INTRODUCTION

What exactly happened in 2008 to the World why it is said to be a Great Recession after the Great Depression and what caused it to happen, let us see.

In 1984 the Secondary Mortgage Enhancement Act (SMMEA) was a law designed to boost the secondary mortgage market which allowed the federally chartered and regulated financial institutions to invest in the mortgage-backed securities, which were previously restricted by state laws in the USA. This made it easier for institutions to invest in MBS that is in mortgage-backed securities and also made it easier to increase liquidity in the housing market. After that the government started helping the lower-income citizens and also ordered the banks not to discriminate against poor home borrowers and for this purpose, the banks were allowed to lower the lending requirements. Soon after 1999 the US government repealed an act that restricts the commercial banks to participate in the activities of the investment banks and the act is nothing but the Glass-Steagall Act of 1933. Actually, in 1933 it was made to stop the speculation that fueled the Disastrous Great Depression; however, this was not a good decision by the government because the banks that were very regulated by their activity turned out to be riskier through speculation to raise their profits.

THE MAIN STORY BEHIND THE GREAT RECESSION OF 2008 WHICH CHANGES THE WORLD BY ITS IMPACT

The mortgage bond is a type of bond that is secured by a mortgage or a pool of mortgages and is generally backed by real estate assets. Again, it is secured by real estate properties as collateral and if the borrower that is who took out the mortgage defaults on their loan payments, then the lender has the right to foreclose on the property that is foreclosure is a legal process through which the lender can seize and sells the property to recover the debt. Often used by financial institutions to raise their capital. Also, they are very problematic for the investors who are invested in these since the borrower can pay off the money at any time they please. That is when the borrower has the flexibility to pay off their mortgage loans early then this creates a prepayment risk that now the bondholders receive the principal sooner than anticipated and miss out on the expected interest payments, again they reinvest their money at the low interest rate because mortgage borrowers typically repaid their loans only when the interest rate fell and as by this, they could refinance cheaply. To limit these uncertainties the banks came up with a good solution that is they took a giant pool of home loans and carved up the payments made by homeowners into pieces and they are called tranches. By dividing the pool of home loan payments into different tranches the financial institutions can segment the risk. The senior tranches have the highest priority for payment and are least risky and their interest payments are also low for example these are the high-quality investments of AAA-rated. The mezzanine tranches have a medium level of risk and return. The junior tranches have the lowest priority for payments and are the riskiest because the citizens who have a low credit score have to bear a high rate of interest. The junior tranche holders are the first to be affected by mortgage prepayments. The pool of mortgage loans conformed to the standards by their size and quality and this is set by one of several government agencies like Freddie Mac, Fannie Mae, Ginnie Mae, etc. With this, the government guarantees that if the homeowner defaults, then the government pays off their debts. This all triggered the crisis of 2008 and the situation is so bad that there are many banks that give loans for homes without even knowing the income of the borrowers. That is there is created a huge and popular market for housing. The insurance companies such as AIG were also taking part in stimulating the crisis by lowering their premiums.

CONCLUSION

In October 2004 the Securities and Exchange Commission relaxed the liquidity requirements for the five banks they are Goldman Sachs, Merrill, Lehman Brothers, Bear Stearns, and Morgan Stanley, and their leverage rose as they borrowed more. This decision allowed them to gamble more. From 2004 to 2007 they each significantly raises their financial leverage. In 2007 they declared 4.1 trillion dollars in debt which is 30 % of America’s GDP at that time. This will give a clue of the disastrous crisis. During 2004 as the US central bank started to increase the rate of interest the home buyers who would enjoy the low rates earlier for about 2 to 3 years were worse off when it started to match the interest rate with the market. For the low-income subprime home buyers, it was a disaster as they paid little monthly interest payments and had to pay multiple times of it and many buyers could not pay. Even the monthly payments easily jumped from 800 dollars to 1500 dollars by mid-2006. The increase in the number of defaults caused home prices to fall. A market bubble is created by speculation and the expectation of a price rise and by this the house prices of the market exceed their actual value and the demand for it falls and the supply also rises because of the rising number of foreclosures and the bubble bursts and the price falls and by the end of 2007, 2.3 million homes are foreclosed. The subprime specialist lender New Country Financial filed for bankruptcy, and investors were now aware of these risks and were now trying to sell these toxic debt boxes at any cost. France’s BNP Paribas announces that there is no liquidity in the global market for mortgage-backed securities. In other words, no one wants to buy those toxic debt boxes. Many other banks also announce the same thing. In September 2007 the UK’s Northern Rock was also playing with high leverage and going to be bailed out by the Bank of England. In 2008 Bear Stearns fell and Lehman Brothers also by reckless leverage.

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