CHAPTER 14

THE FINANCIAL CRISIS AND THE GREAT RECESSION

DISCUSSION QUESTIONS

3.   If the value of homes across the board decreases, mortgage-backed securities are much riskier because there is insufficient collateral to secure these loans.  If the borrowers are unable to make payments on these mortgages, the values at foreclosure might be less than the original loan amount.  As such, banks are in a precarious situation with no good options.  This situation implies greater risk which would lead to an increased rate of return for mortgage-backed securities, meaning a lower price for these securities.

4.   The significant decrease in housing prices would make both buying and building homes less attractive.  As a result, residential construction which is part of investment would decline significantly, decreasing real GDP.  The decline in construction would lead to substantial unemployment in this sector.  In addition, the decrease in home values would mean that homeowners have less wealth which generally leads to less consumption, another factor that would decrease real GDP.  These homeowners cannot obtain additional funds through second mortgages to purchase various items.  In fact, they may also have to cut back on some purchases if their mortgage rates increase because of limited or negative equity positions.  Declining consumption would lead to more unemployment in other areas.  Lastly, because most real estate purchases are financed through borrowing, the problems mentioned above could lead to significant issues in the banking and financial sectors.

5. Almost all economic activities require credit and banks are central to the credit system. If banks are in peril, they are less likely or able to make loans to consumers, business, and even governments.  As a result, these consumers, businesses, and governments will not be able to spend as much which would significantly decrease real GDP.

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