Reference no: EM132903530

Question - For decades, Phoenix, Arizona, was prospering. It's sunny, dry weather attracted retirees from colder and wetter climates in the United States, and the technology industry brought thousands of new jobs to the city. The boom in Phoenix was reflected in the area's housing prices. Starting in September 1992, the average price of a home in Phoenix rose for 166 consecutive months, in the process increasing by almost 250%. All that began to unravel in June 2006 when house prices started to fall. They reach bottom in August 2011, dropping more than 56% in 5 years. It was bad news for home owners in Phoenix, but financial markets helped spread this bad news around the world.

Consider the position of a home buyer who purchased a $300,000 home in Phoenix in June 2006. Suppose that the buyer purchased the home with $30,000 of his or her own money and a 30-year mortgage for $270,000 obtained from a local bank. Five year later, the home was worth just $150,000, much less than the outstanding mortgage balance, meaning the home buyer has a negative equity in the house. Many home buyers in this position defaulted on their mortgages. Through a process called securitization, mortgages that had been taken out by home buyers in Phoenix were sold to banks and other investors all over the country; thus mortgage defaults had consequences that were felt a long way from Arizona desert.

Although the decline in house prices was more sever in Phoenix than in most other places, home prices were falling in nearly every major U.S. city, and mortgage defaults were rising rapidly. The nation's largest banks appeared to be near collapse in 2008, which led U.S. government to take a variety of steps in an attempt to "bail out" ailing financial institutions. Credit became more difficult for borrowers to obtain, contributing to the deepest and longest lasting recession since the Great Depression.

The experience of the financial crisis and the recession that followed illustrates how important financial markets are to be functioning of a market economy. Financial markets help transfer funds from savers to borrowers and the smooth flow of credit is vital to the health of the economy. When that flow is interrupted and firms are denied access to credit, they invest less and hire fewer people. In this chapter, you will see how financial markets help allocate capital, and you will learn about efforts that policy makers have made to try prevent another financial crisis.

Reaction on the case presented above. Include details on how the financial market environment played a role in its rise and fall.