Case Study: Housing Bubble, Financial Innovation, and Economic Crisis

This case study examines the US housing bubble and its contribution to the global economic downturn between 2006 and 2009. The assignment explores the safety of homeowners in the US economy, focusing on the externalities of standard debt mortgages and the role of financial innovations. It delves into the debate of whether financial innovations aimed at creating safe debt caused the crisis or if the collapse of the housing bubble was the primary cause. The case study analyzes the Coase theorem, shared responsibility mortgages, the views of Amir Sufi and Atif Mian, the impact of interest rate slashes, securitization, and global imbalances. It also discusses the views of Hammad and Ricardo Caballero on the securitization market and the financial crisis, ultimately aiming to understand the complex interplay of factors that led to the worst global downturn since the Great Depression.

Running head: CASE STUDY - HOUSING BUBBLE IN US ECONOMY
CASE STUDY - HOUSING BUBBLE IN US ECONOMY
Name of the Student
Name of the University
Author Note

1CASE STUDY - HOUSING BUBBLE IN US ECONOMY
Executive Summary
The aim of the report is to discuss on the safety of homeowners of the citizens in the US
economy. The analysis is being done about the externalities in the case of standard debt
mortgage. Do the financial innovations help in the creation of safe debts or the main cause
was the collapse of the housing bubble? This is discussed in relating to the article of Ricardo
Caballero. When talking about securities, they are referred to as investment securities
popularly known as stocks. However, equity securities are not the only type of security found
in the market. Securities are the financial investment units whose value is obtained from
assets that are kept underlying. Stocks are the types of securities that are derived when a
person has some ownership in the corporation, and underlying assets are used to derive bonds
and mutual funds as well. So, we can conclude that you just need an asset to make security
out of it.

2CASE STUDY - HOUSING BUBBLE IN US ECONOMY
Table of Contents
Introduction................................................................................................................................3
Discussion..................................................................................................................................3
Answer to Question 1(a):...........................................................................................................3
Answer to Question 1(b):...........................................................................................................4
Answer to Question 2:................................................................................................................5
Answer to Question 3:................................................................................................................6
Answer to Question 4:................................................................................................................7
Answer to Question 5:................................................................................................................7
Answer to Question 6:................................................................................................................8
Answer to Question 7:................................................................................................................9
Conclusion................................................................................................................................10
References................................................................................................................................12

3CASE STUDY - HOUSING BUBBLE IN US ECONOMY
Introduction
There is a mortgage facility introduced by the federal government to finance the
people who want to buy their own home. Such mortgages are introduced, keeping in mind the
safety of families so that they don't face any downturns that may affect the housing market.
The economic benefits of this idea are huge. It is believed that such securities should be taken
care of by the Federal Housing Finance Agency.
Housing is very important for the middle-class families as it helps them to sustain
their life, and they have security for a lifetime. But, the current mortgage system introduced
by the government has increased the risk for homeowners. If mortgages are replaced with
more of equity-like mortgages such as shared responsibility mortgage would help the housing
market to stabilize, and this will also help the homeowners from sudden economic
downturns.
Discussion
Answer to Question 1(a):
A home mortgage that is used to satisfy the normal mortgage definition is known as a
standard debt contract. This may have a great impact on the homeowners. Such debt contracts
make the homeowners bear before the loss is incurred by the lender (Jones, Gatzlaff and
Sirmans 2016). The use of debt contracts indicates that the loss is still being incurred by the
homeowners; instead, they should be borne by the investors.
Negative externality may be defined as a condition when the consumption of a good
or service impacts the third party who is not directly involved in the transaction. Thus,

