Journal of Stock & Forex Trading
Open Access

Abstract

The Deep Cause of the Subprime Lending Crisis

Fred Foldvary

The financial crisis induced calls to extend, strengthen and tighten financial regulations. This paper argues that the deep underlying problem is not in the financial industry, but in the real side of the economy, in real estate. The most important collateral for mortgage loans is land value, which then serves as collateral for packages of loans and leverage derivatives. The problem is that real estate has had periodic boom-bust cycles. The rise in land values becomes magnified as land speculators buy properties for resale at higher prices. Land then becomes priced not for current use but for expected future demand, which at the peak of the boom is overly optimistic. Speculators with the greatest expectations later suffer the winner’s curse. If taxation were shifted to tax almost all of the land value, the price of land would fall to a small fraction of the pre-tax price, eliminating gains from land speculation. Mortgage loans would be collateralized by the value of buildings and of income from tenants, rather than land value. The boom-bust real estate cycle would disappear.