Bursting the Bubble: Analyzing the Real Estate Market

Reflections on the Crisis

“So far, prices have dropped only slightly. But it was enough to cause alarm around the world…Prices are going to fall much lower. The Federal Reserve began a series of interest rate increases in 2004. We were hoping to bring the speculative excesses in the real estate sector under control. We failed. We tried it again in 2005. Failure”-Alan Greenspan, Former Federal Reserve Chairman

“The fact housing was something of a bubble was not hidden. A lot of people, including me, have been saying that the country has been spending more than it’s been producing and that can’t go on indefinitely, and that will have to come to an end. And the question is, does it come to an end with a bang or whimper? And we’re testing that proposition.”-Paul Volcker, Former Federal Reserve Chairman

“People in the market are in a competitive environment. Let’s say some people say this is unsound. Then they stop lending. But the others will continue lending. And the guys who stop lending probably lose their jobs because they are not performing. You go on until the music stops. If you stop too soon you will not be on the floor. That’s what happened here.”-George Soros, International Financier and Speculator

Summary Crisis Timeline

• 2004: Federal Reserve begins raising interest rates up from historic lows, will lead to 17 consecutive rate increases.

• 2005-early 2007: Rising rates begin to slow new construction, subprime mortgage defaults tick up

• 3/2007: New Century Financial, the second largest US subprime lender, suspends its shares and then declares bankruptcy a month later.

• Summer 2007: Subprime defaults cause mortgage backed security prices to fall. Several Bear Sterns hedge funds collapse. Markets decline as firms sell off assets to raise liquidity to de-leverage and cover subprime losses

• Summer-Fall ΄07: US Fed and ECB inject large amounts of cash into markets to ease liquidity demand. Results are lackluster given the amount of intervention.

• Fall ΄07 – Present: Liquidity is still tight despite low (i.e. near negative real) interest rates. Defaults continue to climb.

What Are We Actually Dealing With?

Two Major Issues:

– Real Economic Effects

– Lack of Liquidity

Possible Variables

• Housing Prices• Capital Stock• Macroeconomic

Indicators• Real Economy

Indicators (e.g. capital investment)

What Not to Do (1)

Simply drop housing prices– The model does not

factor in our current monetary tightness…it will just assume people buy up the cheap housing

What Not to Do (2)

Alter amount of capital stock– Optimal level of

capital stock cannot be changed directly

– Actual level of capital stock is not actually changing

Possible Strategies (1)

• Extrapolate a macroeconomic forecast– Pros

• Easy• Data is fairly easy to come

by (e.g. forecasted GDP)– Con(s)

• Imprecise – Only as good as the

forecast – Does not target housing

specifically

Possible Strategies (2)

• Change residential/ nonresidential fixed investment– Pros

• More specific than just using a GDP forecast

• Can be done with either national or regional data

– Cons• Forecasts not as readily available• Input calculations can be done

without a forecast but require many assumptions

Other Considerations

• Business Planning (covered in Session 1)

• Fiscal Stimulus (covered in Session 3)

• Monetary Stimulus (need outside assumptions to derive probable change in investment)

• Institutional Reform (again, need outside assumptions to derive probable change in investment)

Congratulations!This session completes the basic portion of Policy

Insight training

Coming Up Next Week:Session 7 (Advanced): The

Housing Price Equation