The following graph shows median home prices in the U.S. before, during, and after the mortgage crisis of 2006 to 200 (Case/Shiller, 2009). The Case/Shiller Index is one of the most respected indices of home prices. Note that home prices for the 10 largest U.S. cities (the Composite 10) and the 20 largest U.S. cities (the Composite 20) along with the National Index began dropping in early 2006 and continued to drop until sometime in the year 2009.
Figure 11.3. Case Shiller Index by Fred Rowland is used under a CC BY-NC 4.0 License. Source: Federal Reserve Economic Data [FRED] (12/2020).
As Akerloff and Shiller (both Nobel Prize laureates in Economics) contend in their book, Animal Spirits, most recessions begin with a financial crisis (2009). The Great Recession was no exception. Fannie Mae and Freddie Mac were not owned by the government but instead private organizations that offered stock to the public. Fannie Mae and Freddie Mac were very profitable and became the envy of the Wall Street banks. In fact, as of now, they own or guarantee 60% of the mortgages in the United States!
They became so profitable by purchasing mortgages from banks and mortgage brokers (called the originators) and assembling them into bonds they then sold. Fannie Mae’s and Freddie Mac’ guarantees were seen by investors as being equivalent to an implicit guarantee by the U.S. government. Therefore, Fannie Mae and Freddie Mac were able to pay very low interest rates on the bonds, allowing them to make large profits on the difference between the interest rates they were receiving on the mortgages they purchased and the low rates they were borrowing their money at by selling bonds.
Wall Street banks wanted to get in on the action. The problem was that even the biggest banks could not match the implicit government guarantee that backed the Fannie Mae and Freddie Mac bonds. Instead, they came up with the idea of paying for default insurance on the bonds they wanted to issue to buy mortgages. The banks went to AIG, the largest insurance company in the world, and convinced them to issue default insurance. With this AIG guarantee, the banks were able to get the highest credit rating on their bonds and to borrow money almost as cheaply as Fannie Mae and Freddie Mac.
Like all screwy schemes, things went well (and profitably) for a while (from 2000 to 2003), but then the banks got greedy. As they started to run out of very credit-worthy mortgages to buy (the prime mortgages), the Wall Street banks bought less credit-worthy mortgages (known as subprime mortgages). These subprime mortgages were structured in a dizzying array of new types of loans or even loans where the income and assets of the home buyer were self-reported and not verified (called liar loans). These subprime mortgages were all bundled into bonds with some prime mortgages and the AIG guaranteed the bonds the highest credit rating.
In 2006, subprime mortgage holders began to default—not just a few, but millions. This caused a total halt to the bond market for Wall Street banks. According to the Generally Accepted Accounting Practices rules (GAAP), if there is no market for an asset you own, you must write its value down to zero in your financial statements. The Wall Street banks had to write down the mortgage-backed bonds they held to zero, and as a result, every major bank in the United States became insolvent (except for J.P. Morgan, who did not participate as much in this bond party). They all had to be bailed out in 2008 by the Federal Reserve Bank.
Figure 11.4. Delinquency Rates by Loan Types by Fred Rowland is used under a CC BY-NC 4.0 License. Source: Statistical Abstract of the United States data (2020).
The dominoes began to fall. The availability of cheap and easy money to buy houses had caused a spike in housing prices from 2000 to 2005. The mortgage defaults and the resulting disappearance of this easy money then caused housing prices to drop precipitously. Millions had bought homes at elevated prices and borrowed mortgages on those elevated prices. When home prices fell, the value of their homes was less than the mortgage amount they owed on their home (called being underwater). Ultimately, three million people lost their homes to foreclosure in 2008, and it is estimated that as many as ten million people lost their homes to foreclosure in the Great Recession. The financial crisis and the ensuing drop in home prices and foreclosures were one of the major causes, if not the major cause, of the Great Recession. Eight and a half million people lost their jobs in this recession. The value of stocks in the U.S. stock market dropped 38% to 40% during the recession.
Since then, housing prices have recovered in the United States (and internationally). Even further, some cities can be classified as unaffordable for middle class people. Here is data on the most unaffordable cities, when we compare home prices to income:
Figure 11.5. Where it is Hardest to Afford a Home by Statistais used under a CC BY-ND 3.0 License.