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Interest Rates & Economic Bubbles

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

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Interest Rates & Economic Bubbles

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  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 orbusiness. 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! $100,000 cash You buy a Bond 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 • https://www.cnbc.com/2018/03/28/tesla-bonds-blowout-is-a-warning-for-risk-credit.html 7.6% Interest Rate Tesla Bond Matures 2025

  6. Interest Rate Worksheet $200,000 down deposit & $800,000 loan 7) a) @ 4% = $477 X 8 = $3,816 per month for 30-years • fixed rate loan paying back all principal & interest in 30 years b) @ 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 1 $400,000 Total principal paid Total interest paid Loan Balance year 30 $0.0 Year 1 ------------------------------------------------------------------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 $400,000 @ 4.0% Total principal paid = $400,000 Total interest paid = $287,478 Loan Balance year 30 $0.0 Year 1 ------------------------------------------------------------------Year 30

  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) $13,000 $10,000 = principal (loan) + $1,000 in interest per year • 3) $13,000 (+ $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 2005-06 • led to rapidly rising monthly payments in the future

  15. Major Problem! Initial Value of House $1,000,000 Housing Bubble Analysis Subprime Mortgage Example • Price Paid: $1,000,000 • Down Payment: 0 • You owe: $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. Caused by Credit Bubble Too easy to get loans Housing Bubble Analysis

  17. House of Cards 60 minutes video link http://www.cbsnews.com/stories/2008/01/25/60minutes/main3752515.shtml

  18. Economist Financial Markets

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

  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. USA 2002 - 2007 1996 - 2000 Holland 1634 - 1637 Econnomic Bubbles 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. https://www.youtube.com/watch?v=I5ZR0jMlxX0

  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

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

  27. Keynes vs. Hayek • http://www.youtube.com/watch?v=GTQnarzmTOc Animal Spirits versus Malinvestment

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