The Great Recession: Housing Bubble, Safety, and Global Downturn

This report examines the global downturn following the Great Depression, investigating whether the crisis stemmed from an addiction to safety or the housing bubble. It argues that while the housing bubble was the immediate cause, the addiction to safety played a major role, as financial institutions failed to create truly safe debt. The paper analyzes the impact of standard mortgage contracts, the Coase Theorem, and the effects of securitization, including its influence on aggregate demand and supply. It also explores policy responses, such as the Australian government's stimulus checks, and the role of shared responsibility mortgages. The report concludes by emphasizing that financial innovations aimed at creating safe debt triggered the crisis, highlighting the importance of government involvement in mitigating systemic risk. The analysis incorporates concepts like aggregate demand and supply, securitization, and government policies to provide a comprehensive understanding of the crisis.

Housing Boom or Addiction To Safety 1
HOUSING BOOM OR ADDICTION TO SAFETY
By (Student’s Name)
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Housing Boom or Addiction To Safety 2
HOUSING BOOM OR ADDICTION TO SAFETY
Abstract
This paper examined global downturn since the great depression to establish whether it
was addiction to safety or housing bubble. It is determined in this paper that housing bubble was
the immediate cause of the global downturn but the addiction to safety played the major role
leading to the downturn as financial institutions failed to create safe debt. The financial
innovations aimed at creating safe debt triggered the crisis of the downturn while the housing
bubble was the immediate cause.

Housing Boom or Addiction To Safety 3
Table of Contents
Abstract............................................................................................................................................2
Introduction......................................................................................................................................4
Question 1 (a)..................................................................................................................................4
Question 1 (b):.................................................................................................................................5
Question 2:.......................................................................................................................................6
Question 3:.......................................................................................................................................6
Question 4:.......................................................................................................................................7
Question 5:.......................................................................................................................................9
Question 6:.....................................................................................................................................10
Question 7:.....................................................................................................................................11
Conclusion and Recommendations................................................................................................13
References......................................................................................................................................15

Housing Boom or Addiction To Safety 4
Introduction
This paper looks at global downturn since the great depression to determine whether it
was addiction to safety or housing bubble. It is established in this paper that housing bubble was
the immediate cause of the global downturn but the addiction to safety played the major role
leading to the downturn as financial institutions failed to create safe assets. Thus, the financial
innovations aimed at creating safe debt triggered the crisis of the downturn while the housing
bubble was the immediate cause (Taillard nd).
Question 1 (a)
The standard mortgage contracts lacks the ability to adjust to the changing macro-
economic environment which devastated the United States economy and American middle class
through the amplification of losses of wealth via foreclosure externalities and translate wealth
losses into weak Aggregate Demand alongside and high unemployment via aggregate demand
externality (Siddiqi 2017). The big loss in wealth amongst indebted household compel them to
cut back on general spending (from AD0 to AD1) since they feel the need to save due to wealth
loss and also have poorer access to credit markets because of housing collateral loss (Engel,
George and Keller 2016). Propensity to cut back expenditure in face wealth losses remains
thrice as big for poorer households who also have high leverage levels. The aggregate demand
decreases because of wealth loss for indebted household which immediately becomes a challenge
to everyone in economy-whether they initially borrowed or not. For instance, a sharp decline in
spending by households who suffered the loss in wealth led to a sudden drop in employment
everywhere in the economy. The Joblessness in the US in between 2006 and 2009 was fueled by
such aggregate demand externality.

Housing Boom or Addiction To Safety 5
Question 1 (b):
Coase Theorem posit that when transaction is low, two parties shall bargain and reach the
efficient outcome in case of externality. However, in practice private individuals fail to the
externalities problem on their own. Coase Theorem shows that private economic actions are able
to solve externalities problem among themselves. Based on this theorem, if the trade in an
externality is feasible and no transaction costs, the bargaining among parties shall culminate in
efficient outcome irrespective of the original property rights allocation. Coase Theorem tackles
inefficiency triggered by standard debt mortgage contract by awarding the property rights to
externalities to a party and permitting the underlying parties to bargain their ways to effective
solution (Domurath 2017).

