Appendix to Chapter 4: The Housing Boom and Bust1997– – 2006 –Housing prices almost doubled –Bubble Mid-2006 –Falling 1

After adjusting for price changes from general inflation, the housing boom began in 1997, and home prices increased ever more rapidly until That marked the beginning of the housing bust, with prices dropping dramatically for several years. Index of Home Prices, Adjusted for Inflation 2 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Housing Boom Causes for rapidly rising demand –Economic growth –Low interest rates The Fed Global financial forces 3

The Housing Boom Causes for rapidly rising demand –Government policy: encouraged home ownership Mortgage interest payments: deducted from taxable income Increased funding available for mortgage lending Higher capital gains exclusions on home sales 4

The Housing Boom Causes for rapidly rising demand –Financial innovations More-attractive terms for borrowers (ARM) Securitization: made mortgage-lending more attractive –Mortgage-backed securities –Deteriorating lending standards Subprime loans Declining down-payments –Speculation 5

The Housing Bust Mid-2006: a sudden drop in demand –Oil and gasoline prices spiked Many new homeowners were struggling to make ends meet –Interest rates on a large group of adjustable rate mortgages reset to higher levels –Disturbing rise in defaults Subprime mortgages with no down payments –Prospect of higher default rates 6

The Housing Bust Mid-2006: a sudden drop in demand –Interest rates on new mortgages rose –Demand curve for housing shifted leftward Housing prices fell –Speculation Demand curve shifted further leftward Housing prices fell even more rapidly 7

The Long Housing Slump End of 2008 through 2011 –The U.S. economy suffered the aftermath of an unusually severe recession –High unemployment and declining incomes Millions of homeowners struggling to pay their monthly mortgage bills More mortgage defaults 8

The Long Housing Slump End of 2008 through 2011 –Financial institutions foreclosed on close to 3 million homes Several million additional homes had received legal notices By mid-2011 –Average U.S. home price (adjusted for inflation) had fallen to 40% of its peak five years earlier 9

Understanding Leverage Without leverage –10% higher housing prices 10% capital gains Pay $100,000 cash and price increases to $110, % capital gains –10% lower housing prices 10% capital loses 10

Understanding Leverage Leveraged financial investment –Using borrowed money to buy a home –10% higher housing prices More than 10% capital gains –10% lower housing prices More than 10% capital loses Leverage –Magnification of gains and losses through borrowing 11

Understanding Leverage An owner’s equity in an asset –Difference between the asset’s value and any unpaid debts on the asset –Equity in Asset = Value of asset - Debt associated with asset Simple leverage ratio –Ratio of an asset’s value to the owner’s equity in the asset –$500,000 / $100,000 = 5 12

Leveraged Buying and Selling 13 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A.1

Understanding Leverage Simple leverage ratio is a “Rate-of-return multiplier” Rate of return on the (leveraged) investment equals Rate of change in a home’s price x the leverage ratio 10 % price increase x 5 = 50% rate of return 14

Understanding Leverage When asset prices rise –Leverage increases your rate of return dramatically When asset prices fall –Leverage increases the chance of wiping out your entire investment 15