On one of his first trips as president, Barack Obama visited East Peoria. He traveled to central Illinois to put a face on the recession that enveloped the country and to promote his stimulus package. 

Caterpillar Inc., the worldwide heavy equipment maker, provided a poignant example of the swift cruelty of the downturn. The East Peoria-based company had just posted record profits a year before. But now it announced it would lay off 22,000 people to cope with the global crisis. The downturn sapped demand for heavy machinery both at home and abroad. 

“When we say we’ve lost 3.6 million jobs since this recession began … then you know this isn’t about figures on a balance sheet. It’s about families that many of you probably know,” Obama told those assembled at the Caterpillar plant in early February.

“It’s about folks,” he added, “all across this state and all across this country, folks who are losing their jobs and their health care and their homes that were their footholds on the American Dream.”

East Peoria is a long way from Sun Belt cities like Las Vegas and Phoenix, the heart of the early decade real estate craze that ended in a spectacular collapse. The Peoria area has actually avoided the worst of the downturn — the chamber of commerce’s slogan is “It’s better here” — but the region and the rest of Illinois haven’t been able to escape the nation’s economic woes.

“By and large it’s a national story. It’s what we’re seeing in so many parts of America right now. The problems in the financial sector just eat their way through the rest of the economy,” says Christopher Cornell, an economist with Moody’s Economy.com who has studied Illinois’ plight.

To tell the story, Illinois Issues combed through congressional testimony, position papers, media accounts and data from federal and business sources. What emerges is a common thread that explains how we got into this uncommon recession. 

The story of the collapse takes many twists and turns, with fateful swings through Wall Street and Washington, D.C. Those are the places where the economy picked up steam, thanks to the political momentum, financial wizardry, insider deals, lax oversight and loose money they created. And that’s where most of the fingers are pointing now.

But the main reason for the recession is that too many people bought houses they couldn’t afford, and everybody was banking on those houses. 

“This is really unlike any post-World War II recession that we’ve seen. It’s not just a matter of slumping demand that we can prop up through these stimulative measures. This is banking-centered, and in that way… it reminds me more of the banking panics and crises we’d see in the late 19th and early 20th centuries — far more than post-World War II recessions,” Cornell says.

Already this 18-month recession has lasted longer than any downturn since the Great Depression. It long ago spread from the housing sector to virtually every segment of the economy. Rising unemployment, climbing foreclosure rates and skidding housing prices are the norm. Some of America’s biggest banks and best-known brands are either bankrupt or on government life support. The federal government is spending unprecedented sums in an effort to revive the economy or at least prevent a full-blown depression.

The recession has already taken its toll here. 

Illinois’ March unemployment rate hit 9.1 percent, but in Belvidere, home of the state’s sole Chrysler plant, it’s twice as high. Monthly claims for unemployment insurance in Illinois more than doubled between March 2008 and a year later. 

Construction and manufacturing — industries that are especially vulnerable to downturns — are the hardest-hit. But retail, hospitality and white-collar jobs are also being lost.

All told, Illinois is likely to shed 210,000 jobs in this recession, according to a January report prepared for state legislators by the Illinois Commission on Government Forecasting and Accountability.

Normally, recessions start when the Federal Reserve, the central banker in the United States, hikes interest rates to cool down inflation, says Northeastern Illinois University economics professor Ed Stuart. “This is not a normal recession. It was not caused by the Fed, and it didn’t have inflation.”

As Obama warns about folks losing their grip on the American dream, it is one of the core tenets of that dream — owning your own home — that’s at the root of the economic crisis.

The housing boom of the late 1990s and early 2000s was certainly no secret.

Consumers took advantage of plentiful credit and low rates to acquire the houses or condominiums of their dreams. Others refinanced their homes so they’d have extra money to spend. Investors jumped in, too. They were shaken by losses in the stock market in the dot-com bust and — later — the bear market following the 2001 terrorist attacks. The bond market didn’t look much better because low interest rates meant skimpy profits. 

Real estate seemed attractive because, as the saying went, God wasn’t making any more of it, and prices always seemed to climb.

Mortgage brokers, of course, benefited by selling the loans to prospective homeowners on behalf of banks. The banks that underwrote those mortgages then turned around and sold them to investors. The banks then used the money from those sales to offer more mortgages to homeowners. Then they sold the new mortgages to investors and repeated the process.

If that was all there was to the story, the housing bubble might have been just a blip. 

But that’s just the beginning. 

