Who Caused the 2008 Great Recession? | 5-Minute Videos

It was the worst financial disaster since the Great Depression. But what really caused the 2008 crash? Deregulation? Greedy banks? Or something else entirely? PragerU’s Franklin Camargo explains how government mandates and bad incentives created one of the most destructive bubbles in American history.

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Transcript:
Who Caused the 2008 Great Recession?
Presented by Franklin Camargo

From 2007 to 2009, America suffered a severe economic downturn known as the Great Recession, also known as the subprime mortgage crisis.

The economy, as measured by GDP, or gross domestic product, shrank by over 4%. Unemployment doubled, peaking at 10%. The Dow Jones Industrial Average fell 50%.

Millions lost their homes.

How did this happen?

Here’s the short version: in the spring of 2006, housing prices, which had been rising for years, began to decline and then freefall—30% nationwide, 60% in some markets like Las Vegas and Phoenix.

Why did this lead to a recession?

The usual explanation goes something like this: free-market ideologues in Republican administrations deregulated the banks. Free from constraints, these institutions enticed millions of Americans to take out home loans that were beyond their means.

It was, according to Forbes Advisor, “a classic tale of greed and deregulation…”

There’s one more crucial component here. These “subprime loans” were variable, that is, they rose or fell based on interest rates. When interest rates were low, monthly payments were affordable. If interest rates increased, so would monthly payments. But few thought that would actually happen.

This raises an obvious question: How did banks, which are inherently risk-averse, become so reckless with their money?

To answer that, we need to look at federal policy, specifically a piece of legislation called the Community Reinvestment Act, or CRA.

Signed in 1977 by President Jimmy Carter and expanded in 1995 by President Bill Clinton, both Democrats, the CRA had an idealistic goal: make homeownership easier for low-income Americans.

But the government wasn’t making an encouraging suggestion. It was making a demand—one with quotas attached.

As Phil Gramm and Donald Boudreaux explain in their book, The Triumph of Economic Freedom, there was a carrot and a stick. If the banks didn’t make the loans—actually meet a quota—the government wouldn’t approve the banks’ expansion plans: mergers with other banks, new branches or even how many ATMs they could open.

Nice bank you have got there. It would be a shame if something happened to it.

That was the stick, now here’s the carrot.

The loans weren’t risky because the government promised to take away the downside. This is a concept known as moral hazard: privatizing profits and socializing losses—taking risks because someone else (the taxpayer) bears the cost of failure.

Here’s how it worked: the conventional practice was for banks to sell their mortgage portfolios—large bundles of home loans—to two financial institutions, the Federal National Mortgage Association and Federal Home Loan Mortgage Corporation, commonly known as Fannie Mae and Freddie Mac.

These institutions were ostensibly independent, but in reality, they were controlled by the federal government—which pressured banks to make subprime loans they wouldn’t traditionally make—and forced Fannie and Freddie to buy those loans from the banks, which they wouldn’t traditionally buy.

So to recap: the banks issued risky loans, collected fees for writing them, and sold them—and the risk—to Fannie and Freddie.

And yes, some unscrupulous banks took advantage of this opportunity and did indeed entice people to “buy more house” than they could afford, and some other financial institutions exploited the game of selling and reselling mortgage portfolios.

That is the poison fruit of moral hazard.

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