Speculative Bubbles

2002 - 2007Holland 1634 - 1637

1996 - 2000

1925-29

The Housing Market Crisis

• What Happened?

“The Economist” Magazine Covers During the Economic Crisis

The Housing Market Crisis

• What Happened?

Consumers were required to put a 20% down payment

• For a $500,000 home: – $100,000 down payment & borrow $400,000 (mortgage)– loan is paid back over 30-years at a fixed interest rate (ex: 6%/year)

• The loan is less than the value of the house– So banks are taking very little/no risk of default

PRIME MORTGAGES ONLY!!!

Buying a house (before 2000):

New Sub-prime Mortgages

• Sub-prime mortgages were introduced in the year 2000

• These mortgages required no down payment to borrowers with poor credit history

• Mortgages often had low initial interest rates which adjusted up later– Known as ARMs (Adjustable Rate Mortgage) or variable rate loans– Example: 2% interest rate/year for the first 3 years; after that the

interest rate changes to 9%/year– Personal example

Housing Bubble Analysis

Subprime Mortgage Example• Price Paid: $1,000,000• Down Payment: 0

• You owe: $1,000,000

Initial Value of House $1,000,000

Housing Bubble Bursts: New Value of House: $900,000

Homeowner now owes 1 million but only has a house worth $900,000. • Now he can’t refinance his loan and his house payments skyrocket when the loan resets.• If he can’t pay his monthly mortgage, the Bank will foreclose on his house!• Huge incentive to just walk away from the house.

Major Problem!

Subprime Mortgage Analysis

The Binge• Banks made loans to consumers who were not qualified with zero down

payments

• In the short run, this caused home prices to rise

• In the long run, this led to “inflated” home prices & people unable to pay their mortgage

• The Hangover: – home prices have fallen substantially – consumers are losing their homes to foreclosure– banks are failing (as they take the losses on foreclosures)

House of Cards

Caused by

Credit Bubble

Led to