The burst of the housing bubble resulted in the Great Recession, the worst global recession since World War II, which was sparked by the U.S. subprime mortgage crisis and financial crisis of 2007 and 2008. The burst of the dot-com bubble resulted in a recession, but a mild one. The following will explore what factor in both situations triggered the substantial difference between the Great Recession and a mild one.
The dot-com bubble: The commercial growth of the Internet was soaring, and low interest rates were encouraging the amount of start-up companies to increase. As the Internet became more accessible throughout the world, it shifted from a luxury good to a necessity good. Unprecedented amounts of people were conducting personal investments during this time. At the same time, companies were being over-valued. Internet companies exercised a “growth over profits” mentality, which led to excessive spending throughout the Internet companies, and were encouraging traders to overvalue their worth. As a result of the overspending and false impression that the company was doing better than it actually was, many technology companies tumbled into debt or bankruptcy. Eventually, the bubble burst and the stock market plummeted. The tragedy of 9/11 caused the stock market drop to accelerate. Investors lost sizable investments during this time.
The housing bubble: The price of the American homes had increased over 100% in the years leading up to the burst of the housing bubble. In an effort to heighten yields offered by the U.S. Treasury bonds, investment banks on Wall Street created products such as mortgage backed securities and the collateralized debt obligation that were recognized as safe ratings according to credit rating agencies. In doing this, Wall Street connected trillions of dollars in worldwide fixed income investments with the mortgage market in the United States. The high demand in the housing market caused lending standards to deteriorate over time after Wall Street connected the money with the mortgage industry. The market of responsible homeowners had been exhausted, yet there was still a massive demand by less responsible homeowners to get into homes. This evoked banks to begin making loans with high risk, and betting against that risk. The collateralized debt obligation product provided financial institutions the ability to use the pool of investments to finance subprime and other lending, further increasing the size of the bubble. Eventually, home prices declined and borrowers with adjustable rate mortgages were unable to refinance and avoid higher mortgage payments as interest rates increased, resulting in wide span national default on home payments in the United States, and thus millions of foreclosures were conducted each year.
The main reason why the burst of the housing bubble led to the Great Recession and the dot-com bubble did not is due to the people that were affected in each individual situation. In the case of the housing bubble, most of the financial losses were endured by those with the least capability to incur the loss. The result of the housing burst disproportionately affected the poor, who as a result cut back their other expenditures significantly, creating a domino effect on the rest of the nation’s economy activity. The dot-come bubble was financed by the wealthy, and they were mainly the victims when that bubble burst. However, the wealthy had little to no debt, and they did not need to cut back their spending nearly as much as the poor were forced to after the housing bubble burst.
When the poor cut back their spending so much, the whole economy felt the effects of the bubble burst, not just homeowners and mortgage professionals.
For low-income homeowners, housing was the most important asset to them by a landslide. In many cases, the home accounted for 80% of the homeowner’s total assets. These homeowners were not very well versed in the stock market, nor did they have any assets to cushion loss such as stocks, bonds, or mutual funds. For the wealthy, housing accounted for significantly less of a portion of their total assets – more along the lines of 20% their total assets or less. By comparison, lower income households borrowed much higher loans in relation to the homes value than high income earning households. Loans were as high as 80% the value of the home for a low-income borrower, but high-income borrowers needed to borrow way less as they could cover a larger percentage of the cost up front. They were asset rich and debt poor versus the opposite situation among poor homeowners.
Due to the concept of leverage, many ran into trouble when home prices fell. For example, a homeowner with a mortgage of $75,000 on home valued at $100,000, the homeowner has 25% equity on the home if the home value remains the same. However, if the value of the home decreases 25% down to $75,000, then the homeowner has lost $25,000, or, 100% of the equity that was on the home. This type of situation affected millions throughout the country. More likely than not, home values decreased so far that homeowners lost more than 100% of their equity, and as a result were ‘underwater’ on their mortgages, meaning that the loan amount on their mortgage is valued at more than the actual value of the home. Many underwater homeowners were not allowed the opportunity to refinance and get out of this situation, which is why almost seven years later the economy and the housing market are experiencing lethargic growth.
In conclusion, it is evident kicking people when they are already down can have a sizable income on the economy as a whole, and the weakness resonates throughout the country. When investors assume their own risk on a situation, they most likely have a backup plan should things go awry. However, when low-income households assume a risk, it may be one of their only assets. As a result, homeowners today are treading more lightly than they were prior to the burst of the housing bubble.