The recent recession was unusual because it stemmed from an unsustainable easing of credit standards and financing, which fueled the prior expansion but also the imbalances that led to the worst recession since the 1930s. When losses on new financial practices ended excessive lending, the economy was hit by housing and credit shocks, culminating in a financial crisis. Home construction plunged, wealth fell, credit standards tightened and financial markets seized up. ; The initial impacts of these four shocks on gross domestic product (GDP) were amplified by cyclical interactions between income and spending. Since the second half of 2009, these negative shocks have been unwinding, setting the stage for economic recovery. An analysis of the shocks and their aftermath offers clues to the direction and pace of the recovery.Global financial crisis ; Construction industry ; Housing - Prices ; Mortgage loans ; Credit ; Securities

David Luttrell

John V. Duca

English

Research Papers in Economics

Insights from the 
Federal reserve Bank oF dallas
EconomicLetter
vol. 5,  no. 7
JUlY 2010   
Since the second half 
of 2009, four negative 
shocks to the economy 
have been unwinding. 
Nevertheless, the U.S. 
recovery still faces 
downside risks.
T
he recent recession was unusual because it stemmed from an 
unsustainable  easing  of  credit  standards  and  financing,  which 
fueled the prior expansion but also the imbalances that led to the worst 
recession since the 1930s.1 When losses on new financial practices ended 
excessive lending, the economy was hit by housing and credit shocks, 
culminating in a financial crisis. Home construction plunged, wealth fell, 
credit standards tightened and financial markets seized up.
The initial impacts of these four shocks on gross domestic product 
(GDP) were amplified by cyclical interactions between income and spend-
ing. Since the second half of 2009, these negative shocks have been unwind-
ing, setting the stage for economic recovery. An analysis of the shocks and 
their aftermath offers clues to the direction and pace of the recovery. 
Home Construction and GDP
Housing demand is driven not only by income and mortgage interest 
rates but also the credit standards used to approve or deny mortgage appli-
cations. The easing of credit standards associated with the rise of nonprime 
mortgages enabled more people to obtain mortgages and contributed to 
a  large  upswing  in  housing  demand  through  the  mid-2000s.  Standards 
quickly tightened in 2007, causing housing demand to plummet.2 
Home  construction,  which  normally  makes  up  5  percent  of  GDP, 
added 0.6 percentage points to GDP growth at the height of the housing 
boom and subtracted 0.3 to 1.4 percentage points for 14 straight quarters 
after (Chart 1). These are notable effects on GDP growth, which averages 
about 2.5 percent annually. When new construction slipped below levels 
needed  to  replace  depreciation  and  accommodate  population  growth, 
the  stock  of  unsold  homes  fell  and  home  construction  shifted  from   
Recovering from the Housing 
and Financial Crisis
by John V. Duca and David Luttrell	 EconomicLetter	 Federal reserve Bank oF dallas 2 	 Federal reserve Bank oF dallas  EconomicLetter
having a negative to a neutral impact on 
GDP growth.
Housing’s Wealth Effect
The home price increases earlier 
in the decade began to reverse as 
housing demand retrenched.
Because mortgages are collateral-
ized, housing wealth enabled many 
families to borrow at lower interest 
rates or in higher amounts than they 
might have otherwise. In this way, 
house price gains boosted consumer 
spending. Borrowing against hous-
ing rose to as much as 8 percent of 
disposable income in the mid-2000s. 
When home prices fell, so did such bor-
rowing. Studies indicate that the swing 
in housing wealth had a significant 
effect on consumption growth, adding 
1 to 3 percentage points and then sub-
tracting a similar amount by late 2008.3 
The economic impact of housing 
spurred declines in other asset prices, 
such as stocks, imparting a negative 
wealth effect on consumption. Since 
early 2009, the economic outlook 
and investor tolerance of risk have 
improved, partially reversing the 29 per-
cent drop in inflation-adjusted wealth 
from second quarter 2007 to first quarter 
2009. The decline was the largest since 
the data series began in 1952 (Chart 2). 
Financial industry losses on resi-
dential mortgage loans and securities 
were sizable, estimated at $370 billion 
at U.S. banks since 2007.4 The losses 
were large enough to result in the 
failure, assisted sale or rescue of many 
banks and nonbank financial firms, 
including investment bank Lehman 
Brothers. These losses were large 
enough to impart two additional nega-
tive impulses to GDP in the form of 
tighter credit availability from lenders 
and the reduced ability of large firms 
to borrow from securities markets.
Credit Availability
Many long-lasting goods, like 
autos and business equipment, are 
bought on credit. Consequently, their 
sales and output partly depend on loan 
interest rates and the credit standards 
of lenders. Thus, the willingness and 
ability of bank and nonbank lenders to 
extend credit can affect these financial-
