What is Past is Prologue

In my last post “How Sub-Prime Lending Created the Housing Bubble,” I went through a thought experiment to demonstrate how the psychological and technical factors interrelate to create a speculative mania. In this post I intend to examine the details of the most recent Southern California residential real estate bubble to deflate, and see what it portends for the future.

Today, we are just past the market top. Predicting when a top will occur is very difficult, but recognizing when one has occurred is not: The market has topped. Volume is down as the pool of buyers is exhausted, and inventories are increasing. Flippers are looking for renters, and everyone is praying for the big spring selling season to bail them out. Denial and bargaining dominates the mindset of sellers.

Since prices are softening, there will be one last push of buyers entering the market: those who felt they were “priced out” but see this softening as an opportunity. These buyers actually believe in the fantasy of continual appreciation. They just missed out on the rally. They are classic “bitter renters.” That is why the first selling season after the top gets the most robust bear rally. Many will call the bottom, and many more will be duped into buying this false rally. The strength of the first selling season gets weighed down by the large volume of inventory that ultimately reverses prices and pushes prices lower.

Early 90’s House Prices

Owners move from denial and bargaining to anger after seeing the failure of the spring selling season and even lower prices than the year before. Many begin to recognize they have a real problem, but many hold out hope that things will turn around “next year.” The second year after the peak, the spring selling season is even weaker than the first, mostly because sellers are more motivated and buyers less so. In year two the remaining sellers who were in denial have moved to anger and acceptance. By the end of year two, all the market participants know prices are declining and will continue to do so.

The third year after the top, selling really gets panicky. Prices are falling quickly and volume is increasing. There is no spring bounce, and prices decline every month of the year. Everyone has accepted that prices are going to fall, and owners are very depressed. This may continue for multiple years if prices remain above fundamental valuations.

In the fourth year, if prices have fallen low enough to be close to the upper range of fundamental valuations, buyers begin to enter the market. The market may even experience its first price rally in two years. However, the large number of foreclosures and large overall inventories prevent this rally from taking hold. Prices resume their descent after the spring push. At this point in the decline, most participants in the market see residential real estate as a bad investment. Why wouldn’t they, most just lost money? People believe that renting is better than buying, and the belief in appreciation is dead.

LA Prices vs. Rents

In the years that follow, market prices enter the range of fundamental valuations where they find support. Prices may continue to decline somewhat, perhaps even overshooting the fundamentals due to the foreclosure inventory, but if prices fall low enough, cashflow investors will enter the market in force and create a durable bottom. However appreciation will not return quickly. The market will flatten at the bottom as the Rent Savers and Cashflow Investors absorb the market inventory. The inventory will remain high. All of the ARM’s issued during the rally are now resetting, and most of the borrowers are underwater. This forces a sale, and generally another bankruptcy.


“What is past is prologue.” William Shakespeare. The Housing Bubble vs. The Great Depression

9 thoughts on “What is Past is Prologue

  1. renter

    Good stuff. It is instructive to look at history, but we must be aware of the fact that history will never play out exactly. Things could go better or worse than history suggests. I predict worse, mainly because by looking at your graphs and your earlier post about the number of exotic mortgages makes it seem so.

    I think it would be good to intersperse these posts with facts from the ground. I loved the earlier posts about flips in Irvine gone bad. Please also educate us about what houses are selling for today compared with before, flips gone bad, job market/economy in Irvine and other such realities. For example I heard New Century laid off a bunch of people a couple of weeks ago. How is the housing slowdown affecting the economy in Irvine? Other specifics related to Irvine/OC would be very useful.

  2. Neil

    I think that’s further proof that the Irvine (and OC area overall) are, to put it nicely, thoroughly screwed. We might be behind San Diego, but it’ll happen here.

  3. rkp

    I really like your posts IrvineRenter. However, I think it would be great to see posts on flips and have Zovall and IrvineSingleMom post in between your posts. The best part of this blog was seeing what was happening in the Irvine housing market. Don’t get me wrong though, your posts have been extremely valuable in convincing my friends and family that my waiting has been the right approach.

  4. graphrix

    rkp – Don’t worry there could be a very interesting post coming from zovall about a group of failed flips.

    To add to the psychology of the market and relating it to the past I thought it would be good to add these gems I found in the OC Register’s archive. Sorry if it cuts off at the end but that is what the Register gives you for free.

    I think if we had a blogs back then Nick would be a bubble blogger.

    Housing costs price many out of home
    July 7, 1990
    Byline: Nick Harder
    The Orange County Register

    “Let’s get back to reality, shall we?” That’s the way Jim Kiel of Anaheim started his letter to me this week. He has a real problem grasping the nature of housing prices.
    “Today’s (June 30) front-page introduction to Home said, `OC home sales still slow; When will the market rebound?’ In the name of sanity, Nick, does it NEED to? If the OC housing market needs anything, it needs to crash-dive pronto to bring

    Hearts and minds
    Mood key to selling houses
    September 8, 1990
    Byline: Andre Mouchard
    The Orange County Register
    The Orange County Register
    Fred Moss can’t sell his house, and he thinks he knows why. His would-be buyers are cranky.
    “I wish that just once I could pick up a newspaper on the weekend and see a story about how this is a good time to buy a house,” said Moss, who is asking $284,000 for a three-bedroom, two-bath house about a mile from the ocean in San Clemente.
    “But instead of good news, whenever I pick up a paper and read anything about real estate, it’s

    This sounds familar!

