Background of the Recession

The financial crisis of 2008 was one of the worst recessions in US history. The financial collapse saw the collapse of several large investment banks, bailouts of insolvent banks by the government and sharp declines in the stock market. These changes had far reaching global ramifications, and caused many other global economies to also suffer.[1]

The chain of events that led to recession began with the bursting of the US Mortgage Loan Bubble. This caused the Collateralized Debt Obligations (CDO) securities that were tied to the housing loans to fail. This in turn caused the financial institutions that were selling and insuring the CDO securities to fail, which led to a major credit crunch and loss of liquidity, which then affected other companies and that was reflected with a large decline in the stock market.

There were many factors, for example the overvaluation of sub-prime mortgages, poor trading practices of the underlying securities, and an over extension of financial credit, that were interspersed together to cause recession that caused a huge credit hole in the US financial system and a devastating ripple effect across the rest of the world.

During this financial crisis and the recession that followed the US Federal Reserve took drastic measures in combination with the US Federal Government to prevent the recession from becoming like the Great Depression of the 1930s.

Events that Led to the Recession of 2008

The events that led to the financial crisis of 2008 and the recession that followed could have its origins traced back to 2006-2007. The crisis began with the Sub-Prime Mortgage loans beginning to show defaults. By 2007 the number of mortgage defaults became substantial to the point that the Collateralized Mortgage Obligations (CMOs) securities were affected and not displaying the anticipated returns.

The CMOs were being bought and sold by major investment banks. As more and more mortgages began to default the investment banks and investors started to lose confidence in the security. This resulted in the value of these securities falling rapidly.

To increase to the complexity of the situation, large investment banks had agreements with insurance institutions, primarily AIG, in which their CMOs will be insured in the event of a default. This is called a Credit Default Swap (CDS). The method in which the CDS operates is the insurer provides insurance to the buyer for the CMO security and the buyer will pay the insurer a premium at stipulated times throughout the insurance contract. In the event of a default of the CMO security the insurer will purchase the CMO security from the buyer at the face value of the CMO security, thereby insuring the buyer from loss in the event of a default of the CMO.