The Creation of a Housing Bubble

Speculative Bubbles

USA 2002 - 2007Holland 1634 - 16371996 - 2000

Economic Bubbles have existed throughout history!

People don’t change: fear & greed drive economic cycles….

Business Cycle

?

2000

1990

’s T

echn

olog

y B

oom

2001

2006

Hou

sing

Bub

ble

2008-09

2011

Great R

ecession

Buying a house (before the year 2000)

• 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– (This meant the monthly payment stayed the same)

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

New Subprime Mortgages

• Subprime mortgages introduced in the year 2000– Required no down payment

– borrowers had very poor credit history

• Mortgages often had low initial interest rates – which adjusted up later

– This led to rising monthly payments in the future

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

New Value of house: $800,000

Homeowner walks away as home price falls & mtg. rates ↑ => Banks now have to foreclose on house and take large loss => this led to bank failures => Gov’t felt forced to “bail out” banks to avoid financial collapse

Major Problem!

Subprime Mortgage Analysis

• Subprime loans created a credit bubble in the USA– In the short run, this caused home prices to rise

– In the long run, this led to:• “artificially inflated” home prices

• people unable to pay their mortgage when interest rates rose

• Current Housing Situation: – home prices are falling

– consumers are losing their homes to foreclosure– banks have failed (due to losses on subprime mortgages)

– U.S. Government has “bailed out” banking & auto industry

FNMA & FHLMC

Government takeover of companies that issued mortgages

AIG Insurance Company

Government Takeover

Wall Street Firms Bankrupt or Bought

Bear StearnsMerrill LynchLehman Brothers

Government “Bailout” of “free market” economy?

Credit Crunch of 2010

Caused by

Credit Bubble

Led to

The Fed’s Dilemma

What happens when interest rates get to ZERO?

As interest rates approach zero =>Monetary Policy loses power!

http://www.gocomics.com/accounts/new?ref=nyt

http://www.gocomics.com/accounts/new?ref=nyt