Could the Great Recession be tied to the Bursting of House Price Bubble?

The longest, and by most measures, worst economic recession that officially lasted from December 2007 to June 2009 was initiated with the bursting of an 8-trillion housing bubble. While the debate has mostly revolved around the financial and banking system, Lehman brothers, and Wall Street greed, were these factors significant enough to bring about the most devastating economic event. Could it be that there were some other factors into play that led up to the economic collapse? Could there be a possible connection between the housing building fatigue and mortgage default risk derived from this fatigue?

Despite the relevance of macroeconomic factors for explaining the financial factors, there were deeper structural issues – especially with the way the U.S economy generated demand growth. A substantial decrease in consumer confidence and an increase in interest rates that spread like wildfire in the economy ultimately led to the financial market crisis that led the Great Recession. As 2008 approached, the crisis worsened. Banks were reluctant to lend to each other, and after the declaration of bankruptcy by Lehman Brothers, the crisis got out of control.

As the debt to income ratio for American households hiked from mid 1980s through 2007, the rise in prices had already started to slow down. It had a devastating effect on the heavily indebted household sector and consumer spending. They began cutting back costs, especially on freshly constructed houses. As a consequence, there was a drop in household demand, leading to the Great Recession.

Of course, housing was linked with other macroeconomic factors. Mortgage debt was the most common form of mortgage borrowing that prevailed during the Consumer Age. Greater availability of mortgage loans especially sub-prime mortgages that extended credit to borrowers with weak financial records added to the attractiveness of home ownership for a vast population of Americans. The expectation was that the trend of rise in home prices would continue to climb; people bought more and bigger houses and there was a substantial increase in home renovations during that period. This hike in demand pushed the prices further up, validating the expectations of economic gurus of climbing housing prices. Americans continued to borrow more against equity in their houses. The entire process was turning out to be profitable for the financial sector, as the home prices were climbing and investors were receiving greater returns.

However, in 2006, the bubble burst and affected millions of Americans. After some increase in short-term interest rates, it became extremely difficult for mortgage borrowers, especially the risk averse ones, to refinance. Refinancing, however, was critical to maintain the bubble and the consumer demand. This forced more homeowners to try to sell their homes. With the decline in home prices, millions of Americans defaulted on mortgages, consumer spending dropped and construction of new homes dropped down sharply, triggering the Great Recession – one of the most horrifying events in American history.