How the housing market led to the Great Recession

1996 - 2000
USA 2002 - 2007
Holland 1634 - 1637
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.
https://www.youtube.com/watch?v=I5ZR0jMlxX0

Assume you buy a $500,000 house in Marin County
You put up a $100,000 down payment (20%)
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)

Total principal paid
Total interest paid
Loan Balance

(
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”

• 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

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!

• 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

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.

60 minutes video link http://www.cbsnews.com/stories/2008/01/25/60minutes/main3752515.shtml

Financial
Markets
Economist

2000 2006
2001
2008-09
2013

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

Caused by
Credit
Bubble
Too easy to get loans

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

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
6) a) @ 4% = $477 X 4 = $1,908 per month for 30-years
( fixed rate loan paying back all principal & interest in 30 years) b) @ 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