Quiz 14: The Financial Crisis and the Great Recession


Housing bubble Housing bubble refers to the rapid increase in the prices of houses; this increase in prices is derived by demand and by speculation and the confidence level in the real estate market that there would be profits and benefits in buying and selling of houses. The 2000-2006 bubble scenario The United States witnessed a huge hike in housing prices; the prices of houses in real estate increased from 60 to 90 percent during 2000-2006. This increase in housing prices was due to two major reasons. They are as follows: • Increase in income • Low mortgage interest Increase in income increased the propensity to consume and the disposal of income; lower interest rate on mortgage loans allowed more people to buy houses.

Interest rate on mortgage-backed security The expected default rate on a particular mortgage-backed security is 4 percent per year, and treasury security carries a 3-percent annual interest rate. A low home mortgage rate will push the house prices up; as a result, owning a house will be more profitable than purchasing bonds or other assets. Hence, the interest rate on mortgage-backed security should be much higher than the treasury securities. Increase in expected default rate A low mortgage rate makes the house price to bubble and vice-versa. Hence, 8 percent increase in expected default mortgage interest rate will make the housing prices to fall steeper.

Differences between prime and subprime borrowers Prime and subprime borrowers are those borrowers who avail a credit from the bank. The bank classifies the mortgages to prime and subprime. When the bank differentiates prime and subprime borrowers with their past credit records, the differences are as follows. img