Shock Therapy for the Homeowner

There is a strong consensus that a bubble in the housing market developed during the previous decade, precipitating the Great Recession. Multiple investigations have pinpointed low interest rates, low down-payments, easy credit, exotic new mortgage products, and a deregulated finance industry preying on first-time homebuyers as contributing factors.

Still, the question remains: what actually tipped the housing bubble into eventual collapse?

Economists Steven Sexton, JunJie Wu, and David Zilberman offer a novel theory in their working paper “How High Gas Prices Triggered the Housing Crisis: Theory and Empirical Evidence.” The authors argue that it was the gasoline price shocks from  2005 to 2008 that burst the bubble and triggered the cascade into recession.

The historical record provides evidence associating oil shocks with recessions. Oil price spikes in the U.S. occurred before 10 of 11 post-World War II recessions. Further, the instance of an oil price shock increases the likelihood of recession by 50 percent after one year and nearly 90 percent after two years.  Of note, the rise in oil prices starting in 2005 preceded the housing market contraction.

Sexton, Wu, and Zilberman contend in particular that:

[a] doubling of gas prices relative to long-run averages made mortgage payments unaffordable for some households, leading to “true” default.

A half century of suburbanization, accelerated during the housing boom from 1998 to 2006, left the housing market highly susceptible to energy price shocks. The combination of federal housing policies, new mortgage products, and poor underwriting practices made housing unusually affordable. Homeownership levels peaked at 69 percent in 2006 after averaging 64 percent in the 1980s and 1990s. As the authors explain, “homes were more likely to be located away from Central Business Districts (CBDs) and occupied by households of limited means than at any other time in U.S. history.”

Spending on gasoline is a major expense in an average-income household’s annual budget, and an even greater one for poor, indebted, suburban households. Between 2005 and 2008, gasoline prices more than doubled to an average cost of $3.35 a gallon. In 2008, gasoline comprised 5.4 percent of average household expenditures, a 59 percent increase from the year 2000. But for the poorest fifth of households, the costs of a typical commute from the suburbs would have comprised a whopping 41 percent of expenditures by 2008. In addition, consumers likely did not anticipate rising gas prices prior to the recession, nor incorporate them into their home purchasing decisions. This left households with long commutes especially vulnerable to energy shocks.

By 2008, a spatial pattern emerged in neighborhoods beset by housing price declines and foreclosures. The authors’ analysis of 30,434 zip codes covering 269 metropolitan areas across the U.S. shows that the housing market collapse disproportionately harmed suburban districts. In fact, the losses in home values are associated with a home’s distance from the CBD. Not only did home values dip first in exurban zip codes, but the outer suburbs have also seen a smaller recovery in prices than areas that are close to cities.

The authors conclude that the gasoline price shocks, magnified by unstable financial markets, exposed the underlying weaknesses in the housing market and pushed the economy into a sharp recession.

A graph shows the relationship between gas prices and home prices in the years leading up to the housing market collapse.

Sources: Energy Information Administration and S&P/Case-Shiller Home Price Indices