How Sub-Prime Lending Created the Housing Bubble

A real estate market decline, like any market decline, is part technical, part fundamental, and part psychological. In my previous post “How Inflated are House Prices?” I discussed the fundamental value of real estate and described how and why prices fall to their fundamental values once a bubble has burst. In this post, I intend to describe the technical and psychological factors at work during a speculative mania, and demonstrate how sub-prime lending created this bubble.

A Thought Experiment

I would like to start with a thought experiment. Imagine a room with 100 people representing the pool of sub-prime borrowers. These are new entrants to the market. They were previously unable to buy due to bad credit, lack of savings, etc. All of them are told they are going to bid on an asset that never goes down in value, and they will be given the ability to borrow unlimited funds (stated income loans, aka “liar loans”) The only caveat is the borrowed money must be paid back when the asset is sold (not that they would care, they already have bad credit). Imagine what would happen?

People would start to buy the asset, and prices would rise. Others in the room seeing the rising prices would come to believe that indeed the value of the asset never declines. They would then join in the bidding. As the bidding drives prices even higher, a manic quality takes over the bidding and people compete with each other, often bidding higher than the asking prices. Nobody wants to be left out. There are fortunes to be made. Greed drives prices upward at a staggering rate. As the last of the 100 people buy, prices are very high, everyone has made money, and it looks as if prices will continue to rise forever . . .

Then something strange happens: there is nobody left to buy. (A key indication of the end of a speculative mania is a huge decline in sales, just as we have witnessed over the last year or two.)

Transaction volume drops off dramatically, and prices stop their dizzying ascent. Nobody is particularly alarmed at first, but a few of the more cautious sell their asset to pay off their loan. Since there are no more buyers, the first selling actually causes prices to drop. This is unprecedented: Prices have never declined! Most write it off as an aberration and comfort themselves with the past history of rising prices; however, a few are spooked by this unprecedented drop and sell the asset. This selling drives prices even lower.

Subprime Mortgage Percentage of Market

(This brings us up to today in the local real estate market. But what about tomorrow?… Let’s continue our thought experiment.)

Now those who still own the asset become worried, some maintain denial that there is a problem, and some get angry about the price declines. Some of the late buyers actually owe more than they paid for the asset. They sell the asset at a loss. The lenders now lose some money and refuse to loan any more money to be secured against the asset (notice the recent implosion of sub-prime lending). Now there are even fewer buyers and a large group of owners who all want to sell before prices drop any lower. Panic selling ensues.

Everyone wants to sell at the same time, and there are no buyers to purchase the asset. Prices fall dramatically. This asset which was sought after at any price is now for sale at any price, and there are few takers. People in the market rightfully believe the asset will continue to decline. Owners of the asset have accepted the new reality; they are depressed and despondent.

In any group of people, there are always a few who don’t believe the “prices always rise” narrative. Some recognize that asset prices cannot rise indefinitely and cannot stay detached from their fundamental valuations. These people witness the rally and the resulting crash without participating. They wait patiently for prices to drop back to fundamental values, and then these people buy. As these new buyers enter the market, prices stop their steep decent and market participants start to hope again. It takes a while to work off the inventory for sale in the market, so prices tend to flatten at the bottom for an extended period of time; however, just as spring follows winter, appreciation returns to the market in time, and the cycle begins all over again.

What is written above is true of any asset whether it be stocks, bonds, houses or tulips. In our case, it is the local housing market, and the room of new buyers are sub-prime borrowers, but the concepts are universal. One phenomenon somewhat unique to the housing market is the forced sale due to foreclosure (stocks have margin calls). Even if the psychological factors at work during the panic could somehow be quelled, the forced sales from foreclosures would drive down prices anyway. True panic is not required to crash a housing market, only dropping prices and an inability to make payments. Sub-prime lending was the leading cause of this market bubble, and its implosion will exacerbate the market decline.


P.S. A special thanks to OC FlipTrack for the Stages of Grief.

