In this lesson, students will learn about a speculative bubble within the context of the U.S. real estate market.

KEY CONCEPTS

Asset, Borrow, Collateral, Credit, Debt, Decision Making, Incentive, Investment, Lender, Real Estate, Risk

STUDENTS WILL

  • Explore investment, asset, appreciation, depreciation, and risk concepts through a reading passage.
  • Learn the difference between overvalued and undervalued assets using words and numerical examples.
  • Use role-play to analyze the incentives behind spending and investment decisions.
  • Investigate the connection between a speculative bubble and credit expansion.

INTRODUCTION

In a market economy, price and quantity are determined by the interaction of supply and demand. Producers and consumers come together in the marketplace. Excess supply happens when producers supply more goods and services than consumers demand, while excess demand occurs when consumers demand more goods and services than producers supply. Excess supply puts pressure on prices to fall, and excess demand pushes prices to rise.

But what happens when the price of a good (like the tulips in Holland) rises by more than normal supply and demand factors would suggest? What happens when that price rises for months, or even years? And finally, what happens when that price crashes? Let’s find out.

MATERIALS


PROCESS

1. Explore the concepts of investment, asset, appreciation, depreciation, overvalued, undervalued, and speculative bubble within the context of the housing industry, by reading Excerpt 1 from How Credit Crises Happen

2. Ask students to complete the fill-in Vocabulary Activity.

3. Explore how the timing of a speculative bubble affects buying and selling decisions. Divide the class into two groups: homebuyers (who purchase their homes to live in) and home sellers (who are selling their primary residences).  Present the following scenario and questions:

Suppose that there is a housing bubble, and housing prices are rising quickly. The housing market is already overvalued, which means that housing prices are higher than expected. For example, normal supply and demand factors (such as population growth and rising incomes) indicate that a house in Rockford, IL would sell for $125,000. But a housing bubble pushed these housing prices upward to $200,000.

   If more explanation of “overvalued” is required, please refer back to the 1600s tulip bubble example in the student version. One might expect a tulip to sell for cents under normal market conditions. But a tulip bubble pushed the price several times higher than a person’s yearly salary.

  • Question to home sellers: During this housing bubble, would you prefer to sell your homes now or later? Encourage students to explain their decisions. [Answers will vary depending on how long students expect the speculative bubble (and rising prices) to last. Some home sellers may wish to sell now, to take advantage of higher than expected prices. Other home sellers may prefer to sell later, if they believe that housing prices will continue to rise.]
     
  • Question to homebuyers: During the housing bubble, would you prefer to purchase homes now or later? Encourage students to explain their decisions. [Again, answers will vary based on future expectations about the duration of the housing bubble. Some students may prefer to buy now. These buyers believe that the speculative bubble in the housing industry will continue, and homes will be even more expensive in the future. Other students may prefer to buy later, since housing prices are higher than expected in the present.  These buyers believe the bubble will soon burst. Why pay more for a house in the present when you could pay less for the same (or comparable) house in the future?]

4. Next, explore what happens when all the students are investors, who both buy and sell real estate. None of the buyers or sellers will actually live in the properties. The student investors are only hoping to earn money by buying properties and then selling them at higher prices than their original purchase prices (“buy low, sell high”).

  • Evaluate the following statements: “In general, a speculative bubble in the housing market means that you have the opportunity to earn more money from your real estate investments than under normal market conditions. But, you also have an increased risk of losing more money from your real estate investments.”

[A speculative bubble means that housing prices are higher than expected and rising quickly. In this market, investors can buy houses in the present and then sell them for much higher prices in the future. So investors are more likely to earn more money than under normal market conditions. But, there is also increased risk. Consider an investor who buys an overvalued property. In a speculative bubble, an investor can turn over this property and earn a profit from the sale. But if the speculative bubble bursts, then prices fall quickly. If the investor has not sold the property, then he or she may lose a lot of money. This happens, because many recently purchased properties are no longer worth their original prices or loan amounts.  So, the increased risk during a speculative bubble results from (1) purchasing an overvalued asset and (2) not knowing the duration of the bubble.]

5. Summarize the discussions from Parts 3 and 4, by asking students to complete the second and third columns in the following table: 

          Economic Role

        Incentive

Effects of Housing Bubble on Incentives

             Investors

To earn money from their investments (like real estate)

During a housing bubble, properties are overvalued, which yield potentially higher rates of return. This creates greater incentives for investors to put their scarce resources into the housing industry.