    Those under 35 have most trouble buying a home
    December 4, 1990
    Byline: Andre Mouchard
    The Orange County Register
    The Orange County Register
    Despite a recent dip in local housing prices, the cost of buying a home in Orange County remains the fastest-growing area of concern among local residents, according to the 1990 Orange County Annual Survey.
    Although 40 percent of the 1,017 people who responded to the survey listed traffic and transportation as the county’s biggest problem, the issues of growth and housing — each mentioned by 16 percent of the respondents — tied for second as areas of most concern.

    Fed’s rate cut isn’t viewed as cure in OC
    December 20, 1990
    Byline: Andre Mouchard
    The Orange County Register
    The Orange County Register
    Prospective homebuyer Colleen Stephano yawned when she heard of the Federal Reserve Board’s move Tuesday to cut the discount rate one-half point to 6.5 percent.
    “So what,” said Stephano, who has been hunting for a $300,000 house in the Yorba Linda area since late spring. “Interest rates are not the problem with Orange County’s housing market,” she said. “Home sellers’ attitudes

    This is one of my favorites. They didn’t even have to get creative this time around they just used what didn’t work last time.

    Making the best of it
    Real estate ads promote up side of a down market
    February 13, 1991
    Byline: Martin J. Smith
    The Orange County Register
    The Orange County Register
    Coldwell Banker Residential Group, the Mission Viejo-based real estate giant, will begin a groundbreaking national advertising campaign this week that acknowledges the sluggishness of the current housing market while suggesting that there’s never been a better time to buy or sell.
    While many advertising and real estate experts agree with the campaign’s central theme — “Now’s the time to make your move”

    It gets tougher to qualify for home loan
    September 8, 1991
    Byline: Andre Mouchard
    The Orange County Register
    The Orange County Register
    After selling his old house in Santa Ana and listening to mortgage lenders vie for his business, Mike Anderson figured his next house buy would be a move up in the world.
    Instead, he’ll be lucky to step sideways. Like many Orange County house hunters this summer, Anderson is caught in a new type of housing squeeze.
    On one hand, mortgage interest rates are as low as they’ve been in a decade and mortgage companies are waging frenzied advertising campaigns to make

    If I changed the dates 2005, 2006 and 2007 no one would know that these were from the past.

  5. SoCalwatcher

    I heard a radio commercial for a stated income mortgage pitch that only looks at the last 12 months of payment history with a 30yr lock in Chicago for a company called Perfect Mortgage.

    Sub-prime ain’t dead here yet….

  6. K.O.

    Reading posts like this gives me the glimmer of hope that a single young professional has a shot of affording housing in southern California.

    Either that, or I can see if any of the older Newport Beach women can be a sugar mama for me. 😉

    Keep up the good work IrvineRenter!

  7. Nani Mouse

    I tend to agree with the above analysis to the extent that I believe also that we are entering a real estate “bear” market.

    And yes, perhaps we are repeating the 1990-1995 real estate cycle which was the worst 5 year cycle since 1975.

    However, I’d like to also point out that the previous 5 year cycle from 1985-1990 as well as the following 5 year cycle from 1995-2000 each had annualized returns of 7%-10%. (Depends on what you are using for your data source.)

    So if you are able to wait it out and invest in the long term then you’ll probably do OK. I’ve been in my condo since 1993 which was right in the middle of that low cycle.

    Since then it’s gone up at about a 7% annualized return. That’s OK for me considering I also get some tax benefits and low stress since I have a fixed mortgage.

    I know I’ll have to give back some of that value when the prices drop over the next few years. I’ll just wait it out for the next up cycle.

    Just think long term and you’ll do fine.

  8. biscuitninja

    Nice work! Some hard numbers and historical data for proof! Althought I must say we really don’t kow what will happen since jobs seem to be healthy in this area. Anyways take it easy.

  9. A POV

    Nani Mouse is right. You buy quality you can handle and over time you will be just fine.
    As a small 51 y/o developer (CA, WA & TX) I feel for you, most likely, younger folks. When I was younger, I was more humble and smart enough not to anoint myself as an appreciation/interest rate guru.
    I bought modest quality, only on stable, long-term, financing.
    Formost, I was taught to buy the home you live in as a home, not a business.
    Folks with enough money buy a home. It is not human nature to be capable and not buy.
    What I see as an option for those renting and have income but lacking in down payment is investing in a REIT or a small duplex way outside Irvine.
    If you see Orange County real-estate appreciation the past century, 50 years or 10 years the graph speaks for itself.
    Single family home sales have hit a rough patch. So what. The marketplace will adjust.
    Two things impress me. One is that when I was in my late 20’s, interest rates hit 21.5% and the housing market survived and accended. Second, Orange County and particularly Irvine is high on many parts of the international radar-screen. Those homes in the hurd that limp or bleed I believe will be absorbed and prices will continue to ultimatly rise.
    Southern California is a hot kitchen. Some may choose to live here and cook elsewhere.
    A POV

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