ly sensitive sectors of the economy. 
Banks are required to fund loans 
held in portfolio with at least 8 percent 
in equity capital by issuing stock or 
retaining earnings; government-insured 
deposits or other debt fund the rest. 
Losses on loans and securities are first 
borne by capital. Reacting to a weaker 
real estate outlook, banks mainly tight-
ened credit standards on mortgage loans 
in 2007.5 But many banks did not have 
enough capital to make new loans after 
they suffered large losses in 2008 and 
Chart 1
Housing Construction’s Drag on GDP Ebbs
Contribution to GDP growth (percentage points)
–1.5
–1
–.5
0
.5
1
2010 2009 2008 2007 2006 2005
SOURCES: Bureau of Economic Analysis; authors’ calculations.
Chart 2
After Plunging, Net Worth and Housing Wealth Stabilize
2005 dollars (trillions)                                                                                                                         2005 dollars (trillions)
0
2
4
6
8
10
12
14
’09 ’06 ’03 ’00 ’97 ’94 ’91 ’88 ’85 ’82 ’79 ’76 ’73 ’70 ’67 ’64 ’61 ’58 ’55 ’52
0
10
20
30
40
50
60
70
Real net worth
Real housing wealth
                 Percent change in real:
          Net worth        Net housing wealth
’68:Q4–’70:Q2               –7.8                     +7.6
’73:Q1–’74:Q3             –11.8                     –8.3
’89:Q4–’90:Q3               –3.9                     –3.7
’00:Q1–’02:Q3             –13.2                   +28.5
’07:Q2–’09:Q1             –29.1                  –57.8
SOURCES: Flow of Funds Accounts (June 2010); Bureau of Economic Analysis; authors’ calculations.	 EconomicLetter	 Federal reserve Bank oF dallas 	 Federal reserve Bank oF dallas  EconomicLetter 3
Lehman Brothers failed in September of 
that year. As a result, banks tightened 
credit standards on all types of loans, 
resulting in a credit crunch.
Unlike banks, nonbank lenders 
cannot issue insured deposits and must 
assure investors that they are liquid 
and capitalized enough to raise funds 
by issuing debt that isn’t government-
insured. When losses on subprime 
and other investments mounted, inves-
tors stopped buying nonbank debt. 
Lacking funding for new loans or fac-
ing maturing debt that financed exist-
ing loans, nonbank lenders cut lending 
sharply by charging higher loan rates 
and tightening credit standards. Such 
changes at banks and nonbank lend-
ers contributed to steep declines in the 
sale and production of consumer dura-
ble and business investment goods, 
especially in late 2008 and early 2009.
By spring 2009, many banks and 
nonbank financial firms had raised or 
received new capital, and risk premi-
ums charged by debt investors fell as 
liquidity and default risks declined with 
an improved economic outlook. For 
banks and nonbanks alike, this meant 
decreased loan funding costs and a 
greater capacity to lend. By mid-2009, 
institutions had lowered loan interest 
rates and stopped tightening credit 
standards on non-real-estate loans. 
Securities Market Swings
The fourth recessionary impulse 
occurred in securities markets as large 
losses on subprime mortgage securi-
ties exposed risks in the structured 
financial product innovations that had 
fueled the prior economic expansion. 
Markets realized the lack of clarity 
regarding which firms bore the risks 
directly or indirectly through their cus-
tomers. To hedge risk, some investors 
bought default insurance on the bonds 
they held via credit default swaps 
(CDS). However, CDS issuers traded 
in largely unregulated markets, weren’t 
required to hold reserves against 
potential payouts and had exposures 
that were unclear. When large losses 
on subprime securities and derivatives 
materialized, risk premiums soared 
on private debt as investors could no 
longer buy low-cost default insurance 
or assess the risk exposures of many 
firms. The situation worsened follow-
ing the failure of Lehman Brothers, 
which had issued many derivatives 
and whose default exposed many CDS 
issuers that backed Lehman’s debt.
Private debt issuance halted in late 
2008, while interest rates on private 
debt soared. Spreads between inter-
est rates on corporate and Treasury 
bonds rose to levels not seen since the 
Great Depression, and spreads jumped 
between interest rates on short-term 
commercial paper and Treasury bills 
(Chart 3). In response to reduced 
availability and higher costs of funding 
from securities markets and lenders in 
late 2008, firms cut software and busi-
ness equipment investment, accounting 
for about 44 percent of the large GDP 
declines in fourth quarter 2008 and 
first quarter 2009. Faced with weaker 
sales and tighter credit, many firms 
quickly laid off workers, deepening 
the recession. In the nine months fol-
lowing Lehman’s demise, the unem-
ployment rate jumped 3.3 percentage 
points to 9.5 percent by June 2009.
Unusual actions by the Federal 
Reserve and the Treasury helped 
reopen the prime residential mortgage 
and commercial paper markets in late 
2008.6 Lacking such help but ben-
efiting from an improving economic 
outlook, corporate bond interest rates 
began falling and corporate bond issu-
ance began rising by spring 2009. This 
aided an upturn in business investment 
in the second half of 2009.
From Recession to Recovery
By mid-2009, home construction 