Housing Boom or Addiction To Safety 6
Question 2:
Amiri and Atif recommended the debt replacement with instruments like equity which
gives an excellent aggregate risk sharing through SRM (Ami and Atif 2016). This is where
instead of placing all house price decline burden on borrower, the risk is shared hence protecting
the borrower from downside risk by lenders and the borrower transfers some amount of gains to
lenders. Thus, it involves reduction of payment of mortgage proportionally whenever prices of
local house, as estimated by the index, plunge to mitigate the negative externality where debtors
lose at the expense of the lenders when the prices of house decline (Ami and Atif 2016).
For example, household who bought a one-hundred dollar home with 20 dollars as down-
payment lose all their home equity which is a negative externality if the house price decreased.
Here, the multiplier leverage is five and home equity change possessed by the debtor is merely
the multiplier for leverage multiplied by the percentage alteration in underlying asset price. It is
noted that mortgage holder shall never lose anything if debtor continues paying. If the decrease
in the price of house is more than twenty-five percent, the debt goes underwater and house will
worth less than mortgage. The debtor will choose to go bankrupt and the foreclosure follows as
the house goes in a fire sale. SRM would have prevented loss of wealth and reduction in
consumption and saved 2.50 trillion dollars loss in wealth by erasing the foreclosure externality
hence translating into a one-fifty billion dollar household expenditure (Ami and Atif 2016).
Question 3:
The private securitization has an effect of increasing likelihood of initiating foreclosure
within the 12 months of the first severe delinquency of mortgage by percentage mean foreclosure
rate of initiation. Securitization also surges foreclosure completion likelihood and lowers
modification probability based on how it is measured. As seen in the diagram below,

Housing Boom or Addiction To Safety 7
secularization will speed up the externality which then lowers spending from AD0 to AD1.
Securitization debt mortgages without securitizing shared responsibility mortgages makes the
government to favor the debt mortgages or lenders. This is because only the SRM contact has a
feature which is five percent capital gain sharing provision. This provision means that whenever
a home owner sells his house or refinances his mortgage, the lender will collect five percent net
capital gain on his house. Because capital gain on owner-occupied housing remains tax-exempt,
homeowners will still get to keep 95 percent of any gain in home value (Mian and Sufi 2017).
Because a lender can securitize a huge mortgage of mortgages together, the lender can fully
diversify uncertainty when a specific homeowner sells his property. Thus, the lender shall
receive a fairly stable flow of five percent capital gain from his mortgage pool. Therefore, the
five percent capital gain provision remains more than sufficient to remove the fourteen percent
up front cost added because of downside protection provided by lender.
Effects of secularization
Question 4:
Aggregate supply is the total output quantity which firms shall produce and sell or simply
the real GDP. The upward sloping AS curve is called short-run AS curve and showcase positive

Housing Boom or Addiction To Safety 8
relationship between real GDP and price levels in short run. AS slopes upward since when level
of price for an output rises while level of input remains unchanged, opportunity for extra profits
inspire additional production. Aggregate demand is amount of total expenditure on domestic
goods and service in the economy. Downward-sloping AD curve showcases relationship between
output price levels and the total expending quantity in an economy. Atif and Amir established
that the major culprit was the household over-indebtedness as opposed to the dominant
perspective that the challenges in intermediaries and ensuing disruptions in credit.
The above shows a shift in AD leftwards or inwards from AD0 to AD1 and a downward
movement along the supply curve. As people were already indebted, there had no money to
spend, and this reduced expenditure leading to new equilibrium level of E1 which is not at full
employment following the collapse of assets. This is because debtor held the most junior claims
on such underlying asset through house mortgages. As the prices of mortgaged house assets
collapsed, debtors incurred the great losses than lenders and hence greater wealth losses due to

Housing Boom or Addiction To Safety 9
leverage multiplier. They thus had nothing to spend and hence a downward shift of the AD as
shown above.
Question 5:
The Australian government policy or move was meant to increase expenditure by mailing
the 900$ to its citizens. This was a bonus payment from the government which aimed at
increasing spending and safeguarding economy from recession. This money was to be spent on
locally-owned businesses to keep their colleagues in employment. The 900 dollars was
specifically for the Australians earning below 100000 dollars per year (Malkin 2009). Thus
mailing people the 900$ checks implied increase in money supply which is monetary policy
(expansionary) to boots expenditure. The surge increase in supply of money is reflected in a
corresponding rise in nominal output, or GDP. Moreover, the increase in money supply shall
culminate in a rise in consumer expenditure and such an increase shall shift the AD curve
rightward while there would be a movement upwards along the AS curve resulting in higher
prices alongside more potential real output (Stout 2016). Thus, the AD would shift rightwards as
shown below:

