The bursting of the U.S. housing bubble and the Great Recession that followed (2007–2009) resulted in a sharp decline in overall economic activity. Home prices dropped on average by about 20 percent between December 2006 and December 2009, but it wasn’t just housing that was affected. Household consumption, business investment, and employment also declined dramatically. A wave of mortgage defaults followed.

In their paper, “Housing Wealth and Consumption: The Role of Heterogeneous Credit Constraints,” S. Borağan Aruoba of the University of Maryland and a visiting scholar with the Philadelphia Fed, Ronel Elul of the Philadelphia Fed, and Şebnem Kalemli-Özcan of the University of Maryland studied the channels by which home price shocks affected consumption (and therefore overall economic output). They conducted their analysis by decomposing into four distinct channels the effects of changing home prices on individual consumption expenditures. Those channels are the wealth effect (in other words, the effect that lower home prices have on an individual homeowner’s wealth), household financial constraints, bank health, and the local general equilibrium effect (that is, how the initial home price shock led to wider economic feedback effects, particularly on employment).

The authors used a data set of credit bureau records (specifically, an anonymized, random 5 percent sample), which were matched with residential mortgage information.1 This combined data set provided detailed information on the individual consumer, including age, creditworthiness, number of auto loans originated, details on the primary mortgage, and the value of the home when the mortgage was originated. To measure the level of household consumption in their data set, the authors took an indirect approach, using auto loan originations as a proxy.2 (The authors took this approach because there is a dearth of good data linking individual consumption to detailed asset and liability information.)

The authors found that the drop in home prices after the housing bubble burst resulted in a significant reduction in overall household consumption. Specifically, they showed that the average drop in home values between 2006 and 2009 led households to reduce spending on autos by about $1,200 on average in 2009.

By examining the key channels responsible for the decline in consumption, they determined that 60 percent of the decline in consumption was from two direct effects: household financial constraints and the wealth effect. They found only a small impact on consumption from the wealth effect but a large impact from household financial constraints.3 Digging deeper, they found that the impact from the financial constraints channel was driven by the borrowing constraints faced by specific sets of households. “Some consumers do not react at all to the change in housing wealth,” they wrote, whereas the reaction of other consumers is “many times larger than the average response.” For instance, households with a high loan-to-value ratio (in other words, households that borrowed a large share of the purchase price of their home) were more affected by falling prices.4

Further, the authors differentiated between ex-ante borrowing constraints that existed as of 2006 or earlier (that is, constraints that were in place before home prices declined and thus affected the financial vulnerability of some households even before the financial crisis) and ex-post borrowing constraints triggered by the decline in home values (which made it even harder for some households to access credit). They found that the majority of the impact of financial constraints on consumption was in fact ex post. Specifically, households that defaulted on their mortgage as a result of declining home values then found their credit risk score impaired, which subsequently made it more difficult for them to qualify for an auto loan.

The remaining approximately 40 percent of the effect on consumption from home price changes, they found, could be attributed to two indirect effects: commercial bank health and local general equilibrium effects. Bank health was a factor because lower home prices negatively affected banks that were exposed to the real estate market. These banks reduced the credit supply to households (thereby contributing to lower consumption) and to firms (thereby reducing investment and employment). Additionally, a local general equilibrium channel influenced consumption levels through economic feedback effects. For instance, reduced household consumption driven by a drop in home prices lowered the demand for goods and services, which led to a decline in firms’ employment, which led to a further decline in consumption.5

Aruoba, Elul, and Kalemli-Özcan also considered the policy implications of their findings. Given the financial vulnerability of consumers as a result of home price volatility, the authors suggested using countercyclical macroprudential policies to limit homeowners’ overall borrowing during economic expansions and to relax borrowing limits during economic downturns. Such policies, the authors argued, may help smooth the aggregate consumption response associated with changes in home prices and thereby make consumers better off.

  1. The views expressed here are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
  2. Their combined data set is composed of information from the Federal Reserve Bank of New York Consumer Credit Panel/Equifax, Equifax Credit Risk Insight Servicing, and Black Knight McDash.
  3. In 2009, 13.5 percent of households in their sample originated a car loan.
  4. They detected this lack of a wealth effect by studying the consumption patterns of individuals who were unlikely to face any credit constraints but who saw the prices of their homes decline.
  5. Their results are consistent with the results found by Garriga and Hedlund, who show that consumers with more mortgage debt and illiquid wealth altered their consumption more as a result of changes in home prices. See Carlos Garriga and Aaron Hedlund, “Mortgage Debt, Consumption, and Illiquid Housing Markets in the Great Recession,” American Economic Review, 110:6 (2020), pp. 1603–1634.
  6. Another general equilibrium effect can occur, the authors noted, when business owners use their personal housing wealth as collateral to obtain business loans. A decline in home prices can then lead to a credit crunch and reductions in employment, triggering additional declines in consumption.