Chapter 11 The Housing Bubble Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

11-2 Chapter Outline How Much Is a House Really Worth? Mortgages How to Make a Bubble Pop Goes the Bubble! The Effect on the Overall Economy

11-3 How Much is a House Really Worth “location, location, location” –Amenities of a Community –Neighboring Property Amenities of Home –Size –Lot Size –Bedrooms –Bathrooms –Pool/Trees/Appliances –Age of Expensive replacements Roof Carpet Heating & Air Conditioning

11-4 Case-Shiller Index

11-5 Mortgages Traditional (Until late 80s) –80% Loan to Value –15, 20, & 30 Year payouts Traditional (now) –90%-100% Loan to Value –PMI –15, 20, & 30 Year payouts Interest Only –100% Loan to Value –PMI –Interest portion of payment for first 5 to 10 years Negative Amortization –100% Loan to Value –PMI –About half of interest portion for first 5 to 10 years

11-6 Traditional Mortgage Payment Number Traditional Mortgage PaymentInterestBalance 0250,000 11,3421,042249,700 21,3421,040249,398 31,3421,039249,095 41,3421,038248,791 :::: :::: 3581,342172, ,342111, ,34260

11-7 Interest Only Mortgage Payment Number Interest-Only for 5 Years PaymentInterestBalance 0250,000 11, ,000 21, ,000 :::: 591, , , , ,4611,042249, ,4611,040249,159 :::: 1221, , , ,827 :::: 3581,461182, ,461121, ,46160

11-8 Negative Amortization Payment Number Negative Amortization 5-years PaymentInterestBalance 0250, ,042250, ,044251, ,046251, ,048252,090 :::: ,175282, ,178283, ,6561,180282, ,6561,178282,297 :::: 3581,656213, ,656141, ,65670

11-9 How to Make a Bubble Fundamental Determinants of Housing Value –Location –Amenities –Interest rate Non-Fundamental Determinants –Expectations that prices will rise in the future causing increased demand now. This is a prescription for a bubble.

11-10 Are These Houses Affordable? Median Family Income Median Sale Price of an Existing Single- Family Home Annual Mortgage Payments (30 years, 6% interest) Homeowner s Insurance* Property Tax* Total Annual Housing Costs Home Costs as a Percentag e of Income Phoenix$64,200$257,400$18,519$2,000$4,000$24, % Los Angeles$59,800$589,200$42,391$2,000$4,000$48, % Washington$97,200$430,800$30,994$2,000$4,000$36, % Miami$49,200$365,500$26,296$2,000$4,000$32, % Las Vegas$63,900$297,700$21,418$2,000$4,000$27, % Cleveland$62,100$130,000$9,353$2,000$4,000$15, % Dallas$65,000$150,900$10,857$2,000$4,000$16, %

11-11 Most Affordable 1. Lima, Ohio 2. Cumberland, Maryland 3. Youngstown, Ohio 4. Canton, Ohio 5. Davenport, Iowa

11-12 Least Affordable 1.Salinas, California 2.Santa Barbara, California 3.Los Angeles, California 4.Anaheim, California 5.Merced, California

11-13 Vocabulary of 2008 Securitization: The process by which mortgages are bundled into groups and sold as investment instruments. –Done by Fannie Mae and Freddie Mac –Geographically diversity Credit Default Swap –Insurance against the loss of principal –Unregulated –ING AIG were large purveyors as were many investment banks Goldman Sachs Lehman Bros

11-14 Vocabulary of 2008 Subprime: A mortgage issued to –A borrower with a lower credit rating –Someone for more than a house is listed Liar Loans –Income and assets are unverified or overstated

11-15 POP Goes the Bubble! 1)When people cannot make payments this puts more homes on the market. 2)When more homes are on the market, the price falls. 3)When the price falls, the expectation of future increases ends. 4)The ability to borrow equity to make payments ends and more homes are on the market. 5)Repeat steps 1) through 5)

11-16 The Risk to the Overall Economy Lower aggregate demand –Less equity to buy large ticket items, vacations etc. –Higher interest rates because of higher default rates –Tighter credit standards for all loans