What’s the Best Way to Pop a Bubble?

Let’s get one thing straight: At the end of the day, our recent financial woes were primarily caused by the mispricing of assets. A housing bubble (or, more accurately, a number of local housing bubbles) emerged as home prices grew much faster than home values. People were buying homes that they knew were on the pricey side because they figured they could always sell them to a “greater fool” who’d pay even more. Lenders financed these transactions because they knew they could sell their mortgages to federally-backed greater fools, Fannie Mae and Freddie Mac. Eventually, though, it became apparent that prices were out of line with values, the stream of greater fools dried up, and lots of folks found themselves in the unfortunate position of owing more on their homes than the homes are worth. Homeowners began defaulting on their mortgages, many of which had been sold off and packaged into securities that were purchased by financial institutions. Those defaults caused the mortgage-backed securities to fall in value, reducing the capital of the financial institutions that held them and causing insurers of those securities (e.g., sellers of credit default swaps) to have to pay large claims. It’s a somewhat complicated story, but at the end of the day there’s a clear culprit: real estate (and real estate-related) bubbles.

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