4CASE STUDY - HOUSING BUBBLE IN US ECONOMY
anything that impacts the demand and supply of standard debt mortgage is known as a
negative externality (Badarinza 2019). Let us take an example where a homeowner bought
the house for $1,00,000 for which he uses a debt mortgage of $80,000. Remaining $20,000
were the share of the equity of the homeowner. After some days, if the price of the home
drops by 20%, which means that the home is now of $80,000. But, the interest payment on
the mortgage and the balance of mortgage remains the same. This case takes place quite often
when the homeowners face an economic downturn due to which they are less capable of
repaying the mortgage loan.
Figure 1: Effect of externality on standard debt mortgage
(Source: Created by the author)
Answer to Question 1(b):
Coase theorem was introduced by economist Ronald Coase. According to the
theorem, if the transaction cost reduces due to some reason, then both the parties will

5CASE STUDY - HOUSING BUBBLE IN US ECONOMY
mutually settle the transaction by agreeing to bargain. With the help of bargaining in the
transaction, both the parties will be able to reach an outcome when an externality is present in
between (Johnsen 2019). However, this theory doesn't work effectively for the homeowners
as they are not able to settle the problem on their own with the help of an externality.
From the above example, if the price of the house falls by 20% and the lender even
agrees to reduce the mortgage loan amount by 20%, then it will be helpful for the homeowner
since the reduction in the price of the home is not in his control. This, if the mortgage loan
amount also reduces, then he will have to pay less amount for the loan taken by him.
Answer to Question 2:
The mortgage contract that is generally promoted by various economists is the Shared
responsibility mortgage. In this type of mortgage, the principal balance and the interest
payments are connected to the price index of a local house that measures the value of all the
houses located in that particular zip code on an average basis. If the price of your neighboring
house falls, then the principal amount of your mortgage loan taken and the interest payments
also fall (Osipov et al. 2017). This way, the homeowner is relieved from the stress of high-
interest payments when it is needed the most.
Let us take an example where the principal balance and interest payments are reduced
by the same percentage as the price of the house falls. If the homeowner has to make a
monthly interest payment of $1,000 and suddenly the price of a house in his neighborhood
falls by 20%, then his monthly payment automatically reduces down to $800. If the prices go
up again by 20%, then the interest amount also rises to $1,000. It should be noted that the
payment amount can never exceed the original amount of interest and it remains the same as

6
Marginal Social Cost
Deadweight loss Marginal Private Cost
Marginal Private Benefit
Q2 Q1 Output
Costs, Benefits
P2
P1
P3
Q3
Marginal Social Cost1
CASE STUDY - HOUSING BUBBLE IN US ECONOMY
it was when the home was purchased, no matter how high the prices of the neighboring house
rises.
Answer to Question 3:
It is believed by the Regional banks that shared responsibility mortgage will help in
keeping the local market served by them stable (Elul 2016). Partner Own has begun the work
of funding from various regional banks so that liquidity can be provided for a new home
mortgage product.
Government favors debt mortgage and is not ready to accept the shared responsibility
mortgage since in the later it will not be able to raise high funds. If there is a reduction in the
price of houses in a particular zip code, then the government will start receiving low-interest
payments from all the houses that are purchased in the mortgage (Kruger 2018). But, as far as
debt mortgages are concerned the interest received by the lenders are fixed irrespective of the
fluctuations in the price of the houses.

7CASE STUDY - HOUSING BUBBLE IN US ECONOMY
Figure 2: Effect of Securitization
(Source: Created by the author)
Answer to Question 4:
The crisis between Amir Sufi and Atif Mian's views raised because according to them
the interest amount and the principal of the mortgage loan taken by a person should not fall
even if the price of the neighboring houses falls. It implied that even if the price of the house
of a neighbor falls, then it should not interrupt the dealing of a third person. The price of
one's own home should be considered as far as his mortgage loan is considered (Mian, Sufi
and Verner 2017). Since buying and selling of houses may depend on the aggregate demand
and supply of the property, the concept of shared responsibility mortgage was introduced
with the help of which almost everyone and anyone can be benefitted. Since when the
demand is greater than the supply of a product than its price automatically goes up and vice
versa. No such situations, the theory of shared responsibility mortgage was introduced to
avoid such crisis in the future.
Answer to Question 5:
When interest rate slashed in 2009 after people received checks from the Australian
government, this situation gave a sudden rise to the interest rates automatically. It was done
purposely to manage the slashed interest rates since people were continuously urging to
minimize high-interest rates that were originally charged for the mortgage loan taken.
With a decrease in the interest rates, the demand for mortgage loan increased in the
market eventually. Since the supply of funds were less, so it was not possible to meet the
increasing demand so, it was decided that the interest rates will be increased to reduce the

