Economic Bubbles How the housing market led to the Great Recession

Econnomic Bubbles USA Holland Economic Bubbles (speculative bubbles) are when the price of an asset (stock, bonds, or even tulips!) strongly differs from the true economic value of an asset Economic bubbles have happened throughout history and reflect both “greed” and “fear” in human nature.

Buying a $500,000 home A $400,000 loan at a 4% fixed rate mortgage cost $1,908 per month over 30-years fixed rate loan paying back all principal & interest over 30 years With property taxes, full Payment is $2,408 per month Property Taxes in California = $500 per month on $500,000 home Both interest & property taxes are tax deductible (lower your income tax) Assume you buy a $500,000 house in Marin County You put up a $100,000 down payment (20%) Loan Balance Total interest paid Total principal paid

Buying a house ( Before 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 for 30-years) The loan was always less than the value of the house –So banks are taking very little/no risk of default –Consumers would not “walk away”

New Subprime Mortgages Subprime mortgages were introduced in the year 2000 –Required no down payment –Borrowers had poor credit history –Had very low initial interest rates –Interest rates eventually adjusted upward Called Adjustable Rate Mortgages led to rapidly 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: $700,000 Homeowner still owes 1 million but owns a house worth only $700,000 If they can’t pay their monthly mortgage, the Bank will foreclose on their house! Major Problem!

End Result of Subprime Mortgages In the short run they caused home prices to rise In the long run left people unable to pay their mortgage –consumers lost their homes to foreclosure Housing Bubble reached the peak in 2006 –home prices declined 30%-50% from the peak in 2006 –Banks had to be “bailed out” by the U.S. Government Banks had huge losses on foreclosed homes & subprime mortgages

Home Loans Bring Losses To Bank of America January 21, 2011 Bank of America on Friday reported a loss of $1.6 billion in the 4 th quarter after its costs related to soured home loans increased.

House of Cards 60 minutes video link

Economist Financial Markets

Recent Economic History Reading

Federal Funds Rate

U.S. Business Cycle ? ’s Technology Boom Housing Bubble Great Recession Internet Stock Collapse

Inside Job Want to learn more about the financial crisis? Good documentary on housing/banking crisis

Housing Bubble Analysis Caused by Credit Bubble Too easy to get loans

Loans turned into Mortgage Backed Securities Banks Makes Home Loans Banks sell Loans to Wall Street Wall Street turns them into securities Securities became worthless and Banks went Bankrupt

FNMA & FHLMC Government takeover AIG Insurance Company Government Takeover Wall Street Firms Bankrupt or Bought Bear Stearns Merrill Lynch Lehman Brothers Government Takeover of Subprime Mortgages

Interest Rate Worksheet 1)You never pay of the credit card bill! $5,000 X 20% = $1,000 per year in interest 2) $11,000 $10,000 = principal (loan) + $1,000 in interest 3) $10,200 +$200 in interest (but prices of goods rose => are you better off?) 4) Borrowers = LOW Savers = High 5) Borrowers love the Fed 4% = $477 X 4 = $1,908 per month for 30-years ( fixed rate loan paying back all principal & interest in 30 years) 8% = $734 X 4 = $2,936 per month for 30-years 7) $500,000 X 1.2% = $6,000 per year in taxes or $500 per month Full Payment for $500,000 home is $2,408 per month at 4.0% loan