When housing prices fall, consumers are more likely to default on their home loans, causing banks to lose money. Also, home equity dries up, meaning that consumers have fewer funds available for spending, saving, investing or paying down their debts. Sometimes, banks are even forced to shut down.
A recent study of regional real estate booms and busts in the 1980s and 1990s found that banks in states that experienced major housing price declines also suffered high loan default rates and, consequently, low profits and high failure rates. Usually, but not always, these declines followed some sort of an economic shock, such as a fall in commodity prices or a cut in government spending.
A decline in housing prices was the precipitating factor in the financial crisis that rocked the world in autumn of 2008. Regulations passed in the United States had pressured the banking sector to allow more consumers to become homeowners. As of 2007, Department of Housing and Urban Development (HUD) rules required that 55% of loans issued by Fannie Mae and Freddie Mac go to borrowers either at or below the median income level, and that nearly half of those loans go to low-income borrowers.
Beginning in 2004, Fannie Mae and Freddie Mac bought up huge numbers of mortgages and mortgage assets characterized by dubious underwriting standards, including Alt-A mortgages which came with high loan-to-value or debt-to-income ratios. In issuing risky mortgages, they charged huge fees and enjoyed high margins, During the same time frame, they used collateral from subprime mortgages to snap up private-label mortgage-backed securities (MBS). When prices on U.S. housing declined and the number of loan delinquencies, defaults and home foreclosures increased, the housing market bubble finally burst.
Unitl that time, a decline in housing prices was usually a leading indicator of a drop in U.S. stock prices. U.S. house prices peaked in the first quarter of 2006, but the U.S. stock market kept rising until the fourth quarter of 2007. The one-two punch of a fall in two major U.S. asset markets produced a liquidity crisis that froze up interbank lending markets around the globe.
Under a scenario like this, banks typically decrease their investments and lending. Consumers can find it more difficult to obtain home equity loans. In the U.K., for example, equity withdrawals put an extra 14 billion pounds into the economy before the financial crisis. In contrast, they amounted to negative 8 billion pounds by the end of 2008.
It is unclear, however, how consumers use the money obtained from home equity loans. Some studies suggest that as much as 60% of the extracted equity is used for consumption spending, but other studies indicate that the money is used for either investments or to help pay down debt.
Although another drastic decline in housing prices would certainly impact banks adversely, banks today are better capitalized, and regulators are keeping a keen eye on the sector in an attempt to minimize the damage that might be spawned by a collapse of the real estate market.