Introduction
From the macroeconomic standpoint, real estate markets join the ranks of the key drivers for economic growth, making market health an essential goal for the nation. In addition, investing in this industry has been considered profitable at all times since there is always a demand for real estate, whether it be private housing, municipal buildings, or offices. State assets include the purchase and sale of real estate, which is one of the budget’s significant items. Numerous mortgage programs that allow ordinary citizens to purchase housing on credit have become an integral part of modern life. However, as practice shows, even in the case of a sustainable business in this industry, some gaps can cause severe economic difficulties and even a crisis.
Before the recession of 2008, the U.S. real estate market saw a massive decline in housing prices, which represents a worthy topic for analysis. The objective of the paper is to identify the cause of the U.S. housing market crash that led to the Great Recession. As an evidence base, relevant academic sources have been drawn on, and a literature review has been carried out to identify valid findings demonstrating likely prerequisites for the recession.
The activities of the supervising bodies are considered, the credit programs of that time are mentioned, and the prerequisites for the Great Recession are assessed. Based on the analysis of the findings, relevant conclusions have been drawn. Unwise credit policy, namely the provision of credit incentives for buyers with weak financial capabilities, is one of the key reasons for the collapse of the housing market in the period under review.
Literature Review
Imperfect Housing Bubble Tracking as a Contributor to the Crash
Some studies link the pre-Great-Recession collapse of the housing market to the absence of reliable metrics and methodologies to detect housing bubbles and react promptly. Such a phenomenon in the real estate market is an overvaluation of objects for a sufficiently long period (Aizenman et al., 2019). As a rule, it arises due to a shortage of supply, which leads to unreasonable excitement and a further rise in prices.
The main signs of such bubbles are the discrepancy between prices in local real estate markets and real incomes of the population and rental rates, as well as excessive volumes of construction and mortgage lending. At the same time, investor sentiment also plays an important role in this process. As Boushey (2019) notes, at a certain point, sales volumes plummet, dragging prices along with them, and those who invest in housing with an eye to the future are the losers. The period of the Great Recession can be considered an example of such a situation in which a mismatch in terms of supply and demand, as well as the share of investment, led to a crisis.
The Federal Reserve’s limited awareness of the housing bubble’s evolution is a management-related factor involved in the market crash (Akan et al., 2022). According to Berendt (2019), despite the existence of consensus regarding the definitions of asset bubbles, economists could not accurately assess the U.S. housing market’s position in the bubble’s lifecycle.
In 2002 and 2003, the first attempts to recognize the bubble met mixed reactions from economic decision-makers (Berendt, 2019). The Federal Reserve’s chairman remained skeptical regarding the bubble’s existence almost until the crash (Berendt, 2019; Levitin & Wachter, 2020). As Berendt (2019) suggests, the Peschian analysis offers insight into the crash, connecting the latter’s causes to the unjustly elevated housing prices before the event. Thus, the lack of real estate bubble analysis tools might have promoted unfavorable macroeconomic consequences.
Loan Practices and Housing Market Crash/Great Recession
In the current literature, the growth of the subprime mortgage (SM) market is widely cited as a factor in the housing market crash, leading to the recession period. SM increased substantially in the late 1990s, with more high-risk borrowers with insufficient credit scores gaining access to housing loans (Levitin & Wachter, 2020). Before the housing market burst, the proportion of the country’s GDP generated in the residential sector had been rising, reaching 6.5% in 2006 (Berendt, 2019). So-called exotic/adjustable-rate housing loans with low monthly payments that gradually increase, as well as no-income-verification mortgage options, permeated the market (Melancon, 2022).
