Introduction to Finance

DISCUSSION QUESTION 3
It is important to own a home? Why, or why not?
credit rating 
indicates the 
expected likelihood that a borrower 
will pay a debt according to the 
terms agreed to 
credit score 
a number that 
indicates the creditworthiness or 
likelihood that a borrower will 
make loan payments when due
prime mortgage 
home loan made 
to a borrower with a relatively 
high credit score indicating the 
likelihood that loan payments will 
be made as agreed to 
subprime mortgage 
home loan 
made to a borrower with a relatively 
low credit score indicating the 
likelihood that loan payments 
might be missed when due 

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7.7 Role of the Individual in the 2007–08 Financial Crisis
185
7.7
Role of the Individual in 
the 2007–08 Financial Crisis
Early Factors
CRISIS
The “seeds” that culminated in the 2007–08 fi nancial crisis were sown at the beginning 
of the twenty-fi rst century. Businesses emphasized cost cutting and improved operating effi
-
ciencies in the latter part of the 1980s. These eff orts, coupled with a nearly decade-long eco-
nomic growth in the 1990s left the United States awash with vast amounts of unused fi nancial 
capital. The U.S. economy benefi ted further from large expenditures to, hopefully, minimize 
the so-called “Year 2000 (or Y2K)” problem associated with the fact that many computer 
programs used only two digits to indicate the year. For example, 1901 was coded as “01” and 
1999 as “99.” No one was sure what would happen when the fi rst year of the new century was 
designated as “00.” As a result, large precautionary expenditures were incurred to hopefully 
minimize potential problems. 
The late 1990s saw the Internet “bubble” in the stock market—stock prices rose out of 
proportion from the ability of fi rms to generate earnings or cash fl ows. In particular, “high-
fl ying” stocks included Internet or “tech” oriented stocks. Some forecast the end of 
long-standing business models and the genesis of new ways of doing business with the Internet 
and information as tools to gain profi ts. However, the movement from “brick and mortar” fi rms 
to “e-commerce” fi rms did not pave the way to a “new economic world,” and the Internet/
tech bubble burst. 
Stock prices peaked in 2000 and began a rapid decline. The falling stock market, coupled 
with a slowing post-Y2K economy and a recession in 2001, encouraged the Federal Reserve 
System to lower interest rates to try to stimulate spending, borrowing, and economic growth. 
The terrorist attacks of September 11, 2001, added concern and uncertainty about the economy. 
To assist the economy, the Federal Reserve maintained liquidity of the fi nancial sector and 
continued to lower interest rates. The Federal Reserve System was covered in Chapter 4, 
and we discussed the role of the Federal Reserve Board as a major policy maker group in 
Chapter 5. 
Fiscal policy became stimulative, with increased government spending and the passage of 
tax cuts in 2002. Fiscal policy infl uences economic activity through taxation and expenditure 
plans, and it is carried out by the president and Congress with the support of the U.S. Treasury. 
We discussed the role of fi scal policy in Chapter 5. Overall, the setting of low interest rates, 
fi scal policy stimulation, and the resulting economic growth helped to create an environment 
conducive to excessive spending and borrowing. 
A Borrowing-Related Cultural Shift 
On the whole, U.S. consumers had in the past limited their use of debt, but over time the 
American psyche changed to wanting sooner, if not instant, gratifi cation with respect to buy-
ing large-ticket items. Rather than saving and waiting to purchase expensive items, the use of 
credit cards rose. Borrowing now replaced “save now, buy later” as a spending philosophy. As 
we saw earlier in the chapter, the personal savings rate exceeded 10 percent in the 1960s and 
1970s before declining to high single-rate levels in the 1980s and 1990s. During the fi rst half 
of 2000s decade, the personal savings rate declined to a 2 to 3 percent level that coincided with 
increased subprime mortgage loans and other large amounts of borrowing. However, probably 
as a result of the onset of the 2007–08 fi nancial crisis and the 2008–09 Great Recession, indi-
viduals increased their personal savings rate to more than 5 percent of their disposable income.
The cultural shift that allowed the public to “spend now, pay later”—rather than their 
parents’ or grandparents’ philosophy of “save now, spend later”—also aff ected household 
budgets. In addition to carrying a home mortgage and/or car loan or lease payments, indi-
viduals increased their use of high interest rate credit card debt. The growing use of debt 
during most of the decade of the 2000s resulted in a larger portion of U.S. household budgets 
being used to service debt—repaying both the principal and interest on borrowed funds.

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186
C H A PT E R 7 Savings and Investment Process
U.S. government offi
cials engaged in eff orts during the 1990s and the decade of the 2000s 
to expand home ownership by encouraging lenders to make mortgage loans available to a 
broader spectrum of individuals. The typical, traditional home loan has been a 30-year, fi xed 
interest rate amortized loan involving a constant monthly payment that would result in a zero 
loan balance at maturity. These traditional home loans also typically required a 20 percent 
down payment. In order to increase the number of individuals who could qualify for home 
ownership, alternative mortgage loan instruments were developed and in some instances 
credit standards were lowered.
As discussed earlier in this chapter, the traditional fi xed-rate mortgage was often replaced by 
an adjustable-rate mortgage called an ARM. Mortgage lenders often off ered initial below market 
interest rates on ARMs, as well as off ering subprime mortgages to borrowers with relatively low 
credit scores, which suggested a likelihood that loan payments might be missed when due. Soon 
after the housing price bubble burst in mid-2006 and the economy began slowing in 2007, poorly 
qualifi ed borrowers began defaulting on their mortgages. Developments in the mortgage markets 
were major contributors to the severity of the 2007–08 fi nancial crisis and contributed to the 
2008–09 Great Recession. Of course, while individuals were ultimately responsible for entering 
into very risky home mortgages, they were encouraged to do so by government offi
cials, govern-
ment-supported agencies, and mortgage originators and fi nancial institution lenders.
As the United States moved into the second decade of the twenty-fi rst century, individuals 
and businesses have been using less fi nancial leverage (i.e., they have been de-leveraging). 
More prudent use of credit seems to be occurring. This use of less credit, accompanied by 
moderate economic growth and the recovery of housing prices, has resulted in improved eco-
nomic conditions for individuals.
Applying Finance To...