21 thoughts on “How Sub-Prime Lending Created the Housing Bubble

  1. gn

    This is why in a typical correction, there are 3 stages:

    1. Disbelief – Much of southern CA was in this stage in 2005 – 2006

    2. Acceptance – We are now in this stage. I think we will be in this stage until the end of 2008.

    3. Despair – 2009 – ???

  2. jerry

    maybe this can explain why, most of the people I know of, who brought the houses in the recent year are without much of saving and most of them are first time buyers.
    And the people sold their houses in last couple of years, if not trade-up right away, most of them renting still.
    One year ago, once I overheard three engineers, who all from same foreign county for a few years, all just brought their houses, taking about the take and risk and all willing to take the risk because the upside is too tempting.

  3. Ranger Rick

    Talking to people here at work we are still very much in the initial stages of disbelief. Most believe this is a very temporary blip and housing will return to 15 to 20% a year shortly. It must… since most have multiple investment properties. They are constantly telling me they have gone up in value since their tax appraisals say so. The more I talk to them the less I think humans are an intelligent specie.

  4. The Patient

    Great Post. I have been lurking on these blogs for quite some time. I currently rent in Downey, CA. I try to inform my friends and family about current market conditions. I feel I have to do this, because to some it makes no sense that I should be renting. I believe that I will wait it out untill at least 2008. Irvine Renters posts really help me to understand some of the fundamental aspects that crated this unprecedented run up in housing prices. Keep up the great work.

  5. IrvineRenter

    “Most believe this is a very temporary blip and housing will return to 15 to 20% a year shortly. It must… since most have multiple investment properties.”

    This is exactly why prices will decline. Those that need prices to go up the most (owners depending on appreciation) are only in a position to drive prices lower (they can’t buy, they can only sell). When you buy a house to save money on rent, or when you buy it for rental cashflow, you don’t care what happens to prices: Price changes don’t impact why you purchased, so you feel no pressure to sell. The people who are counting on appreciation will be the first to sell when things don’t go their way. Since nearly everyone who bought over the last 4 years has been counting on appreciation, there will be a large number of motivated sellers — Motivated to panic.

  6. roller

    This post reiterates the fundamental underpinings of economics 101. The difficult part of any economic theory is the timeline during which the “supposed” events will unfold. …even a broken clock is correct twice a day. If one is very confident of the future outcome, they should place a huge stake in the Case Shiller index.

    I believe that prices SHOULD come down…timing the decline is very difficult. One needs to assess their risk tolerance, financial condition, value of home ownership, estimate housing decline/appreciation cycle before they buy a home in this market….for some waiting for 3/5/10 years to buy a home at the supposed bottom of the market makes no sense…your kids may be too old by then.

    I intend to wait and see what happens with the market for the remainer of this year and will reassess what I need to do. So far, I haven’t seen measurable price decline where I live.

    As a side note, my sister who resides in London, scoffs at the state of our housing market…London’s housing market has been going up for over 14 years (they a slight pause 3 yrs ago which lasted 8months and kept going up)….you just never know what our market would do.

  7. Neil

    Most people treat their mortgage like rent. If it gets too high… they walk away and just don’t pay it. Whiskey Tango Foxtrot? A co-worker’s neighbor just did that. Mortgage went up $600/month and he just walked. No discussion, no further payments. Over $600 bucks!

    By about june the market will hit the wall. At that point the rats will no longer have an escape route. And sales will be so slow there will be no more pretending its going to get better.

  8. Albert


    Have you even taken into consideration the huge growing percentage of double income families in the new generation? I am not sure if it plays a huge factor in the appreciation of homes but I believe it contributes to the affordability. Most married couples in my generation both possess high paying jobs, especially in Irvine.

    Have you also thought about the foreign money that goes into the Irvine market? Also, the huge increase of Asian families in Irvine. The Asian culture and family dynamics play a huge role in the affordability of these homes as well.

    Just some thoughts.

  9. red

    Albert –

    The bear argument is foregin money is dumb always late to the party.

    But this article probably helps illustrate your suggestion on foregin money.

    “Koreans spent $780 million on real estate abroad in 2006, 34 times more than in the previous year, and almost half of it was in the U.S. Most people bought houses rather than commercial property, according to the central bank.”

    ” Home-shopper Kim says he’s tired of regulations and high taxes in Korea. With a sister in New Jersey’s neighboring state of Pennsylvania, he may even move to the U.S. from Seoul, where he and his wife now divide their time between a 600 million-won apartment and his parents’ 1.5 billion-won home.