Housing Boom or Addiction To Safety 10
As shown above, the AS is the Aggregate Supply curve while AD0 and AD1 are the
aggregate demand curves before and after mailing the checks (900$) respectively. Initially, the
Australian economy is at recession with equilibrium price level and output shown at point Er.
Mailing Australians the 900$ reduces interest rate and shift aggregate demand rightwards from
AD0 to AD1 which leads to novel equilibrium (Ep) at potential level of GDP output with a
comparatively small increase in level of price as it stimulates investment and consumption
(Fernandez and Aalbers 2017).
Question 6:
The wide adoption of shared responsibility mortgages and securitization to create safe
debt alone as demanded by Amir Sufi and Atif Mian would never deter a future financial crisis
according to the above articles. This is because Ricardo Caballero held that the best approach to
prospectively tackling the issues is when the government explicitly bear a significant portion of
systemic risk. This is because the surplus economies on net demand financial asset will rebalance

Housing Boom or Addiction To Safety 11
their portfolios towards the riskier assets and the asset-producer economies will have mainly two
polar alternatives (Easthope and Randolph 2018).
The government need to take care of supply of much of triple-A assets or let the private
sector assume the lead role with government backing only in the course of thrilling systemic
events. Adopting the public-private option within the asset-producing economies would be
effective since the major failure during the crisis was never in the ability of the private sector to
create triple-A asset via complex financial engineering, rather, it was in the systemic
vulnerability established by such a process (Gezinski and Gonzalez-Pons 2019). Thus, the good
aspects of such a process could be preserved while simultaneously finding a means of relocating
systemic risk constituent produced by this asset-creation task away from the banks and into
private sectors (for medium and small-sized shocks) and into the government (for extreme
events). This is achieved through ex-ante basis as well as for a fair free that might integrate any
concerns with size, systemic exposure and complexity of particular financial institutions
(Jayasundara et al. 2018).
Question 7:
The financial innovations aimed at the creation of safe debt triggered the crisis and it is
not true that it was created by the collapse in housing bubble. This is because the whole world
showed voracious demand for safe-debt instruments hence mounting intense pressure on United
States financial system alongside its incentives, expedited by the regulatory markets. Because
this crisis independently was a consequence of adversarial feedback loop between the original
financial industry’s tremors established to mitigate safe-assets divide and the fright linked to
muddle disentanglement of such sophisticated industry (Haley and Dajani 2015). This means that

Housing Boom or Addiction To Safety 12
financial industry failed to establish “safe” assets from lower quality ones’ securitization,
however, at cost of economy exposure to a systemic dread (Aitamurto 2016).
The IMF irrationally implemented a desperate move while searching for a novel mandate
which would merely justify its existence by singling out pre-existing global imbalances (massive
and persistent current account deficits) as fundamental global economy risks. Having convinced
the like-minded people globally and intellectually grounding it on devastating crisis usually
experienced by emerging economies running chronic current account deficits, IMF idea triggered
such crisis through its abrupt macroeconomic adjustments aimed at dealing with a sudden
reversal in net inflows which backed the past expansion alongside the deficit current account (so-
called “sudden stops”). This is because there was a global concern that the United States was
facing the fate that would inevitably drag the global economy into deeper recession (Mian 2013).
As the crisis eventually arrived, the mechanisms or innovations never resembled the
dreaded abrupt halt. During the crisis, on the contrary, net inflows in capital to the United States
showed a steadying source instead of a weakening one. As a whole, the United States did not
experience, not even remotely, the problem of the external funding. Thus, it was never the global
imbalances per-se, or at minim not via their conventional mechanisms, which need to be the
primary concern in such cases (Caballero 2010).
Thus, it can be correctly argued that the root imbalances stood a distinguished kind (even
though not related to worldwide imbalances): the whole globe, with inclusion of foreign central
banks alongside investors, but additionally several United States financial institutions, had the
ravenous safe debt instruments demand which placed intense pressure of the United States
financial system and its incentive leading to the cause (Mian, Sufi and Trebbi 2015). This is
because the increase in the demand for safe assets remained a fundamental consideration behind