1. Interest Rates & Economic Bubbles
How the housing market led to the Great Recession

2. Bonds & Interest Rates
Reflects the cost of borrowing money (or benefit of saving it!)
There are short term (Fed) & long term (10 year) interest rates
Bonds: are a loan to a Gov’t or business. Saver earns interest every year until paid back at maturity of bond.
If the company/Gov’t goes bankrupt => you will not be paid back!
You buy
a Bond
$100,000 cash
U.S. Gov’t Bond
10 -Year @ 3.0%
$3,000 per year interest
Plus $100,000 principal in 10-Years => Total = $130,000

3. Interest Rate Worksheet

4. Interest Rate Worksheet
Borrowers = LOW interest rates Savers = High
Expand Purchasing power (what about risk?)
Borrowers love the Fed!
Tesla is a credit risk: 3.0% vs 4.0%
You gain +1.0% more per year => On $100,000 => +$1,000 per year
But if Tesla goes bankrupt, lose -$100,000
20% down payment
$100,000 down payment (savings) and a $400,000 mortgage loan (debt)

5. Tesla vs. 10 year Gov’t 7.6% Interest Rate Tesla Bond Matures 2025

6. Interest Rate Worksheet
$200,000 down deposit & $800,000 loan
7) 4% = $477 X 8 = $3,816 per month for 30-years
fixed rate loan paying back all principal & interest in 30 years
8% = $734 X 8 = $5,872 per month for 30-years
8) $1,000,000 X 1.2% = $12,000 per year in taxes or $1,000 per month
9) Full Payment for $1,000,000 home is
a) $4,816 per month at 4.0% loan
b) $6,872 per month at 8.0% loan

7. Rent vs. Buy Analysis Assume you buy a $500,000 house in Marin County
You put up a $100,000 down payment (20%)
With property taxes, full Payment on 4.0% loan is $2,408 per month
Both interest & property taxes are tax deductible (lower your income tax) 
Rent vs. Buy:
You stop renting => what was the cost?
You give up use of $100,000 (where was it saved?)
You have a tax deduction & are paying down a loan
Price could fall or rise
Loan Balance year 30
Total interest paid
Total principal paid
Loan Balance year 1
$400,000
$0.0
Year Year 30

8. End Day 1

9. Buying a house (Before 2000)
Consumers were required to put a 20% down payment
For a $500,000 home:
$100,000 down payment & borrow $400,000 (mortgage)
loan is paid back over 30-years at a Fixed interest rate
(This meant the monthly payment stayed the same for 30-years)
The loan was less than the value of the house
So banks were taking very little/no risk of default
Consumers would not “walk away” or they would lose deposit

10. Amortization Schedule: Paying off the principal of a loan

11. Rent vs. Buy Analysis Rent or Buy:
Compare total cost of loan including all expenses vs. rent
Consider job stability, level of savings, expected time period
Consider transactions costs (6% real estate fee to sell)
Calculate ROI or CAP rate on rental properties
ROI = Return on investment CAP = capitalization rate
Total payments = $687,478
Loan Balance year 1
4.0%
Total principal paid = $400,000
Total interest paid = $287,478
Loan Balance year 30
Year Year 30
$0.0

12. Interest Rate Worksheet #2

13. Interest Rate Worksheet
You never pay of the credit card bill!
$5,000 X 20% = $1,000 per year in interest
2) $13, $10,000 = principal (loan) + $1,000 in interest per year
3) $13, (+ $600 in interest per year) (but prices of goods rose => are you better off?)
4) - $64 more per month
- $24,360 total payment
$4,360 interest & $20,000 principal
- $64 X 60 months = +$3,840 for an 8.0% loan versus a 1.0% loan!

14. New Subprime Mortgages
Subprime mortgages were introduced in the year 2000
Required no down payment
Borrowers had poor credit history
Had very low initial interest rates (teaser rates)
Interest rates were “adjustable”
Interest Rates increased rapidly in
led to rapidly rising monthly payments in the future

15. Housing Bubble Analysis
Subprime Mortgage Example
Price Paid: $1,000,000
Down Payment: 0
You owe: $1,000,000
Major Problem!
Initial Value of House $1,000,000
New Value: $700,000
Homeowner still owes 1 million but owns a house worth only $700,000
If they can’t pay their monthly mortgage, the Bank will foreclose on their house!

16. Housing Bubble Analysis
Caused by
Credit
Bubble
Too easy to get loans

17. House of Cards 60 minutes video link

18. Economist
Financial
Markets

19. Loans turned into Mortgage Backed Securities
Banks Makes
Home Loans
Banks sell Loans to
Wall Street
Wall Street turns
them into securities
Securities became
worthless and Banks
went Bankrupt

20. End Result of Subprime Mortgages
In the short run they caused home prices to rise
In the long run left people unable to pay their mortgage
consumers lost their homes to foreclosure
Housing Bubble reached the peak in 2006
home prices declined 30%-50% from the peak in 2006
Banks had to be “bailed out” by the U.S. Government
Banks had huge losses on foreclosed homes & subprime mortgages

21. Econnomic Bubbles
USA
Holland
Economic Bubbles (speculative bubbles) are when the price of an asset
(stock, bonds, or even tulips!) strongly differs from the true economic value of an asset
Economic bubbles have happened throughout history and reflect both “greed” and
“fear” in human nature.

22. Home Loans Bring Losses To Bank of America
January 21, 2011
Bank of America on Friday
reported a loss of $1.6 billion
in the 4th quarter after its
costs related to soured
home loans increased.

23. Good Debt vs. Bad Debt
Borrowing money? What do you need to consider?

24. Wrap-up Day 1
Income vs Wealth

25. $1.3 Trillion
$500 billion

27. Government Takeover of Subprime Mortgages
FNMA & FHLMC
Government takeover
Wall Street Firms Bankrupt or Bought
Bear Stearns
Merrill Lynch
Lehman Brothers
AIG Insurance Company
Government Takeover
Government Takeover of Subprime Mortgages

28. Keynes vs. Hayek Animal Spirits Malinvestment
versus
Malinvestment