OPPapers.com

Recession

RECESSION(FINANCIAL CRISIS)

INTRODUCTION

In economics, a recession is a general slowdown in economic activity in a country over a sustained period of time, or a business cycle contraction.During recessions, many macroeconomic indicators vary in a similar way. Production as measured by Gross Domestic Product (GDP), employment, investment spending, capacity utilization, household incomes and business profits all fall during recessions. A recession has many attributes that can occur simultaneously and can include declines in coincident measures of activity such as employment, investment, and corporate profits.
A severe (GDP down by 10%) or prolonged (three or four years) recession is referred to as an economic depression, although some argue that their causes and cures can be different.

CAUSES

Over-leveraging, credit default swaps and collateralized debt obligations as causes

Another probable cause of the crisis -- and a factor that unquestionably amplified its magnitude -- was widespread miscalculation by banks and investors of the level of risk inherent in the unregulated Collateralized debt obligation and Credit Default Swap markets. Under this theory, banks and investors systematized the risk by taking advantage of low interest rates to borrow tremendous sums of money that they could only pay back if the housing market continued to increase in value.
The risk was further systematized by the use of David X. Li's Gaussian copula model function to rapidly price Collateralized debt obligations based on the price of related Credit Default Swaps.This formula assumed that the price of Credit Default Swaps was correlated with and could predict the correct price of mortgage backed securities. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies. According to one wired.com article: "Then the model fell apart. Cracks started appearing early on, when financial...