Appendix to Chapter 4: The Housing Boom and Bust1997–2011

• 1997 – 2006– Housing prices almost doubled– Bubble

• Mid-2006– Falling

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After adjusting for price changes from general inflation, the housing boom began in 1997, and home prices increased ever more rapidly until 2006. That marked the beginning of the housing bust, with prices dropping dramatically for several years.

Index of Home Prices, Adjusted for Inflation

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The Housing Boom• Causes for rapidly rising demand

– Economic growth – Low interest rates

• The Fed• Global financial forces

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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

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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

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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

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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

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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

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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

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Understanding Leverage

• Without leverage– 10% higher housing prices

• 10% capital gains• Pay $100,000 cash and price increases to

$110,000 - 10% capital gains

– 10% lower housing prices• 10% capital loses

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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

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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

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Leveraged Buying and Selling

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Understanding Leverage

• Simple leverage ratio is a “Rate-of-return multiplier”

• Rate of return on the (leveraged) investment equalsRate of change in a home’s price x the leverage ratio

10 % price increase x 5 = 50% rate of return

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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

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