A Rational Bubbles Model and Application in Sub-Prime Mortgage Crisis

50 Pages Posted: 4 Aug 2009

See all articles by Zijun Liu

Zijun Liu

Bank of England

Yiyi Wang

London School of Economics & Political Science (LSE)

Date Written: June 2009

Abstract

We develop a theoretical model of rational bubble. In equilibrium, a bubble can persist until it bursts following an exogenous shock, even when all the agents are aware of the bubble and that it will burst in finite time. Applying the model in the context of the recent sub-prime mortgage crisis, we argue that excessive sub-prime lending behavior may be rational with the introduction of securitization. The process is much like a Ponzi scheme where lending is profitable as long as investors continue to invest, and vice versa. We thus provide a rational explanation for the housing bubble and the dramatic increase in sub-prime default rates.

Keywords: bubbles, Ponzi Scheme, sub-prime mortgage

JEL Classification: D82, D84, G1, G21

Suggested Citation

Liu, Zijun and Wang, Yiyi, A Rational Bubbles Model and Application in Sub-Prime Mortgage Crisis (June 2009). Available at SSRN: https://ssrn.com/abstract=1442157 or http://dx.doi.org/10.2139/ssrn.1442157

Zijun Liu (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Yiyi Wang

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom