Author: Wayne Duggan https://www.forbes.com/advisor/investing/great-recession/

The Great Recession of 2008 to 2009 was the worst economic downturn in the U.S. since the Great Depression. Domestic product declined 4.3%, the unemployment rate doubled to more than 10%, home prices fell roughly 30% and at its worst point, the S&P 500 was down 57% from its highs.

What started as a classic tale of greed and deregulation ended in a global crisis that caused six million households to lose their homes. As a result, unprecedented reforms and bailouts were implemented that are still in place today.

What Caused the Great Recession?

Banks and mortgage lenders became increasingly predatory with their lending practices in the years leading up to the Great Recession. Mortgages became easier to get, with fewer standards in place to ensure borrowers could repay them. With more people suddenly getting access to buying power, there was a construction boom and prices increased substantially.

This new type of mortgage, called subprime, was offered to borrowers with impaired credit records, insufficient incomes and suboptimal credit scores. These mortgages typically featured low or no down payments and low initial monthly payments to entice borrowers. These borrowers typically didn’t understand the complex features of their loans and the nature of their interest rates.

Most subprime mortgages, in addition to having balloon payment features and subpar underwriting standards, were also adjustable rate mortgages (ARMs).

From 2004 to 2006, the U.S. Federal Reserve raised the federal funds rate from 1% to 5.25%, and the rates on subprime ARMs rose at the same time as those low introductory payments were increasing. This sudden jump in monthly payment was more than many borrowers were able to pay and a wave of foreclosures started.

The Subprime Mortgage Crisis

During the housing market boom, banks were also securitizing subprime mortgages by bundling hundreds or thousands of mortgages together and selling them to investors as mortgage-backed securities (MBSs), a form of bonds consisting primarily of mortgage loans.

Any investor looking to have relatively safe investments in their portfolio would historically gravitate towards mortgages, as a low-risk, low-reward option. Banks, hedge funds, pension funds and accredited investors bought these MBSs. They didn’t understand that the new lending paradigm had shifted and these mortgages would experience unprecedented foreclosure rates.

Brian Colvert, certified financial planner (CFP) and chief executive officer of Bonfire Financial, says the combination of risky subprime mortgage issuance coupled with lack of regulatory oversight set the table for the financial crisis that followed.

“The use of complex financial instruments such as credit default swaps, which allowed investors to take on large amounts of risk without fully understanding the potential consequences, contributed to the crisis,” Culvert says.

Credit Default Swaps

Credit default swaps, or CDSs, are like insurance policies for bondholders. Lenders purchase CDSs from investors who agree to pay the lender if the borrower defaults on its obligations.

Dr. William Procasky, a chartered financial analyst (CFA) and assistant professor of finance at Texas A&M University-Kingsville, says the proliferation of CDSs exacerbated the leverage in the housing bubble.

“Because these credit default swaps created ‘synthetic exposure,’ meaning you didn’t have to actually own the physical bond to bear the risk of non-performance, they could be created in theoretically unlimited amounts, resulting in a multiplier effect in subprime credit risk held by banks and investors,” Procasky says.

When homeowners began to default on their mortgages, the mortgage backed securities market tanked, triggering massive losses for banks and investment firms. At the same time, insurance companies that had sold these institutions CDSs were also on the hook to cover billions of dollars in losses.

Bank Failures and Initial Bailouts

Several major financial institutions did not survive the complete breakdown of financial markets in 2008.

Investment bank Bear Stearns was acquired by JPMorgan Chase in April 2008 for a price of $10 per share, about 94% below its 52-week high. In September 2008, investment bank Lehman Brothers, which had a peak market capitalization of $60 billion just 18 months prior, filed for Chapter 11 Bankruptcy protection.

The U.S. government was forced to step in to issue aggressive bailouts to prevent a domino effect of closures throughout the U.S. economy. In September 2008, federally backed home mortgage companies Fannie Mae and Freddie Mac were essentially nationalized via the Economic Recovery Act of 2008, which insured $300 billion in mortgages.