As mortgages got passed along, they grew more integrated into the larger financial system. Yet every time they changed hands, it became more difficult to determine whether the underlying investment was sound. 

Fannie Mae and Freddie Mac, two large corporations that at the time were not technically part of the federal government, bought up a big chunk of those mortgages. The two companies were created by Congress decades ago to spur home lending. 

The money they used to buy mortgages came from the U.S. Treasury. But as publicly traded companies, both firms also answered to stockholders who wanted maximum profits. 

As the housing market heated up, the two companies lost market share. Wall Street firms snatched up mortgages as an attractive investment, compared with the stock market. Wells Fargo, Lehman Brothers, Bear Stearns, JP Morgan, Goldman Sachs and Bank of America got in the game, as did lenders who primarily focused on the more risky “subprime” mortgages.

Fannie and Freddie’s combined market share of mortgage-backed securities dropped from 76 percent in 2003 to 43 percent in 2006. The two companies responded by more aggressively pursuing subprime loans.

Fannie, Freddie and their new competitors didn’t just sit on the thousands of loans they owned. Instead, they bundled them up into new packages, called mortgage-backed securities, to sell to investors. 

The goal, ostensibly, was to spread the risk. As an investor, if you own one mortgage and the homeowner stops paying, you could be devastated. But if you own pieces of 1,000 mortgages and a dozen homeowners stop paying, it’s not a big deal. You’re still getting income from the hundreds of other borrowers paying into the pool.

What happened next was new and, these days, highly controversial. It basically allowed companies to buy risky investments that, on paper, looked solid.

Wall Street firms bought up the mortgage-backed securities. Then they sliced and diced the securities into collateral debt obligations (CDOs). Other types of debt, like auto loans or corporate debt, often were combined into the CDOs, too. 

The CDOs typically came in three varieties, with low, medium and high risk. Of course, the higher the risk, the higher the reward. 

When it came time to divvy up the profit from the underlying mortgages, people who bought the low-risk CDOs would get paid first, but not much. If there was anything left, the holders of the medium-risk CDOs would get paid. Whatever was left would go to the owners of the riskiest CDOs.

But credit ratings agencies often assigned identical ratings to the top two tiers of CDOs. This meant that the medium level CDOs, which were higher-paying and higher-risk, were considered to be “investment grade.” 

The blessing from the ratings agencies meant that pension funds, insurance companies and other regulated entities could purchase the top two levels of CDOs. It meant financial institutions could sock away less in reserves in case the housing market went bust because they thought they were buying safe investments.

There was a run on CDOs. In 2006, $503 billion of CDOs were sold, compared with $84 billion five years earlier, according to Morgan Stanley.

Much of the demand for CDOs came from foreign investors, newly flush with money and looking for ways to earn a decent return. So Wall Street tried to bring more CDOs to market. To do that, they needed more new mortgages. 

When dependable borrowers grew scarce, lenders turned to less-dependable borrowers. Banks required less verification of income. Lenders peddled adjustable rate mortgages and required little or no down payment. 

It’s worth remembering that all of this sounded good to a lot of people. 

“We’re creating ... an ownership society in this country, where more Americans than ever will be able to open up their door where they live and say, ‘Welcome to my house, welcome to my piece of property,’” President George W. Bush said while running for re-election in 2004. Bush often touted the idea of an ownership society, and he especially stressed the importance of poor and minority families owning their own homes.

At the same time, congressional Democrats pressed Fannie and Freddie to increase lending to low-income families. Congress spent $200 million to help low-income families get mortgages they couldn’t otherwise afford. The mortgage giants staked a bigger role in the subprime mortgage market.

The home-ownership rate rose — hitting 69 percent nationally at its peak in 2004 — but real incomes didn’t keep up.

Illinoisans enjoyed the boom, too. For most of the 1990s, the average house price in the Chicago area hovered around the same number, when adjusted for inflation. By 2000, that average crept up to about $159,000 — or the equivalent of $200,000 today. At the peak of the housing bubble in 2006, that price shot up to more than $266,000 — or $280,000 in today’s dollars. That’s a 40 percent increase in six years.

But Chicago-area prices have since tumbled faster than they had climbed. By the end of last year, that average price was back down at $217,000. The halt of rising home prices ended the housing boom and triggered the larger economic woes. 

During the boom years, home builders had responded to consumer demand by building more and more houses and condos. Eventually, they overbuilt. With the supply of housing increasing faster than demand, prices fell. That caused a lot of problems, especially because Americans’ earning power did not keep up with the price of their homes.

