The Cavalier Daily first examined subprime loans and the credit crunch as a whole March 13, 2008. Only three days later, venerable investment bank Bear Stearns became the first major victim of the crisis. In the months following, though, the S&P 500 Index — a major benchmark of the broader economy’s performance — jumped over 150 points to close at 1426.6 May 19, indicating a good amount of optimism. From then until now, though, the index has fallen more than 10 percent. But the drop hasn’t been a steady one — from July 15 to 23, the market rebounded more than 4 percent, with the vast majority of that occurring in just two days. Simply put, investors just don’t know how long this downturn will last or what will come next.
The trouble all started when low interest rates allowed for easy borrowing, which artificially propped up home prices and spending. Various financial institutions flourished as they assembled mortgages into products so complex that no one realized the tremendous risk within. Homes served as the collateral behind many of the securities, so if the housing bubble were to burst, the prices of the securities would plummet.
Whether the lenders and banks knew they were acting dangerously is up for debate — New York State Attorney General Andrew Cuomo is currently investigating potential fraud committed by several brokers in a niche security market. Either way, home prices did fall, the securities lost their value and lenders ended up too scared to lend lest they make the same mistake again.
Borrowed money is what funds investment by businesses. So, when that source of funds dries up, business slows, workers get laid off and overall, people’s confidence in the economy decreases. Financial services companies — banks in particular — especially depend on cheap borrowed money that they can then lend out at higher interest rates. Regional banks — small-town savings and loan institutions that concentrate in a specific area of the country — have been hit especially hard after lending to fund previously overvalued construction projects.
“The credit crunch has morphed into a banking crisis,” Commerce Prof. Robert Webb said. That is, worry has condensed from a broad feeling of despair about the lending environment to one more concentrated on a series of Depression-style bank failures. The public got a taste of that in the middle of July when California-based IndyMac Bank failed and was seized by the federal government. Luckily, institutions like the Federal Deposit Insurance Corporation were devised after the Great Depression to protect deposits and to ensure there would never be a repeat. Nevertheless, fear remains about how much stress the system can sustain should too many banks throw in the towel.
Recent sharp downturns in the equity values of Fannie Mae and Freddie Mac have further depressed confidence. These two government-sponsored enterprises essentially guarantee or own half of all mortgages in the U.S. market, serving as middle-men to ensure the market operates smoothly. But, with all the turmoil surrounding mortgage lending during the past year, investors have fled from the two companies. Since the beginning of this year, Fannie Mae’s stock price has fallen almost 83 percent to a mere $6.84 as of August 29’s close. Freddie Mac trades at $4.64, down nearly 87 percent for the year. Treasury Secretary Henry M. Paulson has been debating whether government intervention would be a feasible solution. While a government backing of the struggling mortgage giants would stabilize markets, it would mark a government intervention into the economy of unprecedented scale and scope.
Aside from the financial sector, though, the biggest fear is that the banking crisis could make the jump “from Wall Street to Main Street” — as is so often stated — to start a full-blown recession. After a slight contraction in the last quarter of 2007, gross domestic product grew just less than 1 percent in the first quarter of this year. In the second quarter, the growth rate jumped to 3.3 percent, making it tough to argue that the economy is mired in a recession. A popular rule of thumb says a recession occurs when GDP growth is negative for two consecutive quarters, which has not happened yet in this downturn.
“There are signs that the crisis is not over, but so far the evidence is that we’re not in a recession yet,” Webb said.
The official definition of a recession, though, is much less definitive. According to the National Bureau of Economic Research, a recession is characterized by “a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.”
The Federal Reserve published the Beige Book — a summary of economic conditions — yesterday. According to the report, “the pace of economic activity has been slow in most districts. Many described business conditions as ‘weak,’ ‘soft,’ or ‘subdued.’”
There has been no recession declaration as of yet, but as Commerce Prof. Richard De Mong pointed out, “NBER often tells us that we are in a recession after we have come out of that recession.” As for now, he added, “I cannot give a precise answer as to whether we are, or are not, in a recession.”
The signs remain mixed. Wildly inflated oil prices have hurt both the consumer, who now has less money to spend on things other than gas, and business, which has to spend millions more to fuel trucks and factories. However, home-improvement retailers Lowe’s and Home Depot — companies at the intersection of the housing and retail markets — posted better than expected results earlier this month. While sales and profits decreased at both companies, the results beat expectations and could indicate that troubles are beginning to fade.
Overall, though, no one is ready to make a call one way or the other.
“The outlook certainly remains cloudy,” Webb noted.
Though this downturn has lasted much longer than originally expected, it remains to be seen how much farther — and lower — it can go.
David Victor-Smith is the president of the McIntire Investment Institute, a student-run equity fund.
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