Contagion and Sunspots Surrounding Speculative Home Equity Lending Losses

Abstract

Subprime mortgages, HELOCs, supply-side restrictions, fraud and misrepresentation have been postulated as causes of the bubble in the U.S. in the early- to mid-2000s, and the subsequent crash and mortgage crisis. In this paper, I offer a theoretical demand-side explanation instead. Utilizing a sunspot model of housing demand and home equity lending, I show how agent preferences generate sunspot equilibria which cause housing prices to be excessively volatile, and how this results in home equity lending losses. I also suggest how the Fed's dramatic reductions, then increases in interest rates during the early- to mid-2000s, could have played a role in increasing housing price volatility. In addition, I examine financial contagion (cross-country spillovers of housing price volatility). Finally, I suggest how tax policy could be used to eliminate sunspots in housing markets and possibly avert future mortgage crises.