A month later, Congress and U.S. President George W. Bush passed the Emergency Economic Stabilization Act of 2008, which included $700 billion in government bailouts under the Troubled Asset Relief Program (TARP).

Companies that received bailouts under the TARP program include insurance company American International Group, auto company General Motors and big banks JPMorgan, Citigroup, Bank of America and Wells Fargo.

Monetary Policy Efforts

The Federal Reserve was also forced to take unprecedented monetary policy measures during the Great Recession to preserve the financial system. From September 2007 to December 2008, the Fed implemented 10 interest rate cuts, bringing the fed funds rate down from 5.25% to essentially zero.

The Fed also implemented a quantitative easing program in November 2008 by announcing it would be purchasing $100 billion in direct obligations of Fannie Mae and Freddie Mac, as well as $500 billion of MBS backed by Fannie Mae, Freddie Mac and Ginnie Mae.

Finally, the Fed implemented several new federal lending programs to provide liquidity directly to specific markets that needed it.

The End of the Great Recession

In February 2009, under new President Barack Obama, Congress passed the $789 billion American Recovery and Reinvestment Act, which helped bring about an end to the economic recession. The stimulus package included $212 billion in tax cuts and $311 billion in infrastructure, education and health care initiatives.

The next day, Obama announced the Homeowner Stability Initiative, a $75 billion program to help more than 7 million U.S. homeowners avoid foreclosure.

In March 2009, the Federal Housing Finance Agency announced the Home Affordable Refinance Program (HARP), a program that helped credit-worthy homeowners that were underwater on their homes refinance their mortgages and take advantage of lower interest rates.

The S&P 500 reached its 2009 low of 666 on March 6, 2009. By March 23, the index was up more than 20% from its lows.

Following the aggressive government stimulus measures, U.S. GDP increased 1.5% year-over-year in the third quarter of 2009, officially ending the recession.

Reforms Implemented

In July 2010, Congress passed the Dodd–Frank Wall Street Reform and Consumer Protection Act, a collection of new banking regulations aimed at preventing another financial crisis. The Dodd-Frank Act also created the Consumer Financial Protection Bureau to oversee subprime mortgage loans and the consumer credit market.

Procasky says Dodd-Frank legislation has significantly reduced systemic risk in the U.S. banking sector.

“Large banks who pose potential threats to the banking system if they fail are stress-tested by the Fed to ensure they have sufficient capital to withstand adverse environments,” he says.

“Also, there is no longer a market for credit default swaps written on subprime mortgages, eliminating the aforementioned multiplier effect in the spreading of risk.”

Great Recession Investing Opportunities

By March 2013, the S&P 500 had fully recovered its Great Recession losses and made its first new all-time high since 2007.

Opportunistic investors made a killing during the 2008 and 2009 stock market crash. Billionaire Wall Street legend and Berkshire Hathaway CEO Warren Buffett reportedly earned more than $10 billion in profit on his Great Recession investments by late 2013.

Ryan Kaysen, CFP and owner of Integritas Financial, says the Great Recession provided generational buying opportunities for investors, but seeing and acting on the opportunity in real time was challenging.

“Many investors were blindsided by the crisis so not many saw this as an opportunity. For those lucky few who had their investments in cash, they were able to buy up some of the biggest companies at extreme discounts,” Kaysen says.

For example, Apple shares dropped from a split-adjusted 2007 high of $7.25 to a 2009 low of $2.79. Roughly 15 years later, Apple shares are now trading at more than $150. Microsoft shares dropped from a 2007 high of $37.50 to a 2009 low of $14.87. Microsoft shares now trade at around $265, a nearly 1,700% gain over 15 years.

Investors who simply bought the SPDR S&P 500 ETF Trust on the day the S&P 500 bottomed in 2009 have also enjoyed some impressive returns. Since March 6, 2009, the SPY ETF has generated a more than 500% total return.