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Vol. 5, No. 7
JULY 2010­­

Insights from the

Federal Reserve Bank of Dall as

Recovering from the Housing
and Financial Crisis
by John V. Duca and David Luttrell

Since the second half
of 2009, four negative
shocks to the economy
have been unwinding.
Nevertheless, the U.S.
recovery still faces
downside risks.


he recent recession was unusual because it stemmed from an
unsustainable easing of credit standards and financing, which
fueled the prior expansion but also the imbalances that led to the worst
recession since the 1930s.1 When losses on new financial practices ended
excessive lending, the economy was hit by housing and credit shocks,
culminating in a financial crisis. Home construction plunged, wealth fell,
credit standards tightened and financial markets seized up.
The initial impacts of these four shocks on gross domestic product
(GDP) were amplified by cyclical interactions between income and spending. Since the second half of 2009, these negative shocks have been unwinding, setting the stage for economic recovery. An analysis of the shocks and
their aftermath offers clues to the direction and pace of the recovery.
Home Construction and GDP
Housing demand is driven not only by income and mortgage interest
rates but also the credit standards used to approve or deny mortgage applications. The easing of credit standards associated with the rise of nonprime
mortgages enabled more people to obtain mortgages and contributed to
a large upswing in housing demand through the mid-2000s. Standards
quickly tightened in 2007, causing housing demand to plummet.2
Home construction, which normally makes up 5 percent of GDP,
added 0.6 percentage points to GDP growth at the height of the housing
boom and subtracted 0.3 to 1.4 percentage points for 14 straight quarters
after (Chart 1). These are notable effects on GDP growth, which averages
about 2.5 percent annually. When new construction slipped below levels
needed to replace depreciation and accommodate population growth,
the stock of unsold homes fell and home construction shifted from

having a negative to a neutral impact on
GDP growth.

ized, housing wealth enabled many
families to borrow at lower interest
rates or in higher amounts than they
might have otherwise. In this way,
house price gains boosted consumer
spending. Borrowing against housing rose to as much as 8 percent of
disposable income in the mid-2000s.

Housing’s Wealth Effect
The home price increases earlier
in the decade began to reverse as
housing demand retrenched.
Because mortgages are collateral-

Chart 1

Housing Construction’s Drag on GDP Ebbs
Contribution to GDP growth (percentage points)












SOURCES: Bureau of Economic Analysis; authors’ calculations.

Chart 2

After Plunging, Net Worth and Housing Wealth Stabilize
2005 dollars (trillions)

2005 dollars (trillions)


Percent change in real:
Net worth
Net housing wealth



Real net worth


Real housing wealth











’67 ’70




’82 ’85









SOURCES: Flow of Funds Accounts (June 2010); Bureau of Economic Analysis; authors’ calculations.

EconomicLetter 2

Federal Reserve Bank of Dall as

When home prices fell, so did such borrowing. Studies indicate that the swing
in housing wealth had a significant
effect on consumption growth, adding
1 to 3 percentage points and then subtracting a similar amount by late 2008.3
The economic impact of housing
spurred declines in other asset prices,
such as stocks, imparting a negative
wealth effect on consumption. Since
early 2009, the economic outlook
and investor tolerance of risk have
improved, partially reversing the 29 percent drop in inflation-adjusted wealth
from second quarter 2007 to first quarter
2009. The decline was the largest since
the data series began in 1952 (Chart 2).
Financial industry losses on residential mortgage loans and securities
were sizable, estimated at $370 billion
at U.S. banks since 2007.4 The losses
were large enough to result in the
failure, assisted sale or rescue of many
banks and nonbank financial firms,
including investment bank Lehman
Brothers. These losses were large
enough to impart two additional negative impulses to GDP in the form of
tighter credit availability from lenders
and the reduced ability of large firms
to borrow from securities markets.
Credit Availability
Many long-lasting goods, like
autos and business equipment, are
bought on credit. Consequently, their
sales and output partly depend on loan
interest rates and the credit standards
of lenders. Thus, the willingness and
ability of bank and nonbank lenders to
extend credit can affect these financially sensitive sectors of the economy.
Banks are required to fund loans
held in portfolio with at least 8 percent
in equity capital by issuing stock or
retaining earnings; government-insured
deposits or other debt fund the rest.
Losses on loans and securities are first
borne by capital. Reacting to a weaker
real estate outlook, banks mainly tightened credit standards on mortgage loans
in 2007.5 But many banks did not have
enough capital to make new loans after
they suffered large losses in 2008 and

