Introduction to Finance

2.1
The 2007–2008 Financial Crisis
CRISIS
A number of negative economic and fi nancial trends and events all came together to 
contribute to the fi nancial crisis of 2007–2008 and the Great Recession of 2008–2009. A rapid 
decline in housing prices began in 2006. This led to increased unemployment, fi rst in housing-
related activities and then more broadly. As a result, many homeowners were forced to default 
on their home mortgage loans. These developments occurred at a time when individuals, 
fi nancial institutions, and business fi rms were heavily in debt. The result was a so-called “per-
fect fi nancial storm” accompanied by a fear that the fi nancial system might collapse. 
While there continues to be some disagreement as to specifi c causes of the fi nancial 
crisis, most economists and others trace the beginning of the crisis to the bursting of the U.S. 
housing bubble in mid-2006. For a period of time prior to mid-2006, housing prices were 
continually rising year over year with some areas of the United States experiencing annual 
double-digit housing price increases. The fi rst part of the twenty-fi rst century was a time 
when U.S. federal government policies encouraged home ownership. Lenders were willing to 
lend to fi nancially “risky” borrowers seeking mortgage loans to make home purchases, and 
individual borrowers were willing to take on excessive amounts of mortgage debt, all in the 
belief that housing prices would continue to rise. Once housing prices began to decline, many 
homeowners had the equity in their homes “wiped out” and many mortgage loans became 
“underwater,” which occurs when mortgage debt on the home exceeds the value of the home. 
This rapid decline in housing values was accompanied by a major loss of jobs in home con-
struction and related industries.
Many home mortgage loans were combined into “pools” of loans, and then mortgage-
backed securities were issued with the mortgage loan pools as backing, or collateral. 
Large amounts of mortgage-backed securities were held by banks and other fi nancial 
1
John Kenneth Galbraith, The Age of Uncertainty, (Boston: Houghton Miffl
in, 1977), Print.

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2.2 Process of Moving Savings Into Investments
23
institutions, and as home prices collapsed it became clear that these mortgage-backed securit-
ies had been previously overvalued and they also declined sharply in value. A “credit crunch” 
occurred when banks and other fi nancial institutions found that they did not have adequate 
equity capital to cover their large mortgage loan and other debt commitments. As a result, 
fi nancial institutions were forced to lay off many employees. Businesses found it diffi
cult to 
borrow from banks and other fi nancial institutions because of the credit crunch, causing even 
higher levels of unemployment. 
During 2008, the federal government helped some fi nancial institutions to merge, “bailed 
out” a number of institutions and businesses, and allowed other fi nancial institutions to fail. 
The fi nancial crisis and associated credit crunch were accompanied by the 2008–09 economic 
downturn, which began in early 2008 and ended in mid-2009 with economic activity declining 
more than 10 percent and the unemployment rate exceeding 10 percent. The 2008–09 eco-
nomic downturn is referred to as the Great Recession since it involved the largest economic 
downturn since the Great Depression of the 1930s.
We will discuss more details relating to the fi nancial crisis and the Great Recession at 
various points throughout the fi rst two parts of this textbook. In this chapter we begin with a 
discussion of money and the monetary system. Many economists and others believe there is a 
link between the supply, or availability, of money and economic activity. The argument is that 
monetary policy makers can stimulate economic activity through increased monetary liquid-
ity by making more money available (at lower borrowing costs) to businesses, investors, and 
others. It is presumed that the investment of these low-cost funds will result in more economic 
growth. However, there is a diff erence of opinion as to how direct the relationship is between 
the availability of money and economic activity. We will provide further discussion later in 
the chapter.