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Chapter 12: Q.17 (page 344)

How did a decline in housing prices help trigger the subprime financial crisis that began in 2007 ?

Short Answer

Expert verified

The financial crisis of 2007鈥�2008, also known as the subprime mortgage crisis, was caused by the collapse of the U.S. housing market, which caused severe reductions in liquidity in global financial markets.

Step by step solution

01

Concept Introduction

Before the financial crisis of 2007, the deregulation of banks allowed providing credits to borrowers with low credit scores who were generally not considered credit worthy. Such borrowers were provided housing mortgages relatively easily than before.

02

Explanation

The banks were taking the homes as a mortgage so that if the person who has taken the loan does not pay the EMI or repay the loan the bank can sell the home and recover the amount.

For example, when the bank gave the loan the home cost was 100 million, but due to the housing market decline, the home cost declined to 90 million for example.

Then if the loan buyer defaults the bank will not be able to recover the full loan amount as the home prices themselves have declined.

03

Final answer

This triggered losses for banks and subprime crises. It is called subprime because the person whom the bank gave loan was sub prime i.e low creditworthiness.

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Most popular questions from this chapter

Define 鈥渇inancial frictions鈥� in your own terms and explain why an increase in financial frictions is a key element in financial crises.

What technological innovations led to the development of the subprime mortgage market?

Some countries do not advertise that a system of deposit insurance like the FDIC in the United States exists in their banking system. Explain why some countries would want to do that.

What is a credit spread? Why do credit spreads rise significantly during a financial crisis?

. Go to the St. Louis Federal Reserve FRED database, and find data on house prices (SPCS20RSA), stock prices (NASDAQCOM), a measure of the net wealth of households (TNWBSHNO), and personal consumption expenditures (PCEC). For all four measures, be sure to convert the frequency setting to 鈥淨uarterly.鈥� Download the data into a spreadsheet, and make sure the data align correctly with the appropriate dates. For all four series, for each quarter, calculate the annualized growth rate from quarter to quarter. To do this, take the current-period data minus the previous-quarter data, and then divide by the previous quarter data. Multiply by 100 to change each result to a percentage, and multiply by 4 to annualize the data.

a. For the four series, calculate the average growth rates over the most recent four quarters of data available. Comment on the relationships among house prices, stock prices, net wealth of households, and consumption as they relate to your results.

b. Repeat part (a) for the four quarters of 2005, and again for the period from 2008:Q3 to 2009:Q2. Comment on the relationships among house prices, stock prices, net wealth of households, and consumption as they relate to your results, before and during the crisis.

c. How do the current household data compare to the data from the period prior to the financial crisis, and during the crisis? Do you think the current data are indicative of a bubble?
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