treasury states that TARP accomplished its goals of limiting recessions through specific actions aimed toward stimulating economic conditions. “These actions included purchases of mortgage-backed securities to help keep interest rates low, broad-based guarantees of transaction accounts at banks and money market funds, liquidity facilities provided by the Federal Reserve, and support for Fannie Mae and Freddie Mac. And in 2009, at the urging of President Obama, Congress passed the American Recovery and Reinvestment Act (ARRA) to help create and save jobs, spur economic activity and invest in long-term growth. (US Department of Treasury, 2021)” By purchasing these securities and by supporting Fannie May and Freddie Mac, the United States economy was able to push forward.
Effects on the Global Economy
The financial regulation originated from the misaligned practices of sub-prime lenders, but the effect was worldwide. The US Bureau of Labor Statistics states that “In a 2-year span starting in December 2007, the unemployment rate rose sharply, from about 5 percent to 10 percent. In late 2009, more than 15 million people were unemployed (US BLS 2018).” Other nations had large stakes in some banking institutions. Due to how important the United States is in the global economy, there are effects that are bound to occur in other countries regarding trade, GDP, and diplomatic measures. NATO is an alliance made by some countries from Europe and North America. NATO’s purpose is to guarantee the freedom and security of its members through political and military means. In a research publication by Hartley and Solomon, they discuss the effects that the financial crisis will have on their alliance since the economy of the USA is very important in their relationship. They divide up the macroeconomic indicators of a country's business cycle, which are the Annual Growth rate of a Nation's GDP, and the unemployment rates of a country. Finally, the third measure is government balance and net government debt in proportion to GDP. Through Hartley and Solomon’s research, they critically assess all of the NATOs countries using charts and tables based on these metrics. The crisis’ effects are clearly shown for the US, showing the -6.1, -13.6, and -9.7% General Government Balance from 2008 to 2010, respectively. Although the Financial Crisis occurred in the US, the effects were widespread since the alliances the US had made as part of NATO are a clear example of how surrounding and connected countries' economies also suffered.
Krishnakumar, a global economist, discusses the effects of the financial crisis on new market economies in his journal article. He uses different metrics like a country's GDP and per Capita. This article is relevant to my research because it talks about the effects on other countries' economies as a result of the crisis. Connecting this article to Hartley and Solomons’ research, these sources are an important part of my research because they discuss global effects, which is something that really hasn’t been discussed as much as it should be over the past few years. “Even Germany, which had a favourable current account surplus and no domestic housing bubble to begin with, soon became a part of the crisis. Although it was and remained a big exporter due to its favourable real exchange rates, German bankers were also involved in buying asset/mortgage backed American securities, which proved to be toxic and pushed many banks into trouble (Krishnakumar 2015).” This quote from Krishnakumar's research shows a great example of how countries from the European Union, like Germany, also bought financial securities, as discussed in the Causes of great Recession section. The banks had a similar downfall when the housing bubble popped, even though it was in the US. The EU had to bail out countries similar to the Trouble Asset Relief Program in the United States.
The Economy's Rebound and the Aftermath of the Crisis
The Financial Crisis’ rebound took two years to return to somewhat acceptable levels and another three to return to project returns levels, which was partly due to the economic stimulation of the United States and banks becoming more stable. Daniel K. Tarullo is an accredited Harvard Business School Law Professor who has multiple research publications on the various financial regulatory acts passed both before and after the recession. He talks about the Glass-Steagall Act and the different banking acts that occurred aiming to protect a different type of crisis. Economists strived to create ideas that protected commercial banking from investment banking and trading, in his opinion, which was not the problem that we faced in 2008. Through analyzing the Dodd-Frank Act and its impacts on investment banks, Tarullo goes a lot more into his explanations and ideas behind his claims and research on the Fed's actions after passing the Act: “The Federal Reserve has also recently proposed integrating point-in-time and stress test capital requirements, along with some changes in stress test assumptions (Board of Governors of the Federal Reserve 2018). As proposed, this step would likely increase the risk-weighted requirements of the largest banks modestly, but it would also effectively reduce leverage ratio requirements (Tarullo 2019).” This is important because, as part of the Dodd-Frank Act, testing of banks at certain levels might help prevent these types of events from happening in the future, even at a smaller scale. The United States took on a lot of debt from their bailout programs for banks and companies backed by the government like Fannie May and Freddie mac.“Real government debt increases for three years following a banking crisis with an average debt increase of more than 86 percent (Verick & Islam, 2010)” Verick and Islam also highlighted the point that labor market policies should continue to play a complementary role in responding to the crisis because they have helped individuals find jobs that can speed the process of returning to pre-crisis employment rates.
