The Housing Bubble and the Great Recession: The Good, the Bad and the Ugly

While it has been quite a long time since the Great Recession ended, there is still a debate going on the factors that led to this crisis. While there is a standard and widely shared explanation of the causes of the bubble including Wall Street greed, carelessness and irregularities in the system etc; there could be an alternative explanation of the factors that led to the Great Recession.

It is said that Wall Street, through a network of mortgage brokers channeled too much money into home purchase and construction. As a result, credit standards declined, sub-prime mortgage borrowers were loaded with too much debt, and when the home prices reached unsustainable levels, the bubble eventually burst.

While the macroeconomic factors pretty much explain the financial factors, the issues ran deeper, especially with the way growth was generated by the U.S economy. Consumer confidence had declined substantially and there was an increase in the interest rates. This eventually spread across the economy like the plague and led to the financial market crisis. As 2008 approached, the crisis became even worse. Banks were reluctant to lend money to each other, and after Lehman Brothers declared bankruptcy, the crisis became incurable.

As the debt to income ratio increased for American households during 1980-2007, the trend of price appreciation had already started to fade away. It had a devastating effect on consumer spending and the household sector that was already indebted. As a consequence, consumers began cost cutting, and there was a decline in household demand.

Easy access to sub-prime mortgage loans extended credit to borrowers with a not-so strong financial track record which added to the attractiveness of home ownership. Hopes were that the trend would continue to rise. People bought more and bigger houses and there was a significant drop in home renovations during that period. The increase in demand pushed the prices up. Americans continued to borrow more against equity in their houses. The process became extremely profitable for the financial sector, as the home prices were increasing and investors were enjoying greater returns on their investment.

Nevertheless, the bubble burst in 2006, affecting millions of Americans. The increase in short-term interest rates became extremely difficult to manage for mortgage borrowers especially risk-averse borrowers. Since refinancing was critical to sustain the bubble, and the resulting consumer demand, it was important. However, it became difficult for homeowners to refinance. As a consequence, more homeowners tried to sell out their homes. With the decline in consumer confidence and demand, more home owners tried to sell out their homes. Millions of Americans defaulted on mortgages, construction of new homes dropped and led to the Great Recession.

If the deeper cause of the matter was the bubble psychology, the matter is even harder to understand and it didn’t arise in a day. And if Wall Street’s greed was the only issue, the problem could have been resolved by designing and implementing a stricter policy.