1. “The problem with the economy is the loss of close to $6 trillion in housing wealth and an even larger amount of stock wealth.” -Dean Baker To understand what exactly got us into the current recession, we must analyze why there was an asset bubble in the housing market. Some foreign and domestic investors had already placed money into the real estate market after the dot-com crash, viewing housing as a safe haven.

2. BuyRent Invest3, 1 1, 2 Do Not Invest1, 32, 1 Domestic and Foreign Investors New Potential Buyers It is not a typical game; each player is a single investor or new potential buyer, but his payoff’s are determined by what the majority of the other players do. In other words, an investor must consider what a typical new homeowner will do, not what any one particular homeowner will do, and vice versa. Game 1. The housing bubble begins The rational action for potential buyers would be to rent, because an initial investment had already been placed by some investors, and a quick glace at price to rent ratios (which had remained constant since WWII) would have told a well informed potential buyer to rent. Since political campaigning had placed an emphasis on homeownership, investors acted rationally to invest in real estate.

3. Regular LoanARMDeny Good 2, 21, 30, 0 Mediocre2, 11, 30, 0 Poor2, 01, 10, 3 Borrower’s Claimed Credit Lender The game has little strategy and some may hesitate to call it a ‘game,’ however this is because the incentives given to both sides simply dictate strategy. If the borrowers were required to be more truthful and the lenders had to consider risk while underwriting loans, then the game would play out much like any other game. Game 2. The bubbles grows Since all borrowers are given adjusted rate mortgages, then both investors and potential homeowners can purchase homes more easily, causing the bubble to grow. The advent of loans which required no background verification (No Income, No Job, No Assets, NINJA loans), allowed for borrowers to claim whatever they wished in order to obtain a loan. The passing of risk through mortgage backed securities and derivatives (along with deregulation) allowed lenders to carelessly underwrite ARM loans (which were more profitable than regular loans) to virtually everyone.

4. StaySell Continue Investing3, 3-1, 2 Stop Investing1, 10, 0 Domestic and Foreign Investors Homeowners Game 3. The bubble bursts As we can see through the iterated elimination of dominated strategies, the homeowner will choose to stay in their current house and the investor will continue to invest in real estate. Since this will lead to an ever increasing demand for housing (when factoring in new homeowners), the bubble will continue to grow. This is precisely what happened through around mid 2006, when housing prices peaked. As we can see from the model, this self reinforcing process of increasing prices would have continued because neither player has any incentive to deviate from their current action. However, as the ARM’s re-adjusted to a higher interest rate and the default rate on subprime loans increased, a relatively large percentage of homeowners were forced to choose the action sell. Once an investor realizes this, he will choose to stop investing and try to liquidate his assets to avoid a significant loss in net worth; thus the investor subsequently chooses the action stop investing. The combination of these two actions will lead to the bursting of the housing bubble.

5. Conclusion: Why did homeowners irrationally chose to buy in game 1, and why was it rational for lenders to underwrite loans to everyone in game 2? By using a simple game theoretic model, we are able to easily identify the factors which led to the observed outcomes. The answer to both questions given is political: The ‘ownership society’ pushed by President Bush and the republicans caused the deviation from the rational in game 1. Furthermore, the push for increasing the amount of minority homeowners by the democrats through subprime lending allowed for the deregulation of the banking industry, and thus provided incentives for lenders to underwrite bad loans. In both cases, the republicans and democrats simply wished to increase their support, and such actions by both parties played a critical role in undermining the economy and subsequently leading to the current recession.