Conclusion
In conclusion, there were many financial regulations passed as a result of the Financial Crisis. Understanding what caused the Crisis is critical for realizing the effects of preventative legislation. Furthermore, the effects were not contained within the United States but stretched to all major financial centers worldwide. Acts like the Glass-Steagall Act, Gramm-Leach-Bliley Act, Troubled Asset Relief Program, Emergency Economic Stabilization Act of 2008, and the Dodd-Frank Act all helped the economy return to normal and prevent future recessions.
Throughout this research report, while compiling my sources, I learned a lot of interesting information that I will later use to help me create my product.
References
Amadeo, K. (2021, June 26). What is too big to fail? Retrieved January 14, 2022, from https://www.thebalance.com/too-big-to-fail-3305617
Bailey, M. N., Klein, A., & Schardin, J. (2017). The Impact of the Dodd-Frank Act on Financial Stability and Economic Growth. JSTOR. Retrieved January 14, 2022, from https://www.jstor.org/stable/10.7758/rsf.2017.3.1.02
Clement, D. (2010). Interview with Gary Gorton. Federal Reserve Bank of Minneapolis. Retrieved January 15, 2022, from https://www.minneapolisfed.org/article/2010/interview-with-gary-gorton
Coghlan, E. (2018, September). What really caused the great recession? Institute for Research on Labor and Employment. Retrieved January 13, 2022, from https://irle.berkeley.edu/what-really-caused-the-great-recession/
Field, A. (2021, July 8). What caused the great recession? understanding the key factors that led to one of the worst economic downturns in US history. Retrieved January 14, 2022, from https://www.businessinsider.com/what-caused-the-great-recession
Hartley, K., & Solomon, B. (2009). NATO and the Economic and Financial Crisis. JSTOR. Retrieved January 14, 2022, from https://www.jstor.org/stable/resrep10382
NATO is an alliance made by some countries from Europe and North America. NATO’s purpose is to guarantee the freedom and security of its members through political and military means. In this article they published, they discuss the effects that the financial crisis will have on their alliance since the economy of the USA is very important in their relationship. In the article, they divide up the macroeconomics indicators of a country's business cycle, which are the Annual Growth rate of a Nation's GDP, the unemployment rates of a country, and finally, the third measure is government balance and net government debt in proportion to GDP. This is related to my topic because NATO and how they responded to the financial crisis is an important topic for the effects of US legislation being passed.
Heakal, R. (2021, December 10). The Glass-Steagall Act. Retrieved January 14, 2022, from https://www.investopedia.com/articles/03/071603.asp
Keely, B., & Love, P. (2010). OECD insights from crisis to recovery: The causes, course and consequences of the great recession. From Crisis to Recovery. Retrieved January 14, 2022, from https://www.oecd.org/insights/46156144.pdf
Kenton, W. (2021, September 21). Emergency economic stabilization act (EESA) of 2008. Emergency economic stabilization act (EESA). Retrieved January 14, 2022, from https://www.investopedia.com/terms/e/emergency-economic-stability-act.asp
Krishnakumar, S. (2015). Global Imbalances Since The Financial Crisis: EFFECTS ON EMERGING MARKET ECONOMIES. Journal of International Affairs. Retrieved January 14, 2022, from https://www.jstor.org/stable/48505140
Palmer, C. (2015, April 14). Why did so many subprime borrowers default during the ... Consumer Finance Gov. Retrieved January 14, 2022, from https://files.consumerfinance.gov/f/documents/P5_-_CPalmer-Subprime.pdf
Tarullo, D. K. (2019). Financial Regulation: Still Unsettled a Decade After the Crisis. JEP. Retrieved January 14, 2022, from https://www.jstor.org/stable/26566977
U.S. Department of the Treasury. (2021, March 9). Troubled assets relief program (TARP). U.S. Department of the Treasury. Retrieved January 14, 2022, from https://home.treasury.gov/data/troubled-assets-relief-program
Verick, S., & Islam, I. (2010, June 29). The great recession of 2008-2009: Causes, consequences and policy responses. SSRN. Retrieved January 14, 2022, from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1631069
Weinstein, K. (2015). Banking from financial crisis to Dodd-Frank: Five Years on, how much has changed? PERI. Retrieved January 14, 2022, from https://peri.umass.edu/component/k2/item/691-banking-from-financial-crisis-to-dodd-frank-five-years-on-how-much-has-changed