Financial Innovation

Tomorrow we will be covering the expansion in subprime lending.

On Wednesday we will be covering financial innovation and the creation of such financial products as credit default swaps. To learn about these watch the following three videos from Marketplace's Whiteboard (another great resource connected to public radio).

• "How credit cards became asset-backed bonds," about credit cards, but covers the basic idea of securitization. Also check out the wikipedia entry on Mortgage backed securities (MBS), these pictures are useful. pic #1 pic #2
• "Crisis explainer: Uncorking CDOs," covers the general idea about creating new securities from bonds
• "Untangling credit default swaps" our first exposure to the notorious `credit default swap'

Also, please listen to another episode from "This American Life," here they cover the credit default swap, talking to people involved in the market.

• "Another Frightening Show About the Economy" for class listen to acts two and three that start at 20:00. However, the first twenty minutes are interesting since they capture the mood of the economy in October 2008 when the markets really started to collapse.
  

Mortgages, Government Regulation, and Subprime Lending

Today we talked about mortgages. A good reference that covers the various types of mortgages is found in "Mortgage Innovation, Mortgage Choice, and Housing Decisions" by Chamber, Garriga and Schlagenhauf from the St. Louis Fed. Read the first half of the paper, the second part contains a model that is beyond the scope of this course.

For the next class meetings please read over two more articles from the St. Louis Fed:

• An article about Federal Government involvement in the mortgage market: "Federal Credit and Insurance Programs: Housing" by John M. Quigley, (this was published in July 2006).
  
• An article about growth in the subprime lending market: "The Evolution of the Subprime Mortgage Market" by Chomsisengphet and Pennington-Cross, (published January 2006).

After you have read about the growth in subprime lending, please listen to this classic piece from "This American Life" entitled "The Giant Pool of Money." That episode launched the Planet Money blog and thrice weekly podcast--a really great source for explaining economics. Today they (along with Russel Roberts from Cafe Hayek) debut an entertaining `rap' video between Keynes and F.A. Hayek about their disagreements in Macro.

Book to Order

Please order the following three books. I have linked them to Amazon, but feel free to get them from any source. We will be starting on Irrational Exuberance in a couple of weeks, so do not delay in ordering. (Note that Amazon is currently offering a discount on the joint order of `Animal Spirits' and `This Time is Different'--however I believe that is only for the hardcover for `Animal Sprits,' which is now out on the cheaper paperback. )

• `Irrational Exuberance' by Robert Shiller.
• `Animal Spirits' by George Akerlof and Robert Shiller.
• `This Time is Different' by Carmen Rheinhart and Kenneth Rogoff.
  

Housing Bubble? Housing Market Readings

Here are the readings covering the housing market leading up to the bursting of the bubble. Please have these read for class on Wednesday January 20th. I have provided direct links to the readings on the sidebar. For details on the readings, read on.

Some readings from the popular press:

• Business Week, July 19, 2004: "Is a Bubble About to Burst?"
• Jim Jubak, Columnist at MSN Money, June 10, 2005; "Why there is no housing bubble"
• Article about Ben Bernanke in Washington Post, Oct. 27, 2005; "Bernanke: There's no Housing Bubble to go Bust"

In reading these, ask yourself what were the main issues the popular press was pointing to to determine whether there was a bubble in the housing market.

Next some readings from economic researchers. Note that a lot of researchers discounted the likelihood that there was a housing bubble. Therefore, the papers and researchers listed here should not be singled out as having made a terrible prediction. Rather their work here represents what a lot of very smart people were thinking and saying at the time. The papers should be read as a way to understand the relevant issues and to better understand how people were thinking. Further, note how most researchers made conditional predictions for the economy in the case where there was a bubble--most of these conditional predictions came to fruition!

First, two short articles from John Krainer, an economist at the Federal Reserve bank of San Francisco. Note that both of these articles were written early in the housing bubble, before 2004.

• Economic Letter, May 3, 2002: "House Price Dynamics and the Business Cycle"
• Economic Letter, March 7, 2003: "House Price Bubbles"

What does Krainer argue about the likelihood of a fall in Nominal house prices?

Next two papers with differing views about whether there was a housing bubble. First a paper by Jonathan McCarthy and Richard W. Peach, two economists at the Federal Reserve Bank of New York. They found that house prices were justified by the fundamentals.

• FRBNY Economic Policy Review, December 2004 "Are Home Prices the Next `Bubble'?"
  

The NY Fed economists were just part of a large crowd who justified high house prices with fundamentals, for instance see "Assesing High House Prices: Bubbles, Fundamentals and Misperceptions" by Himmelberg, Mayer and Sinai.

The next paper is by Karl Case and Robert Shiller. In this paper they examine whether there is a bubble. The innovation in their work is a survey about buyer's expectations--concentrate your reading on this part of the paper.

• Brookings; "Is There a Bubble in the Housing Market" (this version of the paper comes from JSTOR, requiring you to be over an IU connection. An earlier unrestricted version can be found at Karl Case's webpage here)
  

Slides for Today: Could We See a Bubble at the end of 2004?

Here are slides for today's lecture.