Lehman Brothers failed in September of
that year. As a result, banks tightened
credit standards on all types of loans,
resulting in a credit crunch.
Unlike banks, nonbank lenders
cannot issue insured deposits and must
assure investors that they are liquid
and capitalized enough to raise funds
by issuing debt that isn’t governmentinsured. When losses on subprime
and other investments mounted, investors stopped buying nonbank debt.
Lacking funding for new loans or facing maturing debt that financed existing loans, nonbank lenders cut lending
sharply by charging higher loan rates
and tightening credit standards. Such
changes at banks and nonbank lenders contributed to steep declines in the
sale and production of consumer durable and business investment goods,
especially in late 2008 and early 2009.
By spring 2009, many banks and
nonbank financial firms had raised or
received new capital, and risk premiums charged by debt investors fell as
liquidity and default risks declined with
an improved economic outlook. For
banks and nonbanks alike, this meant
decreased loan funding costs and a
greater capacity to lend. By mid-2009,
institutions had lowered loan interest
rates and stopped tightening credit
standards on non-real-estate loans.
Securities Market Swings
The fourth recessionary impulse
occurred in securities markets as large
losses on subprime mortgage securities exposed risks in the structured
financial product innovations that had
fueled the prior economic expansion.
Markets realized the lack of clarity
regarding which firms bore the risks
directly or indirectly through their customers. To hedge risk, some investors
bought default insurance on the bonds
they held via credit default swaps
(CDS). However, CDS issuers traded
in largely unregulated markets, weren’t
required to hold reserves against
potential payouts and had exposures
that were unclear. When large losses
on subprime securities and derivatives

materialized, risk premiums soared
on private debt as investors could no
longer buy low-cost default insurance
or assess the risk exposures of many
firms. The situation worsened following the failure of Lehman Brothers,
which had issued many derivatives
and whose default exposed many CDS
issuers that backed Lehman’s debt.
Private debt issuance halted in late
2008, while interest rates on private
debt soared. Spreads between interest rates on corporate and Treasury
bonds rose to levels not seen since the
Great Depression, and spreads jumped
between interest rates on short-term
commercial paper and Treasury bills
(Chart 3). In response to reduced
availability and higher costs of funding
from securities markets and lenders in
late 2008, firms cut software and business equipment investment, accounting
for about 44 percent of the large GDP
declines in fourth quarter 2008 and
first quarter 2009. Faced with weaker
sales and tighter credit, many firms
quickly laid off workers, deepening
the recession. In the nine months following Lehman’s demise, the unemployment rate jumped 3.3 percentage
points to 9.5 percent by June 2009.

Unusual actions by the Federal
Reserve and the Treasury helped
reopen the prime residential mortgage
and commercial paper markets in late
2008.6 Lacking such help but benefiting from an improving economic
outlook, corporate bond interest rates
began falling and corporate bond issuance began rising by spring 2009. This
aided an upturn in business investment
in the second half of 2009.
From Recession to Recovery
By mid-2009, home construction
had bottomed out, wealth had partially
recovered and financial markets functioned better. Lenders stopped tightening credit standards on non-real-estate
loans by late 2009. GDP began growing in third quarter 2009, owing to
three general influences. First, output
was reduced less by the four unusual
impulses that had pushed the economy into recession. Next, the secondhalf upturn in GDP partly reflected
fiscal and monetary policy actions to
stimulate aggregate demand. Third,
given a partial recovery of access to
some forms of finance and the expectation of economic growth, aggregate
demand benefited from a release of

Chart 3

Corporate Interest Spreads Retreat from Crisis Highs



Failure of
Lehman Bros.