    “Living in the States is incomparable,” Kim said. “

  10. red

    Koreans spent $780 million on real estate abroad in 2006, 34 times more than in the previous year, and almost half of it was in the U.S. Most people bought houses rather than commercial property, according to the central bank.”

    Home-shopper Kim says he’s tired of regulations and high taxes in Korea. With a sister in New Jersey’s neighboring state of Pennsylvania, he may even move to the U.S. from Seoul, where he and his wife now divide their time between a 600 million-won apartment and his parents’ 1.5 billion-won home.

    “Living in the States is incomparable,” Kim said.

  11. IrvineRenter


    I have one more coming before I take a little rest.


    The mutliple income households would be reflected in the median household income statistics. This becomes apparent when you see the median pesonal income statistics and the median household statistics side by side. So, unfortunately, there is no hidden level of buyer support or income justifying these prices.


    The influx of outside capital into a real estate market is always a disruptive thing. I have no idea how large a segment of our current market this is, or how long it will go on. Typically, foreign money arrives late to a speculative mania, and they most often lose a lot of it.

    You can observe the opposite impact of this when you see how California Equity Locusts have driven up prices in other markets around the West. Look up Ashland, Oregon, Boise, Idaho, and others. Even within California, you have markets like Redding or Eureka where house prices are more than 10 times local income because of Bay are equity locusts. These fringe markets will collapse first, which will in turn create stress on the prime markets like ours.


    Thank you for that link. It is a fantastic article. It makes me feel more confident when I see the managing director of a large, local bond trading company saying the same things I am (and probably better than I said it). These guys are fund managers who buy and sell mortgage backed securities, so they are very conscious of the outlook in this market. I have read that Pimco has been selling MBS’s for the last couple of years trying to reduce their portfolio exposure.

  12. red

    From McCulley:

    “It may be a while before the Fed accepts and recognizes this, waiting for these Minsky style debt-deflation dynamics to become evident in broader measures of the economy’s health, notably job creation. But make no mistake: A Minsky Meltdown in the most important asset in most Americans’ asset portfolio is not a minor matter. Bill Gross’ Plankton Theory ain’t just a theory, but a reality.

    Once the Fed begins easing, it will be a long journey down for short rates.”

    My question. Is he saying the Fed will have to reduce short term rates to save housing bust?

  13. gn


    McCulley is saying the Fed will TRY to save the housing market by reducing short term rates. But it will not work because :

    – It was the “loose credit standard” that motivated many folks to buy homes. The interest rate also plays a factor, but a much smaller factor.

    – By the same token, it will be the “tight credit standard” make buyers stay away. Of course, lower interest rates help, but not much.

  14. IrvineRenter


    Those two Jubak articles were really good as well. I don’t read his stuff that much. From what I understand, there are actually a number of ghost writers who write under his name. Sometimes his/their opinions have been pretty far off. His stock picks are almost guaranteed losers. However, I would say those two articles were right on the money.

  15. gn


    I’m not into stocks investing. So, I don’t read the “stock recommendation” sections of Jubak’s articles. The thing that impresses me the most about Jubak is the breadth and the depth of his knowledge.

    >> … a number of ghost writers who write under his name

    That is interesting, to say the least. This would explain how he knows so much. Is your “source” reliable ?

  16. IrvineRenter


    I don’t know how reliable that information is. I don’t remember where I first read this. I have noticed the writing style changes from time to time, so I suspect it is true. It doesn’t take away from the quality of what is written.

  17. AnotherRenter

    Hello IrvineRenter
    Thank you for the useful information. I moved to Irvine about a year ago. I make 6-digit salary but it seems impossible to buy a house now as I am married and we are a single income family.

    I wonder how long, you think, this unaffordability will continue? Will house prices ever get to reasonable levels? When that happens will the economy be still in good shape? Will we still have jobs to pay reasonable mortage bills?

  18. IrvineRenter


    Realistically, I don’t see prices nearing the bottom before late 2009. I will start looking summer of 2010, but with all the ARM resets looming, we probably will not hit bottom until 2012-2014. Affordability will improve, it is just a matter of time.

Comments are closed.