had bottomed out, wealth had partially 
recovered and financial markets func-
tioned better. Lenders stopped tighten-
ing credit standards on non-real-estate 
loans by late 2009. GDP began grow-
ing in third quarter 2009, owing to 
three general influences. First, output 
was reduced less by the four unusual 
impulses that had pushed the econo-
my into recession. Next, the second-
half upturn in GDP partly reflected 
fiscal and monetary policy actions to 
stimulate aggregate demand. Third, 
given a partial recovery of access to 
some forms of finance and the expec-
tation of economic growth, aggregate 
demand benefited from a release of 
Chart 3
Corporate Interest Spreads Retreat from Crisis Highs
Percent                                                                                                                                                                       Percent
Baa–10-year
Treasury bond yield
0
.5
1
1.5
2
2.5
3
3.5
4
Apr. Jan. Oct. July Apr. Jan. Oct. July Apr. Jan. Oct. July
0
1
2
3
4
5
6
7
8
3-mo. commercial paper–
Treasury bill rate
2007 2008 2009 2010
Fed and Treasury actions
on commercial paper
Failure of
Lehman Bros.
SOURCES: Federal Reserve Board; Moody’s; authors’ calculations.EconomicLetter  is  published  by  the 
Federal Reserve Bank of Dallas. The views expressed 
are those of the authors and should not be attributed 
to the Federal Reserve Bank of Dallas or the Federal 
Reserve System.
  Articles may be reprinted on the condition that 
the source is credited and a copy is provided to the 
Research Department of the Federal Reserve Bank of 
Dallas.
  Economic  Letter  is  available  free  of  charge 
by  writing  the  Public  Affairs  Department,  Federal 
Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX 
75265-5906; by fax at 214-922-5268; or by telephone 
at 214-922-5254. This publication is available on the 
Dallas Fed website, www.dallasfed.org.
Richard W. Fisher
President and Chief Executive Officer
Helen E. Holcomb
First Vice President and Chief Operating Officer
Harvey Rosenblum
Executive Vice President and Director of Research
Robert D. Hankins
Executive Vice President, Banking Supervision
Director of Research Publications
Mine Yücel
Executive Editor
Jim Dolmas
Associate Editor
Kathy Thacker
Graphic Designer
Ellah Piña
Federal reserve Bank oF dallas
2200 n. Pearl st.
dallas, tX 75201
demand pent up during the recession, 
when households and firms had post-
poned purchases of big-ticket items. 
The effects of the last two influ-
ences are more typical of economic 
recoveries and are tracked by con-
ventional indicators historically associ-
ated with recoveries. For example, the 
six-month growth rate in the Leading 
Economic Index rose in spring 2009, 
correctly presaging positive GDP 
growth in the second half of 2009 
(Chart 4). 
However, the U.S. recovery still 
faces downside risks. Further losses on 
residential and commercial mortgages 
may delay a return of credit standards 
to normal. Large budget deficits may 
force state and local governments 
to cut spending. Recent declines in 
the ability of foreign governments to 
borrow have induced tax increases 
and spending cuts that will temper 
worldwide economic growth. Finally, 
the return to full employment may be 
delayed by firms’ reluctance to hire. 
These uncertainties appear more likely 
to slow the pace of—rather than end—
the economic recovery given how the 
four major headwinds from the recent 
crisis have been abating.
Duca is a vice president and senior policy advisor 
and Luttrell is a research assistant in the Research 
Department of the Federal Reserve Bank of Dallas.
Notes 
1 “Housing Markets and the Financial Crisis of 
2007–09: Lessons for the Future,” by John V. 
Duca, John Muellbauer and Anthony Murphy, 
Journal of Financial Stability, forthcoming.
2 “The Rise and Fall of Subprime Mortgages,” 
by Danielle DiMartino and John V. Duca, Federal 
Reserve Bank of Dallas Economic Letter, vol. 2, 
no. 11, 2007.
3 “Credit, Housing Collateral and Consumption: 
Evidence from the U.K., U.S. and Japan,” by 
Janine Aron, John V. Duca, John Muellbauer, 
Keiko Murata and Anthony Murphy, CEPR Dis-
cussion Paper 7876, Center for Economic Policy 
Research, June 2010.
4 “Global Financial Stability Report,” International 
Monetary Fund, April 2010, p. 13. 
5 Federal Reserve’s Senior Loan Officer Opinion 
Survey, various releases. 
6 “Fed Confronts Financial Crisis by Expanding Its 
Role as Lender of Last Resort,” by John V. Duca, 
Danielle DiMartino and Jessica J. Renier, Federal 
Reserve Bank of Dallas Economic Letter, vol. 2, 
no. 2, 2009.
Chart 4
Conventional Leading Indicators Point to Recovery
2-qtr. percent change, 1-qtr lead                                                                                            2-qtr. annualized percent change
Real GDP
Leading
Economic Index
–12
–10
–8
–6
–4
–2
0
2
4
6
8
10
12
’10 ’05 ’00 ’95 ’90 ’85 ’80 ’75 ’70 ’65 ’60
–9
–6
–3
0
3
6
9
12
NOTE: Shaded areas indicate recessions.
SOURCES: Conference Board; Bureau of Economic Analysis; authors’ calculations.

Recovering from the housing and financial crisis

http://www.dallasfed.org/assets/documents/research/eclett/2010/el1007.pdf

Recovering from the housing and financial crisis

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics