What Caused the Great Recession in 2008—and What Can We Learn From It?

With the topic of recession heating up, it’s hard not to immediately think of the Great Recession in 2008, which still looms large in many people’s minds due to the havoc it wreaked on the economy. In fact, the aftershocks are still being felt in many industries and by certain age groups, particularly those who graduated in the midst of the carnage and had trouble finding jobs

There's little doubt that the coronavirus has tipped the country into recession, but it's still unclear how bad it will be or how long it might last. So it’s a good time to revisit the last recession and look at what we can learn from it.

What caused the Great Recession in 2008?

Even though it’s often referred to as the Great Recession of 2008, the seeds were sown before that, dating back to 2006 when early-warning bells went off regarding trouble in the housing sector. Let’s take a look at what preceded the recession.

1. Housing prices increased, then fell, due to the subprime mortgage crisis

During the housing boom in the early- to mid-2000s, many mortgage lenders began to expand their definition of credit-worthy and extend mortgages to buyers with poor credit histories who didn’t fit the previous definition of a desirable borrower.

Banks seized on these high-risk loans and began to buy them as “mortgage-backed securities” (investments secured by mortgages), a product that became very popular and yet was largely misunderstood by average investors. High demand for this new investment product led to an increase in risky lending practices and a subsequent increase in the housing market. But while housing prices were escalating, the Federal Reserve Bank also began raising interest rates—eventually rising to 5.25 percent by June 2006.

While those with fixed-rate mortgages were unaffected, millions of new borrowers had mortgages with adjustable rates, which meant that they had lower, affordable payments initially, but their monthly interest payments soon skyrocketed along with the new interest rates.

Unable to make their payments or sell their homes for a profit, many defaulted on their loans. That brought more inventory into the housing market and prices continued to plummet. Ultimately, the housing market hit a low in December 2008.

2. Banks went into crisis

With home prices faltering and mortgage-backed securities clearly no longer the solid-gold investment they had appeared to be, banks stopped lending to each other in fear of being stuck with subprime mortgages as collateral. The Fed made a deep cut in the interest rate in August 2007 in an attempt to restore confidence, but it wasn’t enough.

In November 2007, the U.S. Treasury attempted to assuage the panic by creating a superfund for buying distressed portfolios of subprime mortgages, designed to provide liquidity to banks and hedge funds. Then in December 2007, the Fed created the Term Auction Facility (TAF), which supplied short-term credit to banks with subprime mortgages. Again, it was too little, too late.

Esteemed institutions such as Bear Stearns and Lehman Brothers collapsed, and mortgage giants Fannie Mae and Freddie Mac were on the brink.

3. The stock market plummeted, erasing wealth

Foreclosures continued to rise, and this housing bust caused the stock market to dive and eventually crash in September 2008, ultimately losing more than half its value. The double whammy of the falling housing market and stock market meant that Americans suffered staggering losses. Between 2007 and 2011, one-quarter of American families lost at least 75 percent of their wealth, and more than half of all families lost at least 25 percent of their wealth.

The aftermath of 2008’s recession

Fortunately, all bad things come to an end, and such was the case with the Great Recession in 2008 as the government initiated two key programs designed to provide relief for those in the throes of the economic downturn:

1. Troubled Assets Relief Program (TARP) offered assistance

In September 2008, Congress established the Troubled Assets Relief Program (TARP) which allowed the U.S. Treasury to bail out troubled banks by lending the banks billions to purchase “preferred stock.” Under that plan, banks would give the government a 5 percent dividend that would increase to 9 percent in 2013, which encouraged banks to buy back the stock in that time period.

But TARP funds found a benefit beyond banks. In November 2008, the Treasury used them to rescue insurance giant American International Group (AIG) to avoid bankruptcy. And then in December 2008, President George W. Bush used the funds to bail out the “Big Three” auto companies (GM, Chrysler and Ford), which faced bankruptcy and a massive loss of jobs.

Eventually, in February 2009, TARP funds were used for the Homeowner Affordability and Stability Plan, which allowed homeowners to refinance or restructure their mortgages to allow them to stay current on their payments and stave off further foreclosures, and the Home Affordable Modification Program, which encouraged banks to lower monthly mortgage payments for those facing foreclosures.

2. The American Recovery and Reinvestment Act (ARRA) fueled growth

In February 2009 President Barack Obama proposed a $787 billion economic stimulus package, designed to spur consumer spending and restore confidence. The Act had three main parts:

• Cutting taxes: Both individuals and small businesses saw relief. First, the cut reduced withholdings, resulting in a tax cut of $400 for individuals and $800 for families. Small businesses saw an increase in their tax deduction for equipment and tax credits for hiring unemployed veterans and students, among other benefits.

