A Brief History of Kool Aid

What a Fool Believes — The Doobie Brothers

Kool Aid intoxication is synonymous with irrational exuberance as I outlined in the post What is a Bubble.
It has not always been part of the culture here in California as people have not always believed such foolish ideas. Kool Aid
intoxication is a pathology that infected the populace of California in
the 1970s. Up until the mid 1970s, California had a median home sales
price of approximately three-times income just like the rest of the real
estate markets in the country. (Data: Median Income of Households by State: 1984 to 2006, Median Family Income by State: 1959, 1969, 1979, 1989, and 1999, California median home price since 1968.)

Median Home Prices 1968-2006

Median Home Prices 1986-2006

In the late 1970s, the country was in the grips of a wage/price inflationary spiral.
Under those conditions, people began to bid up the value of real estate
partly as a hedge against inflation, and partly because rising wages
made fixed payments more affordable. If you expect your wages to go up
10% every year, even a debt-to-income ratio over 50% becomes affordable
after just a few years. During the late 1970s, prices were bid up very
high, very fast, and many people made fortunes in real estate. It was
during this time that residents of California learned they could bid up
the price of real estate, and they could make money from it. This
realization spread like a virus throughout the state. The bust of the
early 80s did impact specific properties in various markets, but the
median only leveled out and did not fall. As Robert Shiller noted in
his paper in 1988 (Warning, big PDF file,) this taught people that after a big boom, prices do not fall.

Inflation Adjusted Median Home Prices 1968-2006

Median Home Prices 1968-2006 Inflation Adjusted

By 1985, incomes had risen to where house prices were at four-times
income. This became the new floor beneath prices, and it was the
beginning of the “sun tax” here in California. The combination of lower
interest rates and strong employment started people buying again. By
this time it had been over 10 years since prices were at three-times
income, and it looked as if they would never get down there again. Thus
the fear of being “priced out forever” was born. At this point, people
believed in rapid appreciation, they did not fear a decline in prices,
and now they had the fear of being priced out. Kool aid intoxication
had gripped the society, and people began buying real estate and created the first real bubble in California real estate. Prices rose dramatically, but when the limit of affordability was reached with the loan products of the time, prices stopped rising, and it looked like there was going to be another leveling off period like there was in the early 80s. However, this time, prices were bid up much higher than incomes could support, and the median actually fell across the state by almost 20%. Just as in the first crash, prices of individual properties fell more than the median, and in fringe markets the decline was spectacular.

Affordability as Measured in Debt-To-Income Ratios 1986-2006

Debt-To-Income Ratio 1986-2006

The long decline of the early 90s might have been the end of kool aid intoxication. Prices of individual properties dropped below four-times income, and a relative level of affordability had returned. After 6 consecutive years of falling prices, some of the core beliefs of kool aid intoxication had fallen out of favor and a degree of sanity had returned to the California real estate market. Prices began rising in 1997, and there was solid appreciation for 3 straight years as the market recovered from its slightly oversold condition. However by 2000, prices were high relative to incomes, and it looked as if the market might be at a top. Of course, prices did not top in 2000, and with a dramatic drop in interest rates engineered by the Federal Reserve, the conditions were created for another housing bubble. The beliefs of kool aid intoxication crept back in to the California psyche, and the rest of the story is The Great Housing Bubble (Warning, big PDF file.)

It is my greatest hope that people see that there is nothing special about California real estate. Prices here go up and down because we make them do so. The fallacious beliefs of Kool Aid intoxication makes people behave foolishly and buy properties not because they are a good value but because prices are going up. This price crash is going to be very, very painful to a great many people, and Kool Aid intoxication may fall from favor again. However, As long as this behavior is not seen for what it is, people will continue to repeat the mistakes of the past, and we will have another painful housing bubble crash.

Doobie BrothersHe came from somewhere back in her long ago
The sentimental fool dont see
Tryin hard to recreate
What had yet to be created once in her life

She musters a smile
For his nostalgic tale
Never coming near what he wanted to say
Only to realize
It never really was

She had a place in his life
He never made her think twice
As he rises to her apology
Anybody else would surely know
Hes watching her go

But what a fool believes he sees
No wise man has the power to reason away
What seems to be
Is always better than nothing
And nothing at all keeps sending him…

Somewhere back in her long ago
Where he can still believe theres a place in her life
Someday, somewhere, she will return

What a Fool Believes — The Doobie Brother

45 thoughts on “A Brief History of Kool Aid

    1. IrvineRenter

      Blue bars on the chart represent the recast schedule if all the loans were to recast five years after origination date. Gray bars represent the expected schedule of option ARM resets, which show loans recasting sooner after hitting the principal cap.

    2. Walter

      How do the readers here feel about how this graph will predict the bottom for prices. Would late 2010 be good because the greatest number of homes would be hitting the market, or will the market require what I term a ‘grinding down’ period and we will not see the bottom until years later.

      I have a big down, a good job and need to buy for a new family. But seeing graphs like this scares me. I learned the hard way how this can work, having bought some RE in 1989 and watching it fall 40%.

