The Crisis Unfolds

During the prologue to the crisis, the economy expanded along with consumer confidence and home prices. As mentioned toward the end of Chapter 4, the US had a “pleasant problem” because money was easy to come by, the Federal Reserve kept interest rates historically low, and the federal government was spending at historically high levels.1 Unfortunately, the good times could not last forever. By mid-2006, house prices in most regions of the country peaked (see Figure 4.7). Soon thereafter, borrowers ran into trouble with their mortgage debt because of rising interest rates on adjustable-rate mortgages or an inability to refinance. As borrowers struggled financially, so too did investors and financial institutions who owned MBSs, home mortgages, and other financial products tied to real estate. As the bubble in residential real estate burst, a financial crisis ensued. It was not long before the financial distress caused a decline in real activity. Indeed, between October 2007 and October 2008, $8 trillion in stock market wealth was lost and the economy officially slipped into a recession in December 2007.2 This chapter explains the first financial crisis of the twenty-first century as well as its spread to the real sector.