The Credit Crunch Crisis Unfolds

Average completion time: ~16 minutes

credit-crunch-unfolds-what-happened-foreclosed-homes-america-housing-crisis-mortgages-subprimeBefore what has been called the 'Great Recession' by many pundits, economic prosperity flourished in the United States and overseas.  The S&P 500 Index, perhaps the most widely accepted gauge of the American equity markets, multiplied over twelvefold during the last two decades of the 20th century.  An investor that placed $1000 in an index fund would have seen their original investment grow to over $12,200 during this period.  Aside from the Nikkei 225 Index of Japan, most of the developed world's other major stock indices saw a similar growth in wealth.  In addition to burgeoning equity markets, world GDP rose at a rate between 3.5 and 4 percent per annum.  As citizens of the largest single economy in the world, Americans saw their standard of living as measured by GDP per capita rise from $12,179 in 1980 to $35,058 by 2000. 

A beneficiary of this exorbitant period of growth, the U.S. housing market saw a similar boom.  Since its inception, the S&P/Case-Shiller Index can tell the story pretty well. Between 1987 and 2005, the index grew at a rate of almost 13 percent each year.

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The graph above represents the monthly values of the S&P/Case-Shiller Index, which is a national measure of home prices, from its inception in January 1987 to June 2011. Home prices peaked in mid-2006 and fell rapidly after then, leaving many homeowners with mortgages greater than the total value of their homes.

Another way to interpret this data can be seen by calculating the doubling time of home prices. The S&P/Case-Shiller Index can be thought of as a measure of the average value of a single-family home in America.  By using the estimated formula below, we can approximately determine that the average American saw their home price double every 5 years during this time period.

Doubling time (in years) = 70 Percentage growth rate (yearly)

As discussed in Part 1 of this series, the housing market's increased appetite for both riskier borrowers and mortgage instruments increased the potential for an economic calamity to occur.  Beginning in June 2006, home values began to decrease.  During the next two years, homeowners lost roughly a fifth of the wealth they held in their homes.  Between June 2006 and June 2008, real measures of housing market health began to show degradation.  The 90-day delinquency rate, which measures the percentage of borrowers that are at least 90 days past due on their mortgage payments, increased significantly, from 4 to 5 percent pre-crisis to over 10 percent.  Due to the fact that delinquency naturally precedes foreclosure, the percentage of borrowers entering foreclosure also increased.  In June 2006, only 0.5 percent of all borrowers were in foreclosure, compared to more than 2 percent just two years later.  It should be mentioned that not all delinquent homes eventually foreclose - the fraction that avoids foreclosure can partake in a variety of alternatives sometimes provided by the lender.

Increasing rates of delinquency and foreclosure negatively affected the economy in a few different ways.  First, they decreased home values even further, due to a phenomenon known as the spillover effect.  In any given neighborhood, a foreclosure devalues both the foreclosed home and properties within close proximity.  According to option theory, these additional declines in home prices nudged more borrowers into foreclosure. Now popular with mainstream economists, this theory states that borrowers choose to become delinquent on their mortgage payments once the value of their home is below mortgage value, since at this point, it costs the homeowner more in loan principal payments than the total value of their home.  Thus, a runaway relationship between home prices and foreclosure was born.  In the chart below, it is useful to visualize 'falling property values' as the initial event that triggered this relationship.

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As discussed in Part 2, many parties had large financial interests in the health of the housing market.  Due to securitization, an epidemic of delinquency, foreclosure, and negative home equity drastically reduced the value of consumer wealth in the United States and abroad.  As an increasing number of borrowers stopped paying their mortgage payments, lending institutions were the first to suffer.  In an effort to recoup the original value of the mortgage, the lender usually attempts a short sale or a sale through foreclosure.  Neither of these options is particularly profitable, as most properties sell for less than the mortgage's value.  In fact, recent estimates place lenders' losses anywhere between 50 and 70 percent of the original loan when either action is taken.

Perhaps even more financially devastating, the American investment banking system experienced heavy losses from investments in mortgage-backed securities, specifically those linked to subprime borrowers.  The value of this type of derivative was degraded as home values declined.  A report by the International Monetary Fund valued these losses at $4 trillion dollars.  As this occurred, the value of all outstanding collateralized debt obligations also declined, creating huge losses for investors, including pension funds, mutual funds, hedge funds, and other types of investment vehicles.  This decline in wealth was evident in every major stock index in the world.  In the U.S., the Dow Jones lost nearly 37 percent of its total value in 2008, making it the worst year since the onset of the Great Depression.  The European markets experienced an average loss of 38.1 percent, while Asian markets were hit even harder - losing, on average, over 50 percent.  Hardly any investors were left untouched by this sequence of events due to the extreme amount of systemic risk that was present in the global economy. 

As the crisis deepened and people began holding back on purchases, household consumption declined significantly.  In the U.S. specifically, this was evident by reduced personal consumption expenditures on a national scale.  The eventual result of this 'decline in aggregate demand', as economists put it, was a contraction in GDP and rapidly increasing levels of unemployment.  After two consecutive quarters of negative GDP growth in 2008, a recession was officially underway in the American economy.