• Spending on assistance programs: The ARRA extended unemployment benefits and increased payments to recipients of Social Security, veterans' pensions or Supplemental Security Income benefits. It also offered a wide variety of tax credits for college tuition and first-time homebuyers, improved access to health care and boosted funding to a variety of education programs, including teacher salaries, Head Start (which promotes school readiness for young children from low-income families) and Pell Grants for college students with financial need.

• Creating jobs: One centerpiece of ARRA was to modernize infrastructure while simultaneously creating jobs through funding projects that would enhance transportation, federal buildings and water quality.

Recovery: slow but steady

It took over five years, but in March 2013 the Federal Reserve announced that household wealth had climbed to $66.1 trillion by the end of 2012. That was $1.2 trillion more than three months earlier and represented a 91 percent recovery from the losses suffered. At the time, private economists also said that gains in stock and home prices pushed Americans’ net worth above the pre-recession peak of $67.4 trillion, compared to an estimated low of $51.4 trillion in early 2009. By April 2014 the jobs gap also appeared to have closed.

But even today, the reverberations are felt, and many have not fully recovered—for example remaining underemployed or finding their financial situation hasn’t completely improved.

Financial crises through the years

It’s interesting to see how events such as the Great Recession in 2008 compares with others. There have been five additional major U.S. economic crises in the modern era, most shorter and less severe—with the exception of The Great Depression of 1929:

• The Great Depression of 1929: The decade-long depression remains the nadir, marked by a stock and housing market crash and unemployment that led to rampant homelessness and famine.

• 1970s Stagflation: This economic phenomenon is characterized by stagnant economic growth, high unemployment and high inflation. One of the key causes for the 1970s event, which ran roughly from Nov. 1973 to March 1975, has been attributed to the 1973 oil embargo when the Organization of Petroleum Exporting Countries (OPEC) cut its oil exports to the United States. This was exacerbated by unemployment and fiscal policies that included a freeze on wages and prices, a tariff on imports and a removal from the “gold standard,” which caused the dollar to lose value.

• 1981 Recession: From July 1981 to November 1982, the GDP (gross domestic product) was negative for six of 12 quarters and unemployment rose to 10.8 percent.

• 1989 Savings and Loan Crisis: The failure of more than 1,000 of the nation's savings and loans, coupled with a falling real estate market, led to a recession that ran from July 1990 to March 1991,

• 2001 Internet Bubble and the 9/11 Attacks: The boom and bust of the “dot-com” economy was the root cause of this recession, which was worsened by the 9/11 attacks and resulting turmoil.

Between those events were other milder recessions, but those are the ones that inflicted the most damage.

Can we avoid repeating the 2008 recession?

While recessions start for a number of reasons, it is unlikely that future recessions will be exactly like 2008’s recession. That’s largely because of a law called the Dodd-Frank Act, which was signed into law on July 21, 2010. The main components included:

• Offering additional oversight that prevents any one banking or insurance firm from becoming so big it could threaten the financial industry.

• Banning banks from using or owning hedge funds for their own profit and requiring them to use hedge funds only at a customer’s request (the Volcker Rule). It also requires hedge funds to register with the Securities and Exchange Commission (SEC) and provide data about their trades and portfolios, since one of the underlying causes of the Great Recession in 2008 was that investors didn’t fully understand these complex products.

• Monitoring risky derivatives (financial contracts whose value is derived from an underlying asset which a buyer agrees to purchase at a specific price), which are now regulated by the SEC or the Commodity Futures Trading Commission and traded at a clearinghouse like the stock exchange. (Again, hedge funds’ use of derivatives contributed to the subprime mortgage crisis.)

• Creating additional oversight for reviewing future Fed emergency loans.

• Supervising credit rating agencies, which contributed to the crisis by deeming some derivatives safe when they really weren’t.

• Regulating credit cards, loans and mortgages and creating more rules for all consumer financial products. Most notably, more information is required for mortgage borrowers to ensure they understand the risks. Banks also must verify borrowers’ income, credit history and job status to weed out riskier loans.

Of course, what’s good for some is bad for others, and banks complained that many of the regulations were too harsh on small banks. That led to a rollback of Dodd-Frank rules for small- and medium-sized banks (those with less than $250 billion in assets) in 2018, leaving only the nation’s largest banks subject to the stricter rules. Many consumer protections remain in place, however.

While many elements that caused the Great Recession in 2008 have been mitigated, that’s not to say that new threats can’t inflict recession-style devastation, as we witnessed with the coronavirus pandemic and resulting shutdown of businesses across the country.

Predicting a recession is tricky business. But educating yourself is the best defense since the causes of a recession are largely outside our individual control.

The most important steps consumers can take for weathering a recession is following smart financial habits like limiting excessive spending, staying within a budget and creating a robust emergency fund whenever possible.