The Cycling Economy
The Federal Reserve's Bank definition of a recession is very broad and provides insight as to why a recession might lead to declining home values. The FRB considers a recession to be several months of declines across the economic board, including real Gross Domestic Product, real income, employment, industrial output and wholesale and retail sales. The real estate market is highly correlated with the strength of the overall economy, which is cyclical. As the economy bottoms out, so does the housing market, causing residential real estate values to fall as the market corrects itself in response to a slower economy.
Increased Inventory of Homes
When unemployment rises and real incomes fall, more homeowners experiencing financial difficulty are forced to sell their homes. Depending on the severity of the recession, this can add a substantial amount of homes to the existing inventory of homes for sale. This reflects an increase of supply relative to demand. When supply increases relative to demand, this causes underlying asset values to decline. Additionally, unemployment stifles demand, because people who aren't working do not buy new homes. This creates additional downward pressure on home values.
Longer Periods on the Market
When the supply of homes on the market increases, this causes the average number of days required to sell a home to increase. Each additional home on the market adds to the competition and the amount of time and resources needed to market and sell homes. Particularly during a recession, homeowners feel additional pressure to sell their home quickly, therefore, they are willing to accept discounts to speed up the sale process. These discounts, of course, lead to declining home values.
Decreased Availability of Financing
The most recent recession provided a clear example of how home financing can dry up during a recession. When the market for collateralized debt obligations collapsed due to concerns about the quality of underlying asset, this severely impaired lenders' abilities to securitize the mortgages on their balance sheets. This resulted in less liquid capital available to use to finance new home sales. Also, mortgage lenders lend more conservatively during recessionary periods, which cut prospective home buyers with the lowest credit scores out of the market. This decline in demand relative to supply causes home sales to fall.