Over the last decade, no event has influenced the current real estate environment more than the global economic downturn that began in December 2007. During this seismic economic shift, referred to as the Great Recession, many - if not most people - faced a myriad of unprecedented challenges.

Understanding the dynamics and implications of such a massive economic upheaval is critical for home buyers in today’s housing market. To gain a better understanding of our current real estate environment, home buyers must know how the Great Recession occurred in the first place - and heed the warnings of the last decade. (For more, see: 5 Lessons from the Recession.)

The Great Recession

A boom, decades in the making, deteriorated in a matter of months.

Millions of people lost their jobs and homes when the housing market started to plummet (i.e., the "bursting" of the housing bubble). From the mid-1990s to the mid-2000s the average price of housing spiked 124%, an “unheeded warning sign,” according to University of North Carolina (UNC) research. The combination of rising home prices, loose lending practices and an increase in subprime mortgages was economically unsustainable, yet the housing bubble continued to grow unabated. Over time, the supply of homes greatly surpassed demand, and finally, the bubble broke in 2007.

The crisis hit when numerous foreclosures and defaults crashed the housing market, greatly depreciating the value of deliberately obscure financial securities that were directly tied to subprime mortgages (e.g., mortgage-backed securities). This new reality created a ripple effect throughout the entire global financial system, as banks in the U.S. and around the world began to fail or approach the point of failure. In the end, the U.S. federal government had to intervene quickly to mitigate the damage.

The Housing Market During the Great Recession

The University of North Carolina published a thorough treatment of the subprime mortgage crisis and its ripple effects throughout the entire global financial system. Investors - both foreign and domestic - poured money into the real estate industry and offered home buyers credit without adequate risk management. The combination of rising home prices and easy credit would lead to an increase in the number of subprime mortgages, an underlying cause of the Great Recession.

Essentially, subprime mortgages are financial instruments with widely varying terms that lenders offer to so-called "risky borrowers." A risky borrower is a consumer with a questionable credit history, questionable income stability and a high debt-to-income ratio. Moreover, subprime mortgages were popular among home buyers who were purchasing second homes. In fact, lenders specifically targeted these home buyers for subprime mortgages.

Furthermore, subprime mortgages, more often than not, have adjustable interest rates. Subprime lenders offered consumers mortgages that carried low-interest rates for a short time but after that period, the interest rates spiked considerably. The average subprime mortgage interest rate from 1998 to 2001 was as much as 3.7 percentage points higher than conventional mortgage rates. (For more from this author, see: 8 Questions to Ask Before Managing Rental Properties.)

The Housing Market Aftermath

The subprime mortgage collapse led to many people losing their homes and economic stagnation. Americans faced financial disaster as the value of their homes dropped well below the amount they had borrowed and subprime interest rates spiked. Monthly mortgage payments almost doubled in some parts of the country. In most cases, borrowers were actually better defaulting on their mortgage loans rather than paying more for a home that had dropped precipitously in value.

In turn, home building saw a significant decline, resulting in a restricted supply of new homes for a steadily growing population. The lack of supply and the increased demand saw the real estate environment turn into a seller’s market. More people were now chasing fewer homes, which increased home prices.

The good news for today’s home buyers is that the foundational issues of the Great Recession have been addressed by the real estate industry, the financial industry and U.S. policy makers. To stimulate economic growth, the Federal Reserve, which is responsible for setting conditions to influence employment and economic growth, slashed the fed funds rate to near-zero. Simply stated, the fed funds rate is the interest rate at which banks borrow from each other. The decision to reduce interest costs allowed people to have more access to capital to reinvest in the economy.

Over the last decade, the net effect of near-zero interest rates has stabilized the U.S. economy by encouraging lending among financial institutions that are systemically critical to the housing market, as reported by UNC's study. Today, supply and demand for housing has stabilized enough that we’re now in a heavy buyer’s market. As a result, mortgage rates are finally starting to grow to balance with the economy. (For more from this author, see: Seasons Impact Real Estate More Than You Think.)

For more information on rising interest rates and the housing market, you can download the whitepaper: Buying a Home in a Rising Interest Rate Environment. Ryan Boykin is co-founder of Atlas Real Estate Group, a Denver-based full-service realty firm.

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