The Great Recession's Impact on the Housing Market

The global economic downturn that began in December 2007 and ended in April 2009 influenced the real estate environment more than any other occurrence. This period of economic turmoil is called the Great Recession, when many faced unprecedented financial challenges.

The Great Recession was caused by what has now become known as the Great Financial Crisis (GFC), which began as a boom in the housing market.

Understanding the Great Recession

The U.S. economy had been in a state of growth for several years by the turn of the century. The housing market had seen its share of ups and downs, but in 2001, something happened. As the graph below displays, the number of new one-family homes for sale in the U.S. began climbing drastically in April.

Housing Demand and Lending

New homes were in demand, and companies were building them in a frenzy. Sub-prime mortgages—basically home loans given to risky borrowers—were approved to take advantage of the millions of dollars that were pouring in. A risky borrower might have a less-than-stellar credit history, questionable income stability, and a high debt-to-income ratio. Subprime mortgages were also popular among homebuyers who were purchasing second homes.

Furthermore, subprime mortgages often have adjustable interest rates. Subprime lenders offered consumers mortgages with low interest rates for a short period. However, the interest rates jumped considerably once the initial period was over. 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. At the time, lenders specifically targeted these home buyers for subprime mortgages.

Mortgage-Backed Securities

In a practice that began in the 1960s, mortgages were securitized into mortgage-backed securities (MBS) and sold to investors as collateralized mortgage obligations—which promise income streams for investors—and credit default swaps, which act as a hedge against the risk of default. In a credit default swap, an investor purchases a security at a premium and promises to pay the security's value and interest payments if there is a default.

During the period leading up to the market crash, both foreign and domestic investors continued to pour money into the real estate industry. Regarding sub-prime mortgages, these loans were packaged together, so investors bought securitized packages of mortgages believing that they would make millions—and they did. Once the subprime mortgage borrowers began to default, investors began to lose money. The graph below shows delinquency rates on single-family residential mortgages, starting in 2006 and peaking in 2010.

As the crisis grew, numerous foreclosures and defaults crashed the housing market, vastly depreciating the value of the 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 because they were heavily invested in these securities and swaps. Ultimately, the U.S. federal government intervened to mitigate the damage.

The Aftermath for the Housing Market

The subprime mortgage collapse caused many people to lose their homes. Many 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 better off defaulting on their mortgage loans 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, which increased home prices.

Regulatory Changes

The turmoil led to many regulatory changes for mortgage lenders and financial institutions. To 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.

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 (CFPB).

The Bottom Line

The housing market reached its bottom in 2012 and began slowly recovering into the 2020s. New home construction and sales again began to climb after the COVID-19 pandemic—but this was due to increased demand as consumers started working from home and moving to more affordable areas.

The housing market is still in flux, as mortgage-backed securities are still popular—according to the Federal Reserve, about 65% of all mortgages were securitized into MBS in 2021. It's important to note that the Fed acknowledges that the stock of MBS is much smaller a percentage of GDP than it was leading up to the crisis. It believes there is less reason for concern about the housing market, lending, and investing practice issues that led to the Great Recession.