Current researchers frequently refer to such practices as predatory because they were primarily aimed at economically vulnerable, minority, and financially illiterate lenders (Abdool & Stroud, 2019). New offers actively motivate clients with low repayment capacity to take loans and proceed with extremely unrealistic options, promoting large-scale economic issues for the nation. As the existing studies emphasize, the SM crisis led to multiple adverse consequences and instabilities that contributed to the market crash and the Great Recession. Borrowers’ access to housing loans before the crash created unprecedented and heterogeneous growth of housing prices (Abdool & Stroud, 2019; Costa-Font et al., 2019). Notably, prices in Los Angeles and Boston grew by 230% and 121% during the boom, respectively, and then dropped by 40% and 15% (Costa-Font et al., 2019; López-Santana & Rocco, 2021).
To continue on heterogeneity, Gabauer et al. (2020) suggest that the SM crisis began in the Northeastern and the Southern U.S. regions and fueled market risks in the Midwestern region. Due to new trends, the proportion of payment defaults or the borrower’s failure to submit four monthly payments since starting a subprime loan has soared. It grew from 0.8% to 2.6% between March 2005 and June 2006 (Levitin & Wachter, 2020). Thus, an increase in risky subprime loans resulted in significant issues in 2006.
On September 15, 2008, the American investment bank Lehman Brothers filed for bankruptcy, which became the largest in U.S. history, and its fall was what many considered the start of the 2008 global financial crisis (Mieszala, 2019). Even ten years after the failure of Lehman Brothers, 60% of the economies unaffected by the banking crisis and 85% of the economies hit by it have not returned to pre-crisis growth trajectories (Mieszala, 2019). In subsequent years, the growth trajectory of global investment was, on average, lower than it would have been if it had not been for the crisis.
The Real Estate Market and Recession
Recent research emphasizes close connections between real estate, jobs/employment, migration patterns, and tax collection, shedding light on the discussed market crash event’s large-scale implications. Housing markets can affect local wage levels, employment prospects, workforce inflows/outflows, and the timing of economic recoveries, which made the crash promote overall economic recession in 2008 (Karahan & Rhee, 2019; López-Santana & Rocco, 2021). Karahan and Rhee (2019) hypothesize that sharp declines in house prices affect homeowners’ employment search behaviors, promoting unemployment and candidates’ tendency to apply for low-paid jobs. Price declines were prominent in the housing market crash, and housing busts are known to induce unemployment growth, which was the case during the Great Recession (Karahan & Rhee, 2019).
The housing market’s collapse contributed to property tax declines and a 5% reduction in U.S. governmental agencies’ revenues, which was part of the general economic decline during the Great Recession (López-Santana & Rocco, 2021). Therefore, the market crash’s detrimental impacts on economic fields aside from housing are of interest to researchers. At the current stage, the U.S. housing market and the entire economy may also face risks that could complicate sustainable development. The main threats to the country are the Russian war in Ukraine and the possible resumption of trade and financial restrictions associated with a new wave of the pandemic (Islamaj et al., 2022).
In addition, a decrease in the corporate earnings of U.S. corporations can lead to a fall in the value of shares (Brunnermeier & Krishnamurthy, 2020). As a rule, before a recession, the economy suffers from significant imbalances, such as over-indebted households and businesses, speculative asset markets, or an undercapitalized financial system that has overextended. According to Chen et al. (2019), the share of loans in the U.S. is relatively average compared to the situation before 2008. This means that there is a sufficient number of creditworthy borrowers in the country who can repay loans. Nevertheless, the risks mentioned above may change the situation for the worse and stimulate additional pressure on the domestic economy, which requires an analysis of experience.
Analysis
In response to the objective, a nationwide change in housing loan practices to reach unreliable/low-income borrowers became the key cause of the crash/recession. In the pre-crisis period, lending standards and offers emphasized the borrower’s desire and ability to enter the transaction rather than favorable credit scores and income stability (Abdool & Stroud, 2019; Melancon, 2022). Excessive attention to creating demand and attracting borrowers with a limited ability to submit full payments according to the schedule represents a crucial error that promoted large-scale imbalances in the market.