8
Q2 Q1 Output
Price
P2
P1
Supply
Demand
Demand1
CASE STUDY - HOUSING BUBBLE IN US ECONOMY
excessive demand. This was done specifically to meet the supply, which automatically
resulted in a rise of the interest rates.
Figure 3: Change in demand due to the effect of securitization
(Source: Created by the author)
Answer to Question 6:
According to Hammad, the securitization market can turn the risky financial market
into a safe debt market. But with the presence of loaders in between these debts are no longer
safe as they are collectively put at risk of another financial crisis (Siddiqi 2017). Thus, a
financial crisis is a sudden realization when the fact is realized that what was thought to be
safe is risky. A person needs to be proactive to avoid the situations of the financial crisis.
While on the other hand, Ricardo, when the financial crisis occurs the mechanism did
not have a resemblance or feared sudden stop. The U.S as a whole never faced a funding
problem as a whole or even partially (Caballero 2018). This should be noted that to keep the

9CASE STUDY - HOUSING BUBBLE IN US ECONOMY
financial crisis away, and global imbalances should not be treated through the conventional
mechanism.
Answer to Question 7:
There was a concern of global imbalance before the crisis, which referred to the
account deficit in the U.S and was financed by the periphery. The main effect of such a crisis
is an abrupt macroeconomic adjustment needed to deal with the reversal situation in the net
capital inflows, which supported the previous account deficit (Ben-David, Towbin and Weber
2019). The growth in the rate of GDP was due to an increase in debt generated by the
financial sector more specifically.
Debt liabilities also increased as the demand for safe debt instruments increased.
Central banks and foreign investors demanded such instruments and they were also
demanded by the U.S financial institutions (Holmstrom 2015). This resulted in safe-assets
imbalance in the world economy, and it was assumed that it would not go away so soon. This
gave rise to a very good profit earning the opportunity to the financial system of the U.S. The
U.S financial system decided to create safe assets to meet the rising demand which resulted in
putting enormous pressure on the U.S financial system and its incentives.
These conditions led to ripe situations, where the severe systemic plan came with
great pressure which was much more than anyone has ever imagined. The real estate prices
declined, which led to a significant rise in the subprime defaults. These shocks were still pale
in front of the magnitude of the crisis that was faced at that point of time. As a result,
underlying safe assets were already facing a structural deficit that worsened which further
increased the demand for safe assets. The interest rates were low to keep the level at standard
position.

10CASE STUDY - HOUSING BUBBLE IN US ECONOMY
The crisis took place because of the negative feedback of the financial industry. A
bridge was used to fill in the gap created between safe-assets and the panic that was
associated with the finance industry. The financial sector had the capability of creating safe
assets by securitizing the securities of lower quality. It has a cost associated with it, which
was that it demanded exposure of the economy to a systemic panic. This problem can also be
mitigated if the governments all over the world agree to absorb a larger portion of systemic
risk.
Various options are available to carry this procedure effectively. It ranges from the
surplus countries rebalancing their portfolios towards risky assets, private-public solutions
where the countries that are the asset-producers preserve positive parts of the securitization
industry when systemic risk is removed from the balance sheets of banks. The event that was
much triggering was that the real-estate bubble crashed and this leads to the rise in mortgage
defaults that were followed by it. This was not the only harm. The global financial system
was believed to be in the cardiac arrest mode and it was expected to implode more than once.
The real damage was caused due to non-functioning of the entire securitization industry and
its sudden freezing (Buchanan 2017). The senior and higher level trances were also not
perceived as invulnerable. All these resulted in the plaguing of the financial system. To
overcome such scenarios, the government should be given some liberty. If the governments
could so something in asset-producing countries, they would do it directly by issuing bonds
beyond their needs with the help of which they can, in turn, buy risk assets themselves.
Conclusion
If we try mortgages to house prices would result in reducing the likelihood of giving
rise to unsustainable bubbles initially. According to research, bubbles are fueled by debt as

