By Benjamin Miles
The word on Wall Street is a recession is looming. After all, we are technically in a recession, given that in the last two consecutive quarters, the economy has contracted. With the unemployment rate at 3.7% and housing prices still near recent highs, many are reluctant to describe the current economy as a recession. However, a new survey found more than 60% of executives believe a recession is imminent. It is no secret consumer price inflation is its highest point in 40 years and the Federal Reserve plans to continue raising interest rates to curb inflation. As the Fed tightens the money supply, its hawkish policies are causing the previously red-hot housing market to cool down and mortgage rates to rise rapidly. Yet, if the recession triggers a real estate crash, it will not be nearly as catastrophic as the infamous 2007 collapse.
Background and Current Financial State and Law
The 2007 housing collapse was largely responsible for the 2008 U.S. recession. Over the last decade, economists, congressional committees, and governments have extensively evaluated the triggers of the 2008 recession. Though their investigations have identified many causes, the deterioration in the quality of loans issued by financial institutions such as Wells Fargo and TD Bank is one of the practices heavily discussed in the findings of these investigative agencies. According to the findings, regulatory lapses destabilized the economy by encouraging financial institutions to issue unsustainable mortgages. In the lead-up to the 2008 recession, the Federal Reserve fueled a construction and housing bubble by lowering interest rates to 1% and holding them at that historically low level for three years. The low rates reduced the cost of mortgages, and this contributed to a surge in demand for houses. The heightened demand for homes led to an appreciation in home prices that set the stage for risky mortgage lending practices in which lenders crafted innovative loans with easily achievable initial borrowing terms.
Backed by the Alternative Mortgage Transaction Parity Act of 1982 and the Depository Institutions Deregulation and Monetary Control Act of 1980, 40% of financial institutions weakened their underwriting rules and crafted new rules allow them to lend to high-risk individuals. With the rising house prices and loose regulations, banks implemented short-sighted lending practices render the economy vulnerable to rate hike. Banks eliminated down payments on mortgages and, in some cases, allowed borrowers to forego making any payments in the first two years of their mortgage. With these incentives, borrowers and homeowners took mortgages that would become impossible to service in the event of an interest rate hike. In June 2006, the Federal Reserve hiked the interest rates to 5.25%. The rate hike corrected house prices, deflated the real estate bubble, and triggered widespread loan defaults. One year later during the 2007 housing crash, the price correction and the resultant loan defaults plunged the US into a recession characterized by a credit crisis, bank bailouts, and widespread foreclosures.
Current Financial State
The current state of the economy has led to speculations the country is heading into a recession. Key indicators such as rising inflation, declining real personal consumption expenses, and stagnating manufacturing and trade sales point to an increased chance of a recession. U.S. inflation rates are the highest in the last four decades. Data from the Bureau of Labor Statistics indicate the inflation rate rose 9.1% over the past twelve months. According to the bureau, food prices increased by 10% in the past year. Over the same period, energy prices increased 41.6%, motor fuel prices surged 60.2%, electricity prices 13.7%, and gasoline prices surged 59.9%. The spiraling inflation rate hurt consumers, with statistics showing personal income fell 0.3% and the value of the gross domestic product dropped 0.9% in the second quarter of 2022 after a 1.6% dip in the first quarter. These troubling figures intensified speculation the country will plunge into an economic recession. But, if the recession occurs and it triggers a real estate crash, it will not be nearly as catastrophic as the housing crash of 2007.
New Recession’s Potential Impact on Real Estate Market
In light of the prohibition of risky lending practices, new recession not trigger collapse. Given that lack of regulations largely contributed to the collapse of the housing market in 2007 by incentivizing short-sighted lending practices, the prospects of a 2008-style recession in 2022 are remote. Moreover, in 2008, the applicable laws set the stage for the collapse of the real estate market by incentivizing short-sighted lending practices. The Alternative Mortgage Transaction Parity Act of 1982 abetted the crisis by giving banks the impetus to lower their underwriting standards. Banks weakened their underwriting rules and crafted innovative lending policies that allowed them to issue unsustainable, high-cost mortgages to maximize profits. Financial institutions belie rapidly rising house prices would safeguard them from default-related risks. Accordingly, they created lending policies that eliminated the requirement for a down payment and allowed borrowers to make no payment in the first two years of their mortgage.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, through the Financial Stability Oversight Council will forestall such outcomes. The law has given the FSOC the authority to vet the operations of financial institutions, assess whether they are engaging in high-risk lending practices, and punish errant financial institutions. The Dodd-Frank Act has prevented financial institutions from engaging in the high-risk lending strategies that characterized the years leading to the 2008 financial crisis. In the absence of these short-sighted mortgage lending practices, the risk of a 2007-style housing market collapse is minimal.
ew safeguards in the asset-backed commercial papers market will also prevent the type of run that triggered the collapse of the housing market in 2007. In the years before collapse, the absence of a conflict-of-interest provision in the Securities Act of 1933 enabled banks to generate additional earnings by trading in low-quality asset-backed securities. Unaware that financial institutions had saturated the asset-backed commercial papers market with low-quality assets, mutual funds and other ultra-sensitive investors purchased these “safe haven” assets. News that many of the asset-backed commercial papers were exposed to the subprime mortgage crisis triggered an investor panic that hastened the collapse of the housing markets.
