What caused the housing bubble of the mid 2000s?
After learning about the Financial Crisis of 2008, students will debate which factor contributed most to the housing bubble and subsequent financial crisis.
Context for Use
Course: Principle of Macroeconomics
Prior Knowledge: Need to know about the Financial Crisis of 2008 through a combination of lecture, video, articles (see additional resources). Key vocabulary: mortgage-backed securities (MBS), credit default swaps (CDS), ratings agencies, speculating (there is a list in additional resources)
In introductory economics courses, we often tell students that everyone acting in their own self-interest can make us all better off (hello, invisible hand). The Financial Crisis of 2008 was an example of a time when everyone acting in their own self-interest AND appropriately responding to incentives, made everyone worse off.
The Financial Crisis of 2008 is a seminal event in economics and, until Covid, was the biggest economic calamity since the Great Depression. Students usually have a general idea that the housing market was somehow involved. In this activity, students will use their understanding to debate which factor contributed most to the housing bubble and subsequent financial crisis. They should come away with the notion that there were many factors involved.
Expected Student Learning Outcomes
Students will evaluate the drivers of the housing bubble of the early/mid 2000s that eventually burst and led to the Financial Crisis of 2008.
Information Given to Students
Which of the following contributed the most to the housing bubble and subsequent Financial Crisis of 2008? Defend your answer with at least one example.
A. The Federal Reserve lowered interest rates in the early 2000s in response to the 2001 recession.
B. The creation of mortgage backed securities which allowed mortgage companies and banks to sell off the risk of non-payment.
C. The creation of credit default swaps which allowed banks and investors to believe they were insured against the risk of non-payment.
D. People speculating and buying houses they did not plan to live in long or could not afford for the long in hopes of selling for a profit.
E. Too many subprime loans.
Teaching Notes and Tips
Place the following events in order, starting with #6. In other words, what did the securitization in #6 lead to?
#1 Bubble pops, risky loans default (people stop paying)
#2 Money becomes easy to borrow (lending standards decline)
#3 MBS lose value
#4 Banks/investors lose money
#5 Housing bubble (prices increase rapidly)
#6 Securitization of loans (MBS) & insurance against credit default (CDS)
#7 increase in foreclosures & decrease in house prices
#8 Banks quit lending/investors won't buy bonds
#9 Decrease in economic activity & increase in unemployment
(Answer: Generally #6 → 2 → 5 → 1 → and then can be several iterations of what comes after)
Prefatory remarks: Now that you have a general understanding of the chain of events in the Financial Crisis and have watched The Crisis of Credit (link in additional activities); you will discuss and debate which factor contributed the most to the housing bubble.
Follow up questions:
1. As you can see in this example, it is often difficult to determine causality when dealing with economic issues. Why do you think this is? (answer: because many things are happening simultaneously, not ceteris paribus and we are dealing with people who can behave in less than perfectly rational ways, can succumb to emotion, etc)
2. Which answer(s) is(are) the easiest to understand without any special knowledge of the Financial Crisis? Which are more difficult?
3. What assumption did everyone (from flippers and first time home buyers, to ratings agencies and investment bankers) participating in the housing market in the early 200os have? Was this a good assumption or something we call a faulty assumption?
4. Everyone seems to have been acting in their own self-interest...why were the results not optimal?
5. Is it possible to prevent a bubble from forming? From popping? If so, how?
6. What do you think is causing the current (seemingly) nationwide housing bubble? What, if any, would be an appropriate government response?
Summary remarks?: In the real world, many things change at once (they are not ceteris paribus). As such, it can be difficult to determine causality. While human nature is to search for easy answers and one single cause, that is often not possible in economics. And, while markets can bring great prosperity and allocate resources efficiently, they can fail. The Financial Crisis of 2008 is an example of a time when everyone acting in their own self-interest and responding appropriately to incentives led to an economic calamity of epic proportions.
What do MBS and CDS stand for? Briefly describe each and discuss the role of each in the Financial Crisis of 2008.
References and Resources
The Crisis of Credit is a great 12 minute video about the Financial Crisis (there are also many good clips from The Big Short)