11CASE STUDY - HOUSING BUBBLE IN US ECONOMY
they help in engendering false security among lenders. Lenders think that they are free from
all risks, and they are immune to the bubble since the risk is fully borne by the homeowners.
If the price of the house is tied to the mortgage payments, then the lender will automatically
start thinking before lending into an unsustainable housing boom.
It should be understood that a house is very important to middle-class, but the
mortgage finance system is set in such a way that excessive risk is borne by the homeowner
himself. If shared responsibility mortgages are introduced more in the financial system, then
it would stabilize the housing market, and this will also protect homeowners from directly
getting affected by economic downfall. Such benefits will cause the betterment of the entire
economy. The class chosen by the investors depends greatly on their level of avoidance of
risks involved, as well as their current strategy needs.

12CASE STUDY - HOUSING BUBBLE IN US ECONOMY
References
Badarinza, C., 2019. Mortgage debt and social externalities. Review of Economic
Dynamics, 34, pp.43-60.
Ben-David, I., Towbin, P. and Weber, S., 2019. Expectations During the US Housing Boom:
Inferring Beliefs from Actions (No. w25702). National Bureau of Economic Research.
Black, L., Correa, R., Huang, X. and Zhou, H., 2016. The systemic risk of European banks
during the financial and sovereign debt crises. Journal of Banking & Finance, 63, pp.107-125.
Buchanan, B.G., 2017. The way we live now: Financialization and securitization. Research in
International Business and Finance, 39, pp.663-677.
Caballero, R.J., 2018. Risk-centric macroeconomics and safe asset shortages in the global
economy: an illustration of mechanisms and policies. Available at SSRN 3253064.
Elul, R., 2016. Securitization and mortgage default. Journal of Financial Services
Research, 49(2-3), pp.281-309.
Holmstrom, B., 2015. Understanding the role of debt in the financial system.
Johnsen, D.B., 2019. A Coasean Approach to Cost-Benefit Analysis. Harv. JL & Pub.
Pol'y, 42, p.489.
Jones, T., Gatzlaff, D. and Sirmans, G.S., 2016. Housing Market Dynamics: Disequilibrium,
Mortgage Default, and Reverse Mortgages. The Journal of Real Estate Finance and
Economics, 53(3), pp.269-281.

13CASE STUDY - HOUSING BUBBLE IN US ECONOMY
Kruger, S., 2018. The effect of mortgage securitization on foreclosure and
modification. Journal of Financial Economics, 129(3), pp.586-607.
Mian, A. and Sufi, A., 2015. House of debt: How they (and you) caused the Great Recession,
and how we can prevent it from happening again. University of Chicago Press.
Mian, A., Sufi, A. and Verner, E., 2017. Household debt and business cycles worldwide. The
Quarterly Journal of Economics, 132(4), pp.1755-1817.
Osipov, V.S., Bykanova, O.A., Akhmadeev, R.G., Kosov, M.E., Bogoviz, A.V. and Smirnov,
V.M., 2017. External debt burden and its impact on the countries’ budgetary policy. Journal
of Applied Economic Sciences, 12(2), p.48.
Siddiqi, H., 2017. Certain and uncertain utility: A new perspective on financial
innovation. Economics Letters, 158, pp.7-9.