The Dodd-Frank Wall Street Reform and Consumer Protection Act reduced the prospects of such outcomes by incorporating a new conflict of interest provision into the Securities Act of 1933. Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits underwriters and their agents from transacting in mortgage and other asset-backed securities in ways that would lead to a conflict of interest within 12 months of concluding a mortgage sale. This provision reduces the risk of the 2007-type collapse in the housing market by ensuring financial institutions are dealing exclusively in high-quality asset-backed commercial papers. Instead of dishing out mortgages to people with bad credit scores, banks became more cautious and selective in approving mortgages. As a result, the limited exposure to junk mortgages lowers the prospects of the type of investor panic that triggered the 2007 real estate collapse.
Worse Than Anticipated Economic Recession
Even in a worse-than-expected economic recession, the risk that the real estate market will collapse will still be low. In 2008, four main factors contributed to the housing crisis: (1) lax financial regulation (2) low interest rates (3) high unemployment rates and (4) the lowering of lending standards by financial institutions. The low interest rates drove up house prices. Financial service firms took advantage of the weak regulatory framework and developed innovative lending practices that exposed them to widespread defaults. The risk of default increased with high unemployment rates. From February 2008 to March 2009, 5.1 million Americans lost their jobs. These widespread job losses hastened the loan default rates and worsened the housing collapse. In the present setting, the occurrence of a worse than anticipated economic recession will not trigger the collapse of the housing market. In June 2022, unemployment rate was at a record low of 3.6%. Experts predict that the percentage of Americans actively looking for work will drop below the 3% mark in the final quarter of 2022. These record-low unemployment figures suggest the likelihood of widespread default is extremely low. Additionally, the Dodd-Frank Wall Street Reform and Consumer Protection Act outlawed many of the short-sighted lending practices that exposed financial institutions in the event of widespread loan defaults. As a result, banks issued mortgages to low-risk , and the mortgages in their portfolios are of high quality. If the economic recession increases mortgage default rates, financial institutions will still hold high-value collateral they can dispose of swiftly and recover their funds.
In California, home prices peaked in May 2022 and have been slightly declining ever since. While some economists and journalists believe a 40% crash is possible, evidence suggests a 20-25% correction .
Kevin Paffrath, a 30-year-old multi-millionaire real estate broker and financial analyst, explained why he believes a 20% correction in the housing market is imminent. First, he cited Home Depot’s Q1 2022 earnings report, which claimed the excess demand for homes before the federal reserve began tightening its monetary policy was around 25%. Paffrath further explains the increase in mortgage rates from 2.5% for a 30-year fixed rate mortgage in 2020 and 2021 to slightly over 7% “represent a 45% decrease in purchasing power.” If we offset the 25% excess supply of purchasing power we once had with the 45% drop in purchasing power, we’ll likely see a negative 20% decline in prices, said Paffrath. If this scenario plays out, that will take the market back to roughly three years ago when the average cost of a home in California was $659,380.
Although the likelihood of a 2007-style housing crash is very low, it might be necessary to assess the nature of the response if the recession triggers widespread defaults and foreclosures. If such a catastrophe materializes, the Emergency Economic Stabilization Act will safeguard the public against a 2008-like outcome. Pursuant to the Act, the government has created the TARP fund, giving them the power to intervene and protect financial institutions offering loans to high-risk clients . With the aid of TARP, the government can bail out financial institutions facing liquidity challenges due to widespread defaults among high-risk customers. However, bailing out financial institutions without a well-designed plan can create large deficits that tremendously increase the government’s debt.
If there is a severe housing market crash, many first-time homeowners can seize the opportunity of buying real estate at substantially discounted prices. According to billionaire Andrew Carnegie, “90% of all millionaires get to that level of wealth through an investment in real estate.” A housing crash provides a golden opportunity to buy low and sell high in the future. You can capitalize on this otherwise undesirable event by purchasing an investment property that pays passive income, flipping homes, or simply buying and moving into your first home.
However, a housing crash is troubling for current homeowners, as most people’s net worth is connected to the value of their home. Not only do existing homeowners still have a monthly mortgage to pay, but the value of their homes would also considerably decrease, and their income could drop off during a powerful recession.
Buying real estate during a housing crash and a recession may seem easier said than done, given that many people are unlikely to be in the proper position financially to seize the opportunity. On the bright side, many can capitalize on the current market. For one, potential homeowners can and should attempt to increase their credit scores to qualify for lower interest rate loans the market crash and increase their savings. Second, putting money aside for the sole purpose of investing in real estate if homes are heavily discounted. Once again, this may sound easier said than done, but doing so could pay off in the long run and pave the path to financial prosperity.
As mortgage rates rise, real estate prices will continue to drop. Consumers generally have less purchasing power than before due in large part to high inflation and soaring interest rates. While this article’s analysis argues a 2007-style housing crash is very unlikely, planning and preparing for this downward real estate transition is necessary. A correction in the real estate market will provide first-time homebuyers with an exceptional opportunity to finally make the purchase of their dreams. Homeowners can rest assured that even a worse-than-anticipated economic recession will not lead to widespread foreclosures, given that unemployment is low and that new rules and regulations prevent risky lending practices. Now more than ever, people have equity in their homes and are active in the workforce, and thus can make their mortgage payments. While we probably will see a sizable correction in housing prices, let’s not forget that the real estate market is an ongoing cycle with ups and downs – and over the long run, prices only go up.
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