By Kimberly Amadeo. US Economy Expert
Kimberly Amadeo clarifies economic and business news. She explains how these trends affect you and, most important, the steps you need to take so you can profit now.
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Real estate plays an integral role in the U.S. economy. Residential real estate provides housing for families, and is often the greatest source of wealth and savings for many of them. Commercial real estate. which includes apartment buildings, create spaces for jobs in retail, offices and manufacturing. Real estate income provides a source of revenue for millions.
In 2014, real estate construction contributed $1.0656 trillion, or 6.1%, to the nation's economic output as measured by Gross Domestic Product (GDP).
This is getting closer to its peak of $1.195 trillion in 2006. At that time, it was a hefty 8.9% component of GDP. Real estate construction is labor intensive. That's why a drop in housing construction was a big contribution to the recession's high unemployment rate .
However, construction is only a portion of the economic activity associated with real estate. A decline in real estate sales eventually leads to a decline in real estate prices. This then reduces the value of everyones' homes, whether they are actively selling it or not.
Nearly 70% of the U.S. economy is based on personal consumption. A reduction in consumer spending contributes to a downward spiral in the economy. This results in further unemployment, further reduction in income, and further reduction in consumer spending. If the Federal Reserve doesn't intervene by reducing interest rates. then the country could fall into a recession. The only good news about lower home prices is that it lessens the chances of inflation .
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Real Estate and the 2008 Recession
Falling home prices initially triggered the 2008 financial crisis. but few realized it at the time. ByJuly 2007, the median price of an existing single-family home was down 4% since its peak in October, 2005, according to the National Association of REALTORS. However, economists couldn't all agree on how bad that was. Definitions
of recession , bear market and a stock market correction are well standardized, but the same is not true for the housing market.
Many compared it to the 24% decline during the Great Depression of 1929. and a 22-40% decline in oil-producing areas during the oil-price drop in the early 1980s. By those standards, the slump was barely noteworthy.
However, some economic studies showed that housing price declines of 10-15% are enough to eliminate equity and create a snowball effect that eventually creates severe pain for homeowners. In some communities in Florida, Nevada and Louisiana, that had already occurred. In retrospect, more of us should have listened to them. (Source: International Herald Tribune, "When Does a Housing Slump Becomes a Bust?", June 17, 2007)
Nearly half of the loans issued between 2005 and 2007 were subprime, which meant that buyers were more likely to default. At the same time, home prices soon fell below the value of even top-rated mortgages, so that even owners who could afford to pay their mortgages would rather walk away if they had to sell their home. For more, see Did Fannie and Freddie Cause Mortgage Crisis?
The real problem was that trillions in derivatives were sold based on the value of mortgages to finance those homes. These mortgage-backed securities were sold as safe investments to pension funds, corporations and retirees. That's because they were "insured" from default by a new insurance product called credit default swaps. The biggest issuer was AIG.
When borrowers defaulted, these mortgage-backed securities had questionable value. So many investors tried to exercise their credit default swaps that AIG was overrun, ran out of cash, and threatened to default itself. That's why the Federal Reserve had to bail it out. For more, see How Derivatives Actually Created the Mortgage Crisis .
Other banks, like Bear Stearns and Lehman Brothers, that had lots of mortgage-backed securities on their books were shunned by other banks. Without cash to run their businesses, they turned to the Fed for help. The Fed found a buyer for the first, but not for the second. The bankruptcy of Lehman Brothers kicked-off the 2008 financial crisis . Article updated March 5, 2015.