Fed and Treasury actions
on commercial paper





Treasury bond yield







3-mo. commercial paper–
Treasury bill rate













SOURCES: Federal Reserve Board; Moody’s; authors’ calculations.

Federal Reserve Bank of Dall as

3 EconomicLetter




Chart 4

Conventional Leading Indicators Point to Recovery
2-qtr. percent change, 1-qtr lead

2-qtr. annualized percent change




Real GDP


is published by the
Federal Reserve Bank of Dallas. The views expressed
are those of the authors and should not be attributed
to the Federal Reserve Bank of Dallas or the Federal
Reserve System.
Articles may be reprinted on the condition that
the source is credited and a copy is provided to the
Research Department of the Federal Reserve Bank of
Economic Letter is available free of charge
by writing the Public Affairs Department, Federal
Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX
75265-5906; by fax at 214-922-5268; or by telephone
at 214-922-5254. This publication is available on the
Dallas Fed website,









Economic Index












NOTE: Shaded areas indicate recessions.
SOURCES: Conference Board; Bureau of Economic Analysis; authors’ calculations.

demand pent up during the recession,
when households and firms had postponed purchases of big-ticket items.
The effects of the last two influences are more typical of economic
recoveries and are tracked by conventional indicators historically associated with recoveries. For example, the
six-month growth rate in the Leading
Economic Index rose in spring 2009,
correctly presaging positive GDP
growth in the second half of 2009
(Chart 4).
However, the U.S. recovery still
faces downside risks. Further losses on
residential and commercial mortgages
may delay a return of credit standards
to normal. Large budget deficits may
force state and local governments
to cut spending. Recent declines in
the ability of foreign governments to
borrow have induced tax increases
and spending cuts that will temper
worldwide economic growth. Finally,
the return to full employment may be
delayed by firms’ reluctance to hire.
These uncertainties appear more likely
to slow the pace of—rather than end—
the economic recovery given how the
four major headwinds from the recent
crisis have been abating.

Duca is a vice president and senior policy advisor
and Luttrell is a research assistant in the Research
Department of the Federal Reserve Bank of Dallas.

“Housing Markets and the Financial Crisis of

2007–09: Lessons for the Future,” by John V.
Duca, John Muellbauer and Anthony Murphy,
Journal of Financial Stability, forthcoming.

“The Rise and Fall of Subprime Mortgages,”

by Danielle DiMartino and John V. Duca, Federal
Reserve Bank of Dallas Economic Letter, vol. 2,
no. 11, 2007.

“Credit, Housing Collateral and Consumption:

Evidence from the U.K., U.S. and Japan,” by
Janine Aron, John V. Duca, John Muellbauer,
Keiko Murata and Anthony Murphy, CEPR Discussion Paper 7876, Center for Economic Policy
Research, June 2010.

Richard W. Fisher
President and Chief Executive Officer
Helen E. Holcomb
First Vice President and Chief Operating Officer
Harvey Rosenblum
Executive Vice President and Director of Research
Robert D. Hankins
Executive Vice President, Banking Supervision
Director of Research Publications
Mine Yücel
Executive Editor
Jim Dolmas
Associate Editor
Kathy Thacker
Graphic Designer
Ellah Piña

“Global Financial Stability Report,” International

Monetary Fund, April 2010, p. 13.

Federal Reserve’s Senior Loan Officer Opinion

Survey, various releases.

“Fed Confronts Financial Crisis by Expanding Its

Role as Lender of Last Resort,” by John V. Duca,
Danielle DiMartino and Jessica J. Renier, Federal
Reserve Bank of Dallas Economic Letter, vol. 2,
no. 2, 2009.

Federal Reserve Bank of Dallas
2200 N. Pearl St.
Dallas, TX 75201