Over the last decade, the global economic downturn that began in December 2007 has influenced the current real estate environment more than any other. This period of economic turmoil was is referred to as the Great Recession when many, if not most people, faced unprecedented challenges.
Understanding the dynamics and implications of this period that began with a housing bubble is critical for homebuyers in today’s housing market.
Housing prices have been on the rise again since the housing bubble burst, and some economists believe that the nation could experience another possible real estate bubble, particularly at the local and city level.12
- In 2007, the housing market started to plummet.
- A combination of rising home prices, loose lending practices, and an increase in subprime mortgages pushed up real estate prices to unsustainable levels.
- Foreclosures and defaults crashed the housing market, wiping out financial securities backing up subprime mortgages.
- As banks worldwide began to fail, the U.S. federal government was intervened to avoid a depression.
Understanding the Great Recession
The U.S. economy had been experiencing a boom for many years. But the economic gain was wiped out in a matter of months. Beginning in 2007, millions of people lost their jobs and homes when the housing market started to plummet (i.e., the “bursting” of the housing bubble). From the mid-1990s to the mid-2000s the average price of housing rose rapidly and peaked in 2007 when the average price of a house in the United States reached nearly $314,000, according to U.S. census data.3 In 2000, only seven years earlier, the average price of a house was $207,000.
Artificially high home prices, loose lending practices, and the increase in subprime mortgages were economically unsustainable, yet the housing bubble continued to grow unabated. The bubble finally broke in 2007.
As the crisis grew, numerous foreclosures and defaults crashed the housing market vastly depreciating the value of deliberately obscure financial securities directly tied to subprime mortgages (e.g., mortgage-backed securities). The fallout created a ripple effect throughout the entire global financial system. Banks in the United States and around the world began to fail. Ultimately, the U.S. federal government intervened to mitigate the damage.
The Housing Market During the Great Recession
During the period leading up to the recession, both foreign and domestic investors continued to pour money into the real estate industry. Homebuyers were issued credit without adequate risk management. The combination of rising home prices and easy credit led to an increase in the number of subprime mortgages, an underlying cause of the Great Recession.
Subprime mortgages are financial instruments with widely varying terms that lenders offer to risky borrowers. A risky borrower might have a less than stellar credit history, questionable income stability, and a high debt-to-income ratio. Moreover, subprime mortgages were popular among homebuyers who were purchasing second homes. In fact, lenders specifically targeted these home buyers for subprime mortgages.
Furthermore, subprime mortgages often have adjustable interest rates. Subprime lenders offered consumers mortgages that carried low-interest rates for a short period but, once the initial specified period is over, the interest rates can jump considerably. The average subprime mortgage interest rate from 1998 to 2001 was much higher than conventional mortgage rates, by as much as 3.7 percentage points.
The Aftermath for the Housing Market
The subprime mortgage collapse caused many people to lose their homes, and the fallout created economic stagnation. Americans faced financial disaster as the value of their homes dropped well below the amount they had borrowed, and subprime interest rates spiked.
Monthly mortgage payments almost doubled in some parts of the country. In most cases, borrowers were actually better defaulting on their mortgage loans rather than paying more for a home that had dropped precipitously in value.
In turn, homebuilding saw a significant decline restricting the supply of new homes for a steadily growing population. The lack of supply and the increased demand created a seller’s market in the real estate industry. More people were now chasing fewer homes, which increased home prices.
Prior to the Great Recession, eight out of the ten recessions since World War II were preceded by a downturn in the housing sector.1
The Bottom Line
In order to both stimulate and stabilize economic growth, the Federal Reserve, which is responsible for setting the conditions that influence employment and economic growth, slashed the federal funds rate to near-zero. The federal funds rate is the interest rate at which banks borrow from each other. The decision to reduce interest costs allowed people to have more access to capital to reinvest in the economy. During this timeframe, the foundational causes of the Great Recession were also addressed by the real estate industry, the financial industry, and U.S. policymakers.
Notably, Congress passed and President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. The Dodd-Frank Act, as it is more commonly known, became law and created the Consumer Financial Protection Bureau (the CFPB).
The decision to lower the federal funds rate to near-zero along with thoughtful policymaking helped stabilize the U.S. economy in the years that followed the recession by encouraging lending among financial institutions that are systemically critical to the housing market, championing consumer interests, and creating a new standard financial industry accountability. The Complete Introduction to EconomicsLearning the basics of economics is easier than you think, especially when courses are taught by instructors from all over the world. With Udemy, you’ll be able to understand what economics is all about and the difference between microeconomics and macroeconomics. You’ll also be able to take courses that span over 65 languages and have a 30-day money-back guarantee. Learn more about Udemy and get started today.