First, homeowners who had paid their mortgages by repeatedly borrowing against the ever-increasing value of their homes could no longer do so. When they defaulted, their houses were foreclosed on. In good economic times, that’s no problem for lenders. They simply sell the house. But when there are already too many houses on the market, selling foreclosed houses only drove prices down further.

Soon even healthy borrowers realized they were “underwater,” that is, they owed more on their mortgages than their houses were worth. When they defaulted, even more houses went on the market, and prices sank again.

Meanwhile, shock waves reverberated on Wall Street. Banks and investment firms had used CDOs as collateral on loans in all sorts of transactions. But no one even knew how much the CDOs were really worth now, as more homeowners defaulted and the CDOs turned out to be riskier than advertised. Wall Street couldn’t even judge their value by their market price because CDOs were sold in private transactions, not on the open market.

The Wall Street titans had no choice but to hoard cash and assets. Lending froze.

“The market failure … allowed a 3 percentage point jump in serious delinquency rates on a subsection of U.S. mortgages [the subprime market] to throw a $57 trillion U.S. financial system into turmoil and cause shudders across the globe,” wrote Randall Dodd, a financial expert for the International Monetary Fund.

Officials at the Treasury Department and the Federal Reserve recognized the severity of the problem. But they faced a dilemma. If they used taxpayer money to rescue the troubled investment firms, they would encourage other companies to continue engaging in risky behavior. But if they didn’t act to restore faith in the system, nobody would be able to borrow money, and the economy could grind to a halt. 

Credit is the lifeblood of the economy. Without it, farmers can’t get loans to buy combines and tractors, small businesses can’t improve their facilities, and engineers can’t get hired to build hospitals and shopping malls because they aren’t being built.

The federal government rescued Bear Stearns and later American Insurance Group (AIG) but let Lehman Brothers fail. Last September, it essentially took over Fannie Mae and Freddie Mac, too. 

But credit is still tight. And getting banks to lend again has been one of the most vexing problems for the U.S. government.

Many of its efforts have focused on how to take so-called troubled assets off the balance sheets of the lenders. That was the idea when Congress passed the $700 billion bailout bill last fall. But figuring out how to do that has proven exceedingly difficult, under both the Bush and Obama administrations. 

All told, the federal government and the Federal Reserve have committed nearly $3 trillion to the effort. That’s roughly the size of the federal government’s entire annual budget.

“By the spring and summer of 2008, the tightening of credit conditions had begun to weigh on business spending. And by the fall, household spending was affected as well. Spending was also reduced by the protracted weakness in housing markets, declines in financial wealth, softening labor markets and substantial increases in prices for energy and other commodities,” Charles Evans, head of the Federal Reserve Bank of Chicago, told Rockford business leaders in February.

Within a week of Obama’s trip to Peoria, Congress sent him a $787 billion economic stimulus package. The far-reaching plan aims to revive the economy and create jobs with a mix of hefty government spending and limited tax cuts. 

But there’s still a long way to go before those effects are felt at home. Even the most optimistic economists don’t expect the nation to pull out of the recession until late this year.

In Illinois, home prices registered a slight uptick in recent months, but the Land of Lincoln had the eighth-highest foreclosure rate in the country in April. Its rate of one foreclosure for every 384 housing units pales next to Nevada’s one for every 68. But the Illinois rate is up from just one for every 625 units in November 2007.

Peoria and central Illinois generally have fared better than the Chicago region. Roberta Parks, chief operating officer of the Peoria Chamber of Commerce, says that area’s business base is far more diverse than in the 1980s, when Caterpillar’s woes sent residents packing for warmer climates. Now, she notes, two major new hospital construction projects are under way. City voters approved a sales tax hike for a new riverfront museum to open in 2012, and Caterpillar is building a nearby visitor’s center.

But Parks acknowledges that it’s impossible to ignore the downturn. People are changing spending habits. Companies are slower to fill vacancies. The 22,000 Caterpillar employees Obama talked about have been laid off. The company’s president said that even with the stimulus package, more layoffs may follow.

“In some parts of the country, there is a hurricane going on, and people are drowning,” Parks says. “We’ve got a really bad storm and it’s raining really hard, but we aren’t drowning.”

Daniel C. Vock is a reporter for Washington, D.C.-based Stateline.org.

Illinois Issues, June 2009