Cause or Trigger of Crisis

The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006. High default rates on “subprime” and adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. […] However, once interest rates began to rise and housing prices started to drop moderately in 2006– 2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Falling prices also resulted in 23% of U.S. homes worth less than the mortgage loan by September 2010, providing a financial incentive for borrowers to enter foreclosure. [1]

This quote identifies two forces that influenced the demand for housing in 2007–8. The first was expectations of future home prices. One of the gains from owning a house is the possibility that you can sell it at a higher price in the future. Prior to 2007, there had been a fairly consistent tendency for house prices to increase, but the quote seems to indicate that people began to doubt that this trend would continue. As a consequence, the demand for new homes decreased. The second force in the market for new housing was the availability of credit. Most households buy a new home by obtaining a loan (a mortgage) to cover some of the price of the house. During 2007 and 2008, it became increasingly difficult to obtain a mortgage. This was in contrast to a few years earlier when lending standards were easier, and many households easily qualified for mortgages. These forces affect market demand. The anticipation of lower home prices in the future implies that fewer individuals will choose to buy a home now. Further, if financing is more expensive, then less housing will be purchased. These effects operate given the current price of housing. That is, at any given current price of houses, a smaller quantity of houses is demanded. The market demand curve shifts leftward: at each given price, market demand is lower. The shift in demand is shown in Figure 4.6 “A Decrease in Demand for Housing”. Once the demand curve shifts, the market for new houses is no longer in equilibrium. At the original price, there is now an imbalance between supply and demand: at that price, buyers want to purchase fewer homes than sellers wish to sell. To restore equilibrium in the market, there needs to be a reduction in housing prices and a reduction in the quantity of new houses produced. The decrease in production comes about because the lower price of houses makes suppliers less willing to produce houses for the market. The shift in the demand curve leads to a movement along the supply curve.

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