What is a recession?
A recession is often defined as two consecutive quarters of slowing economic growth, as measured by the gross domestic product (GDP), but it's really a little more complicated than that. Economists must measure data regarding personal income, unemployment rates, industrial production, and sales and manufacturing volume to determine whether we are heading towards or already in a recession. Even after the pros analyze the data, they often don't agree whether we are already in a recession, how long it will last, or how severe it will be.
A recession is a natural part of the economic cycle. Periods of business growth, increased consumer spending, and stock market gains are followed by periods of business cutbacks, consumers tightening the grip on their money, and a volatile stock market. I'm not an economist or here to report the news, so I'll leave the up-to-date technical talk to the experts. My goal is to help the average consumer understand how irresponsible lending and borrowing can lead to possibly long-term trouble for an entire nation.
Our current recession worries were caused by the over-extention of credit.
The recent U.S. housing bust is taking much of the blame for our current recession fears. Recently, it has been extremely easy for many Americans to obtain financing for a home, compared to what it used to be. Lending standards of the past often required a 20% down payment, meaning that a prospective homeowner had to work, plan, and save for many years before their dream became a reality. They were expected to have excellent credit, proving themselves with years of responsible credit and debt management. Owning a home became reality for only those who had the skill and discipline to properly manage their finances.
Over the past few years, many people have been able to buy a home without much credit and debt experience, as well as the income needed to keep up with payments over the long term. Consumers, with no cash saved and shaky credit, became homeowners through creative financing, builder incentives allowing no down payment, and little documentation to prove their ability to afford a home. Sub-prime adjustable-rate mortgages (ARMs) and interest-only mortgages put people into homes that they could not otherwise afford.
Easy financing fueled the fast-growing housing market.
Builders bought up land, and built, built, built. Already inflated home prices steadily increased as the demand for new homes continued to rise. Massive overbuilding was rampant, to keep houses "rolling out the door," as more sales meant more profits for both home-builders and mortgage lenders. Irresponsible lending practices made mortgages available to practically any buyer who wanted one, and hasty borrowers were quick to sign on the dotted line without a realistic money management plan.
The risk of default is always a factor lenders consider; that risk became a reality on a massive scale. Homeowners who were approved for mortgages - just months before - started to miss payments. Consumers with no emergency savings and poor debt-management skills saw their dream of home ownership slipping out the door. Those who made no down payment had less incentive to keep up with increased ARM payments, as they really had no actual cash investment in the home. Some of them have managed to struggle to make payments for a couple of years before their resources are tapped out.
Many new homeowners soon realize they can't afford their new home so they attempt to sell their house to avoid foreclosure. The trouble is, many other homeowners are in the same boat, and also trying to sell their homes. The housing market has been flooded with homes for sale; the supply far exceeds the demand, so homes are not selling for what they were just recently purchased for. Homeowners, who are intent on selling before a foreclosure ruins their credit, are forced to drastically reduce their selling price. Some of them are lucky enough to find a buyer at the reduced price; many will not be able to sell before they lose their home to foreclosure.
Real estate values have suffered tremendously.
The extreme over-supply of housing is bringing down the value of every one's homes, not just the ones who are trying to sell. The average American homeowner suffers a great loss as they lose part of the value of their biggest asset. Some of the most over-valued real estate markets in the U.S. are seeing home prices fall by as much as 25%.
Homeowners who bought their homes with a low down payment during the time of inflated home prices may see all of the equity in their home wiped out, or even worse, they owe more on the mortgage than their house is now worth. Even if they have substantial equity, through a large down payment or many years of making payments, lenders are cautious about loaning money in a market of falling home values. This leads to difficulty in receiving home-equity lines of credit, tightening the flow of money into our economy.
Not only will credit be harder to come by, but people will lose income because of our situation.
Many jobs have already been lost due to the sudden halt in home production. Construction workers, salespeople, and people in the mortgage business are the first that we think of, but many who work in other industries are being hurt, too. Home improvement stores, furniture stores, and garden centers feel the pinch as home sales dwindle, and will have no choice but to cut jobs.
In an attempt to control their losses due to the high rate of mortgage defaults, banks are making it harder for nearly everyone to get many types of loans. This will prevent consumers from getting the personal loans and credit cards needed to keep up with the lifestyle they are used to. Cash-strapped consumers will have no choice but to hang on to their money more tightly and cut out the luxuries they must live without. This hurts business in many more sectors, and when businesses see a reduction in profits, they reduce expenses. Payroll is often one of the first expenses to cut, which means even more lost jobs for Americans, which further reduces the flow of cash into the economy, and the cycle continues...
Even those that are not dependant on credit will reduce their spending. Volatility in the stock market is directly tied to business losses and consumer uncertainty. Investors who have seen healthy gains in the past few years are watching helplessly as the value of their investments lose money. Some may have had the foresight to cash out before their investment flops, but many will hang on and hope that their investments rebound. Concerned investors will limit their extravagant spending in an attempt to preserve their remaining capital, further reducing the flow of cash into our economic system. As the flow of money in our country slows to a trickle, the domino-effect knocks down the economy that thrives on consumer over-spending.
So, are we in a recession?
Only the experts can tells us. They have all that data to analyze before they can tell us if we are in a recession or are heading for one. Since it takes six months to about a year for economists to evaluate our country's economic situation, many recessions of the past have not been officially recognized until we were well on our way to recovering from them. Top economists have different opinions so far, ranging from "There's no worry of a recession." to "It'll be the worst in U.S. history." to "We'll be on our way to recovery after this year." All we really can do is hang on tight, and wait and see.
Though there's not much we can do about it now, it may be time for consumers to think about the habits that got us into this mess. The common acceptance of living beyond our means through the over-use of credit has led us to a scary point in history. Maybe our vision has been blurred by maxed-out credit cards, the use of home-equity loans for luxuries we could not otherwise afford, and trusting mortgage lenders to approve loans based on a borrower's ability to pay.