What is economic recession?

These days everybody is talking about some recession. However most of them don’t know much about it. Just they know that the world economy is suffering from recession. Today I will discuss what exactly is economic recession. If you refer any economics book, there you will see that the word ‘recession’ means reduction of a country’s gross domestic product (GDP) for at least two quarters. Let’s see the official meaning of recession from the United States-based National Bureau of Economic Research (NBER). It defines economic recession as

“a significant decline in the economic activity spread across the country, lasting more than a few months, normally visible in real GDP growth, real personal income, employment (non-farm payrolls), industrial production, and wholesale-retail sales.”

There is one more term called depression which is more severe than a recession. Depression is the extreme case of recession, a depression is normally characterized by abnormal increases in unemployment, restriction of credit, price deflation or hyperinflation, shrinking output and investment, numerous bankruptcies, reduced amounts of trade and commerce, as well as highly volatile relative currency value fluctuations, mostly devaluations. The most well-known depression is the Great Depression of 1929 that affected most of the economies in the world for around ten years. The depression began during the Wall Street Crash of 1929.

But let’s forget the depression, focus on recession, better say the latest recession which has created troubles in our lives. The most important reasons for economic recession of 2008-2009 are high oil prices, high food prices, and a substantial credit crisis leading to the bankruptcy of large and well established investment banks like lehman brothers as well as commercial banks in many nations around the world. These fluctuations in world economy has caused increased unemployment, high inflation etc. The International Labor Organization (ILO) has predicted that at least 20 million jobs will have been lost by the end of 2009 due to the crisis – mostly in “construction, real estate, financial services and the auto sector” – bringing world unemployment above 200 million.

So I think you will be interested to know what has caused this major economic upheaval in the world? What is main reason behind falling share markets across the globe and bankruptcy of major banks? Who is responsible for this? Let’s see.

Boom in US real estates

A few years back there was big boom in US real estate industry. The reason behind this boom was low interest rates on housing loans and many other easy credit solutions. Actually it became quite easy for US people to take home loans. As a result of this, more and more people took home loans and thus the demands for property increased which ultimately increased the home prices. Also, there was enough money to lend to potential borrowers, so the loan agencies relaxed the loan conditions to increase their market base. And they did the terrible mistake as they completely ignored the customer’s repaying capacity while giving the home loans.

Real estate boom and overbuilding of houses finally led to a surplus inventory of homes, causing home prices to decline beginning from the summer of 2006. Once housing prices started depreciating in many parts of the U.S., refinancing became more difficult. Home owners, who were expecting to get a refinance on the basis of increased home prices, found themselves unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts. In the US, an estimated 8.8 million homeowners – nearly 10.8% of total homeowners – had zero or negative equity as of March 2008, meaning their homes are worth less than their mortgage.

Sales volume (units) of new homes dropped by 26.4% in 2007 as compare to 2006. Further, a record nearly 4 million unsold existing homes were for sale including nearly 2.9 million that were vacant. This excess supply of home inventory placed significant downward pressure on prices. As prices declined, more homeowners were at risk of default and foreclosure.

Arrival of Financial investment banks in real estate boom

During the booming period, these sub-prime loans became lucrative part of their investment portfolio for lenders as they were expected to yield a very high return in view of the increasing home prices. Also the interest rate charged on sub-prime loans was about 2% higher than the interest on prime loans due to the involvement of higher risk. Inspite of the risk involved lenders were confident that they would get a handsome return on their investment as a sub-prime borrower will continue to pay his loans installment, the lender would get higher interest on the loans. If a sub-prime borrower could not pay his loan and defaulted, the lender would have the option to sell his home to get his money back. So there was very less risk in this sector as in both the situations the Sub-prime lenders were in profit. The sub-prime loan market thus became a fast growing business in US.

Most of the big investment banks heavily bought these loans (known as Mortgage Backed Securities, MBS) to diversify their investment portfolios. Due heavy buying of Mortgage Backed Securities of sub-prime loans by major American and European Banks, the problem, which was once confined to US propagated into other countries.

As the home prices started declining in the US, sub-prime borrowers found themselves in a big dilemma. Their house prices were decreasing and the loan interest on these houses was increasing. Now they could not manage a second mortgage on their home so it became very difficult for them to pay the higher interest rate. Most of them became defaulter on their home loans and vacated the house.

Since the home prices were falling rapidly. The lending companies, when they went into the market to sell the house to recover the loan amount, found that the loan amount exceeded the total cost of the house. This caused major losses to Citigroup ($55.1 billion) and Merrill Lynch ($52.2 billion).

So this is how the current economic recession started.