A Rational Bubbles Model and Application in Sub-Prime Mortgage Crisis
50 Pages Posted: 4 Aug 2009
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: Suggested Citation
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