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What Were the Tipping Points That Set Off the Great Recession?

Wall Street has infamously had its share of ugly Octobers, so Alison Southwick and Robert Brokamp chose this month to offer their listeners a special treat: a four-part series on the history of market crashes in the United States.

In this segment of the Motley Fool Answers podcast, guest and former Fool Morgan Housel helps them wrap things up with a post-mortem on the downturn we all think we know best, because it's so recently behind us: the Great Recession. People often want to blame homeowners who had overextended themselves, but Housel lays more of the fault at the feet of the overleveraged banks and hedge funds that had been buying and selling mortgage-backed securities. Of course, that was just the beginning.

A full transcript follows the video.

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This video was recorded on Oct. 24, 2017.

Alison Southwick: So what was the tipping point? So everyone is buying these houses they can't ultimately afford. What caused the Great Recession?

Morgan Housel: I think it's not necessarily the people who own homes, but it was the banks and the investors that owned all of those mortgages. When they started defaulting on their loans -- these big banks, hedge funds, and sovereign wealth funds that owned all these subprime mortgages -- that's when credit markets really started seizing up.

So the first one was a group of hedge funds. In the summer of 2007 there were big credit funds and all of a sudden one day out of the blue they shut their doors. If you were an investor you couldn't have your money back because they had no liquidity in their portfolio. They couldn't sell their subprime bonds. There's no market for them. So subprime bonds and mortgage bonds, which was a trillion-dollar industry back then, happened very quickly in 2007 when the market just shut down and you couldn't sell them anymore. And that's really when the panic began.

Southwick: And what happened in the panic?

Housel: So you had all these banks around the world that were leveraged 20-30x. They had 30x as much assets as they did equity. This huge amount of leverage, so if anything even went slightly wrong, they were in a lot of trouble. And so because of that, they started really cutting back on the loans that they were making to the rest of the economy. Cutting back on business loans and cutting back on personal loans to creditworthy borrowers who at any other time would have had no problem getting a loan [they were a great person to lend to], but the banks, themselves, were in so much trouble that they started shutting down those loans, as well.

During this time I worked at a private equity firm in Los Angeles in the summer of 2007 and we experienced, as well, taking out loans and financing for great, healthy companies. These were not sketchy subprime loan companies. These were really healthy, prosperous companies [for which] virtually overnight the credit spigot just stopped. So things happened really quick with the credit crisis.

I think Ben Bernanke, to his credit, recognized this very quickly in 2007, a year before most people started recognizing it. This is when the Fed, in late 2007, really started slashing interest rates and stepping in.

But the stock market, during this time, didn't really blink. So the credit market started shutting down in the summer of 2007. The stock market hit an all-time high in October of 2007. So even after the credit markets were going through all kinds of mayhem, the stock market kept going up.

Southwick: So the stock market is still just doing fine. Doesn't care. But that ends. At some point the stock market starts to care. When is that?

Housel: It starts to decline a little bit, but even as you get into early 2008, it was still doing pretty well. Down a little bit. 5% or 10%, but still at a pretty high valuation that would be associated with optimism. People really weren't that aware of what was going on yet. And I think that's a good takeaway from the Great Recession, is that it's easy to sit here in hindsight and say it was so obvious. Anyone could have seen this coming.

If you just think about stock prices, which is a good reflection for the average opinion out there, even a year after credit markets started tumbling, the stock market really didn't care that much, which I think is something to reflect on of how hard these things are to spot. Even with a year's worth of data in your face, most people really didn't see it.

Southwick: I feel like I also see this tweet [Twitter] at least once a month where someone who's like a financial journalist says the stock market is not the economy. But we kind of always kind of think it is.

Housel: I think that's wrong. It is. I think the stock market is a reflection of people's moods. Of optimism and pessimism. And that also drives the economy. Another aspect of it is that the savings rate, during this period, didn't increase that much. So people with the incomes that they had, unemployment was still fairly low in late 2007. We're still optimistic enough to go out there and spend a ton of money on restaurants, and vacations, and whatnot.

So late 2007, early 2008 the economy started slowing a little bit. But it was still going at a pretty good clip. By a lot of metrics it was stalling, but still fairly healthy. And the summer of 2008 is when things got really dicey.

Southwick: What happened then?

Housel: I think that's when consumers, themselves, and businesses really started seeing the writing on the wall. And a couple of events [like] Fannie and Freddie being seized. Bear Stearns basically failed and was taken over in March of 2008. Fannie and Freddie were in August of 2008. Just this confluence of events is when unemployment really started ticking up.

And it was almost like a tipping point that was not necessarily based on any one specific news story, but I think it just becomes obvious to most people in the economy where you look around and you say, "Well, shoot. This isn't good." And everyone at the same time, down to me. I probably started going to restaurants less often. And one year before I would have spent extra money on this, but now in 2008 I said, "I should hold back."

And you multiply that by 300 million Americans and it really happened so quickly. That on the consumer side and then the banking side, of course Lehman Brothers went bankrupt in September. Washington Mutual. Merrill Lynch. AIG. Everything just happened in a one-week period. And you put those two things together -- a financial crisis and then a slowdown and lack of optimism of consumers -- and those two things really drive each other, as well. But it really just came crashing down in a one-week period in September of 2008.

Southwick: So if so much of the stock market is based on optimism, does that make it often a trailing indicator of how bad things are going in the economy? Or is every market crash its own little unique snowflake?

Housel: I think it's unique. There are tons of periods, historically, where you can look back and say the stock market was looking in the rearview mirror and it hadn't really caught up. And then you can also find a lot of periods where it's obvious that the market was looking ahead at the next six months or the next year and saw a recovery before other people. So it's generally phrased as the market is looking six to 12 months ahead, but I think you can also look at periods like late 2007 where I think it was looking 12 months behind and really didn't see what was coming ahead.

Alison Southwick has no position in any of the stocks mentioned. Morgan Housel has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.