             Homebuyers

To purchase places to live at affordable prices

To own appreciating assets

Housing bubbles affect homebuyers’ incentives because they respond to rising house prices. The effects depend on how homeowners view the bubble’s duration. Many homebuyers will buy now because they can pay less for appreciating assets compared to the near future. However homebuyers who believe that the housing bubble will soon burst have incentives to buy homes later (when prices have fallen).

            Home Sellers

To sell their homes at the highest prices (in order to earn the greatest return on their housing investments)

Home sellers, who are motivated by the already high house prices, will sell now. Home sellers, who are motivated by the rising prices of the future, may sell later to receive even higher prices for their homes.

6. Explore the effects of future expectations on a housing bubble by presenting the following scenario and question:  Suppose that students expect the housing bubble to continue in the near future. As a result, they purchase real estate. Suddenly, the housing bubble bursts, and real estate prices fall. Now, students own real estate properties that are worth less than their original prices.

  • What would happen if the students wanted to sell their properties in this new market? [People react to what they expect to happen in the future, not necessarily what will happen. This uncertainty creates risk. The students expected to purchase appreciating assets. But this did not happen, because the bubble burst. If they try to sell their properties in this new market, they will lose money, because many assets are worth less than their original prices. For example, suppose a student bought a house for $200,000. In the new market, it is only worth $125,000. If the student sells the house at this new price, the student has lost $75,000 just based on the price.]

7. Present the Central California Housing Crash video to learn about the effects of the housing bust on the California housing market and American homeowners. Then, discuss the following questions:

  • When the housing bubble burst, what happened to housing prices? [Housing prices decreased. The video reported that home values were estimated to fall by $4.0 trillion by the end of 2008.]
  • Wealth is the value of total assets that generate current or future income. A house is part of an individual’s wealth. It is an asset that can be sold in exchange for income. After the housing bubble burst, the value of many homes decreased. How did this change affect a homeowner’s wealth? [A homeowner’s wealth decreases, because one of his or her assets (the house) generates less income if sold.

8. Ask students to complete the Buying and Selling in a Housing Bubble Activity.

9. Explore the connection between the housing bubble and credit expansion by reading Excerpt 2 from How Credit Crises Happen. After students are done reading the excerpt, ask them to answer the following questions:

  • According to the reading, a house can be used for collateral. Remember that a loan default occurs when borrowers are legally unable to repay their debts. Why would the existence of homes as collateral reduce the risk of losing money from loan defaults? [When lenders make loans, they take on the risk that borrowers will not repay their loans. If borrowers default, lenders can take back the homes. Then, lenders can try to resell the houses and get back some of the money that was originally loaned out. This reduces the risk that lenders will lose the full amount of their loan balances, if borrowers default.]
  • People can use their houses as collateral to borrow money for expensive items. According to the reading, the housing bubble encouraged a credit expansion. How would rising house prices contribute to borrowing more money? [According to the reading, "the value of your collateral partly determines how much you can borrow." Homeowners with higher house values can usually borrow more money than homeowners with less expensive homes. During the housing bubble, home values were rising. Therefore, homeowners could and did borrow more money, using the rising values of their homes as collateral. This additional borrowing (and spending) contributed to a credit expansion, or an increase in the amount of money in the economy.] 

10. Ask students to complete the Bubble-Credit Connection Exercise.

CONCLUSION

A speculative bubble occurs when the price of an asset is much higher than normal demand and supply factors would suggest. In 2002, a speculative bubble began in the U.S. housing industry. During this bubble, prices of homes rose higher and higher for years, and homeowners used these overvalued assets to borrow more and more money. Investors also placed their scarce resources into real estate, because they could potentially earn more money.

By the end of 2006, the speculative bubble in the U.S. housing market burst. Real estate prices fell. Both homeowners and investors no longer held overvalued properties. In fact, the values of some real estate dropped below the amount of their loan balances. Millions of people were unable to pay their mortgages, and they defaulted on their loans. The bursting of the housing bubble also contributed significantly to the financial crisis that soon affected the world. 

ASSESSMENT ACTIVITY

Instruct students to complete the following assessments:

EXTENSION ACTIVITY

Ask to read the definition, example, and government response to toxic assets .

Ask the students to complete the following Check for Understanding. Questions and answers are below.

EDUCATOR REVIEWS