The word recession has frequently been brought up in the media recently but what is recession exactly? Recession is said to happen when the economic performance, measured by the GDP of a country declines significantly for two consecutive quarters (six months). During this period of low growth, unemployment is high, consumption is low, leading to a downward spiral of low economic activity.
There have been four global recessions in the past since World War II, the most recent one being the 2009 Global Financial Crisis (2009 GFC), which was initially triggered by the housing recession in the US. Economists opined that the 2009 GFC was the most severe financial crisis since the Great Depression that happened in the 1930s.
Now the question is: How did the housing recession in the US trigger the worst financial crisis for nearly 80 years ago?
Housing Recession in the US
Subprime borrowing began to increase in 1999 as the Federal National Mortgage Association (FNMA) directed their attention to helping Americans achieve the American dream of homeownership. Subprime mortgage borrowers are usually less wealthy. The poor credit rating scores of these individuals disable them from obtaining a mortgage from a lender. In that era, homeownership fluctuated around 65% and mortgage foreclosure rates are low.
Mortgages are conventionally financed by the deposits banks receive from their customers, which limit the amount of mortgage lending they could execute. However, in the 2000s, banks transitioned to a new model where they sell the mortgages to a hedge fund on the secondary market. The hedge fund then bundles the mortgages and sell the mortgage-backed security to investors. Since the bank was sold to the hedge fund the mortgage that it gave out to homebuyers, it can now make new loans with the money it receives from the hedge fund.
As the banks now have other means of financing the mortgages that it gives out, and is not limited by the deposits of their customers, they do not conduct a proper investigation towards the creditworthiness of borrowers. At this point, the banks are just focusing on giving out as many mortgages as possible with the aim of earning higher profit. As such, securing a mortgage became easier for Americans, contributing to higher homeownership in America.
The ease of obtaining a mortgage from banks have also led to higher demand in the housing market, bidding up house prices. This induces the expectation of continuous house price gains, further increasing housing demand and prices.
Another important aspect to point out is that in the early 2000s when the interest-only subprime mortgages were introduced, interest rates were low (1.24%- 1.75%) as the Federal Reserve (Fed) tried to relieve the economy from the Dot Com Bubble Burst that happened in 2000. This implies that the interest payment that has to be made by the subprime mortgage holder is low, therefore gaining traction from potential homebuyers. Many of these subprime mortgage holders took up the mortgage hoping that an appreciation in house prices in the future will enable them to pay off their mortgage, even if the interest rate resets to a higher level in the future. In 2004, the Fed started raising rates to cool off the overheated housing market due to a rapid increase in demand. In June 2006, the interest rate went up to 6.25%.
The hike in interest rate, unfortunately, raised monthly payments for those who had interest-only subprime loans based on the Fed funds rate. A large portion of the homeowners took up the subprime mortgage because they could not afford the conventional mortgages, as interest payment for the latter is higher. Now with the increase in the interest rate for subprime mortgage and a falling housing prices after reaching a peak in October 2005, many fail to fulfil their monthly interest payment as they could not afford to pay such high amount in the first place and a falling housing prices disable them from selling their homes for a profit. The only option left for this group of borrowers was to default the mortgage that they once borrowed at a low rate.
Housing prices from Jan 2000 till Jan 2010
Source: Federal Reserve Bank of St. Louis – https://fred.stlouisfed.org/series/QUSR628BIS
A fall in the price of property has an extensive effect on the economy as the property development industry has decided to cut its output by half, contributing to unemployment in the US. While reputable property development companies can still survive, although, at a loss, the smaller ones had no choice but to stop operating their businesses. A slowdown in the housing industry that makes up 15% of the US economy had a domino effect in other industries, for example, the makers of durable goods, such as washing machines, and DIY stores like Home Depot. The slowdown in various industries in the US-led to a drop in employment, therefore consumer spending in the country.
Who is to be blamed for this catastrophe?
Lenders of the mortgages are highly responsible for this widespread disaster because they are the ones who permitted the lending to groups of people with poor credit and high risk of default, in the name of greed. However, from the lenders’ standpoint, interest rates were low at that moment and housing prices had a positive outlook. Lenders probably had an optimistic view towards the mortgage repayment as economic performance at that moment were in favour.
Besides the lenders, the borrowers are also liable for this occurrence as many of them took the risk of committing to interest payments that they could barely afford. Most of these borrowers bought a house with the hope of a price appreciation of their property, which would allow them to refinance the loan by selling off the house if they end up failing to fulfil their monthly interest payment and have no other means of financing it. Had borrowers were more cautious when applying for a mortgage and assumed a less risky commitment, the impact of this crisis on the economy might have been lighter.
Another party to be blamed for this situation in the investment banks who agreed to buy the mortgages from the mortgage lenders. The popularity of secondary mortgage market increased the subprime loans lenders could originate. Instead of keeping the originated mortgages on their books, lenders were able to sell off the mortgages in the secondary market and profit from the sale through the collection of a fee from that transaction. This freed up more capital for further lending, increasing the liquidity for banks. A huge portion of the demand for these mortgages came from the creation of assets pooling mortgages into securities, such as a collateralised debt obligation (CDO). in such instance, investment banks would buy the mortgages from lenders and securitise them into bonds, selling them to investors through CDOs.
Winners and losers of this housing recession
Based on the earlier parts of the article, homebuyers seemed to be the loser of the housing recession. However, this is not totally true as some homebuyers who otherwise would not be able to afford a house, if not through a subprime mortgage, were able to realise their American dream of homeownership. It is apparent that some buyers had to suffer through and resort to a mortgage default, but the winners in such circumstance are the ones who did not overcommit. They did not obtain an unrealistically high mortgage amount and only bought a house that commensurates their income at that moment.
The bondholders, such as pension funds, who bought sub-prime mortgage bonds are on the losing end of this recession. The reason is that the mortgage bonds have fallen sharply in value months after the event and worthed between 20% to 40% of their original value. The ultimate losses suffered by the financial institutions is estimated to be between a staggering amount of $220 billion to $450 billion.
The aftermath of the housing recession
Post-crisis, the housing market crashed as homeowners with subprime mortgage defaulted at record levels. The home values of Americans plummeted, incurring them a loss of $9.8 trillion in wealth. according to Core Logic, a global property analytics site, housing prices across the US, which fell by 33% during the housing recession have rebounded and are now up more than 50%. Although the market has since recovered, new regulations have been introduced to restrict the type of loans banks could offer. The restrictions on the mortgages that could be offered altered the attitude of banks. They now focus more intensely on those with pristine credit score and buying more-expensive homes, leaving behind the low income, low credit score borrowers.
As the homeownership dream becomes harder to achieve for some, the percentage of renters in the housing market increased from 31.2% in 2006 to 36.6% in 2016. Besides an increase in the percentage of renters, the rental payment of houses has risen faster than incomes. Average rents have risen 22.3% while incomes in American fell 5.8% within the 9 years since 2006. To provide some context, household in the US spent 29.7% of their income on rent in 2006, but it hiked up to 31.5% in 2011.
Housing recession making a comeback in the US?
Some organisations suggested that there are signs of a housing recession happening in the US in the near future as a similar housing-income gap that happened in 2005 began happening in 2015. If these trends continue, a slide in home prices beginning by mid-2020 is expected. The falling home prices are anticipated to reduce household spending, contributing to low economic growth in the US and possibly globally.
However, these are just analysis and speculation done by the market watchers, we would not know for sure until it hits the economy.
Researcher: Lim Yue Jia
Editor: Gan Chee Hor
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