Loose and overly broad underwriting guidelines used by banks, as well as practices to capitalize on borrowers’ limited literacy regarding the applicability of particular lending products to their circumstances, increased the incidence of high-risk loans. Eventually, overly aggressive borrowing motivation measures, including seemingly flexible loan terms and less strict standards, added to the housing bubble. The latter eventually collapsed, and financial institutions turned out to be holding enormous amounts of money in useless and worthless mortgages that high-risk lenders could not repay.
To continue, the role of mortgage loans’ high accessibility in the market collapse and the resulting recession is also complicated by borrowers’ poor understanding of macroeconomic real estate price trends. With housing prices soaring before the collapse, it is likely that average financial service consumers firmly believed that price growth would continue (Abdool & Stroud, 2019). For those who don’t own houses yet, an expectation of price and value increases could promote the fear of being incapable of purchasing property in the future. This could act as an additional catalyst for loan-taking intentions in high-risk populations.
An offer to meet that steady demand was present, with banks providing a plethora of attractive yet unrealistic plans for low-income populations, including those with payments to increase gradually (Melancon, 2022). Combined with the impact of irrelevant expectations regarding price growth, the presence of opportunities marketed as borrower-friendly plans could make the “subprime” audience even more motivated to take loans that would not be repaid. Real estate sellers’ incomes began to decline, and many households found it difficult to pay their debts. As a result, consumption began to decrease, and the economy went into recession. The number of jobs was reduced, which aggravated the situation and caused mass discontent (Rothstein, 2020).
Consequently, many households finally lost the ability to repay debts, including paying mortgages, as a result of which the crisis entered an active phase. Pledged property also depreciated against the backdrop of the crisis in the economy and falling prices. Thus, using credit funds during the crisis became even more expensive and more dangerous for capital.
The crisis acquired the smallest scale when it turned out that many non-transparent investment instruments were issued based on mortgage real estate. It was impossible to calculate the risks for such securities. The stability of trillions of financial assets was based on the repayment of mortgages (Spatt, 2020).
When the mortgage began to collapse, securities and banks collapsed behind it. A reserve of free cash could be an airbag for households and investors. Cash is the most liquid of all possible assets because there is always an opportunity to use it as quickly as possible, including repaying loans without overpayments.
In 2007 and 2008, people did not have an airbag in the form of cash. This is evidenced by the fact that during that period, the number of new bank card loans increased sharply (Calem et al., 2020). Since 2008, according to Fligstein (2021), the number of active bank credit card accounts began to decline as people could no longer pay off new loans. Therefore, inadequate control over mortgage programs and an inefficient sales planning system led to what is today called the Great Recession.
The period of economic stability that began in the late 20th century convinced many U.S. bankers, policymakers, and economists that extreme economic instability was a thing of the past. This caused the market to ignore the clear signs of an impending crisis and continue risky lending, borrowing, and securitization. The rate hike before 2008 resulted in a large number of defaults by subprime borrowers who had floating-rate mortgages (Jones & Sirmans, 2019). The housing market, meanwhile, was saturated, and housing prices began to decline. After that, mortgage-backed securities based on subprime mortgages also began to fall in price, which led to losses for many banks and pension funds (Jones & Sirmans, 2019).
Given this negative experience, national financial institutions learned a valuable lesson and began to pay more attention to planning based on long-term prospects and involving the assessment of all factors affecting the sustainability of the economy. Thus, to avoid a repeat of such a recession, several measures have been taken to tighten control over the real estate market and the investment flowing into it through private and public channels.
Conclusion
To sum up, loan incentives to attract borrowers with insufficient financial capacity eventually caused the collapse of the housing market and a period of recession. The academic community has produced a variety of theories to explain the crash. The inability to assess the state of the housing bubble and make prognoses and an increase in risky loans resulting from the government’s accessibility orientation represent important themes in the literature. The housing market’s prominent connections with large-scale employment and immigration trends also inform the understanding of the crash and its implications for the general recession. Conclusively, economic policymakers should thoroughly consider extremely accessible mortgage products in the housing bubble formation, the market crash and the Great Recession to prevent such challenges from recurring.
References
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