      1. AZDavidPhx

        I would also like to see a discussion of the herd mentality – supply/demand (borderline propagandist) Kool Aid arguments that have been pontificated by the bulls on several occasions.

        The argument has generally been along the lines of the following:

        “California is the best place to live and everyone wants to live there these days. Since it is so much better than any place else in the country – it is only natural that it should command the highest prices for housing therefore it is a simple case of supply and demand”

        “There are a lot of people in a small area competing for a place to live which increases demand”

        “I feel perfectly fine with borrowing a half million dollars to purchase an average tract house because I get to live someplace where I will be the envy of the rest of the country and the value will surely continue to rise as more and more people are going to want to move to California.”

        “Californians are typically wealthier than people in the rest of the country because Calfornia attracts all of the talented workers. Therefore, it naturally follows that the house prices are going to be higher than elsewhere, but since California has such a skilled and highly paid workforce, the local economy can easily support the high housing costs. Plus, it makes me feel very good about myself to know that I belong to such a talented/elite group of citizens even if I have to maintain high levels of debt to keep my status.”

        It’s all supply and demand. No bubble. Have some more.

        1. IrvineRenter

          In the post What is a Bubble, I talked at length about the supporting fallacies you describe.

        2. Perspective

          You do understand that you’re making the argument that the market is wrong, and you’re right?

          1. IrvineRenter

            In the short term the market is always right as it is what it is. There is the old trading expression that the market can remain irrational longer than you can remain solvent. In the long term, fundamentals tend to win out. I believe the market will bottom near four-times earnings not because it is “right” but because that is as right as people will allow it to be.

          2. AZDavidPhx

            Assuming that you accept that the market is currently experiencing a “market correction” – it would imply that there must be a wrong somewhere.

          3. BD

            In the short term the market is a ‘voting machine’. In the long term the market is a ‘weighing machine’. We clearly had a bubble and the graphs suggest long grind in housing for the next several years.

      2. No_such_reality

        Reset to foreclosure is at minimum 7 months and more likely 12. Unless by that time, people just flat out stop paying on reset.

        I don’t think the banks will NOD you before you’re 90 days+ behind. NOD to NOT is basically 4 months. Add the backlog and it’s likely longer.

        Then add 3-6 months post auction for the bank to turn it over to a foreclosure clearing house, price it and put it up.

        So that hump that occurs in 2010 will start hitting the market spring 2011 and will trail 12 months.

        Then the market will have continuing pressure for two more years.

        So hard to say, if prices fall quickly enough, we’ll have buyers and if the banks liquidate at enough of a discount, flipping will be alive and well.

        How low can prices go? I suspect we’re about to find out, but looking at that chart, I wonder if we’ll see median home prices at 3X income, which would make a median home in Irvine $240,000.

        1. Iblis

          There’s an important point made here. Market recovery will happen once prices have corrected. The faster prices drop the sooner the market will recover. In contrast, anything that delays the correction or artificially supports prices (i.e. any kind of bailout) will delay recovery.

          Maybe it makes more sense to talk about “how much” instead of “when”.

          1. AZDavidPhx

            Sounds good in principle but not very practical.

            Could you imagine if every seller today said “Screw it I will sell my house for 1 dollar”

            The market would be immediately inundated with a brand new wave of frothing at the mouth speculators and before you know it all the inventory will be absorbed and house prices would jump right back up.

            Granted, the example is ridiculous, but the point is “how low is low enough without re-igniting the fire”.

            You have to price low, but you can’t give it away to all the vultures that are swarming.

        2. ar

          you say a median home for $240,000. where does a nice condo list if the median home is $240,000

    3. 25inIrvine

      I have a question regarding this graph and the story in the link.

      How does the lender determine when the borrower hits the 110% to 125% principal ceiling they are talking about. Do they do a new appraisal when they feel they are close? Do they base it off of comps then decide they have reached that 110%?

      1. IrvineRenter

        It is based on the original loan amount and it does not take into account changes in value.

        1. freedomCM

          Are you certain about this?

          I have no knowledge, but read a comment from RobDawg on bubbleinfo that the lenders may, in fact, take into account declining value.

          Is there fuller discussion at CR?

          1. Brett Krausse

            THe note of an option arm says that the re-cast percentage is based on the origional loan amount. $100,000 origional loan, would recast at $125,000 if it were a 125% option arm.

  1. Allison C.

    Very helpful chart. Gives me a very good idea how much longer I should wait. 🙂 Thanks.

  2. buster

    IR – Your historical figures are not inflation adjusted, correct? Given the current market conditions where real estate prices are plummeting and inflation is kicking up, are not the REAL losses much, much higher? A $600,000 property that “just stays even” over the course of a year with 6% inflation actually LOST it’s owner $36,000 in real money. Just as you pointed out that housing was used in the past as an inflation hedge, it can also be an inflation anchor if it doesn’t keep pace. With an FHA 3% down, you’ve effectively lost your down payment after only six months in the current economic environment.

    1. Priced_Out_IT_Guy

      Great point. RE only acts as a hedge against inflation if it appreciates with or faster than inflation 🙂

      1. CapitalismWorks

        Actually a hedge against inflation is anything that is correlated with inflation. That magnitude of the correlation is not required for a hedge. In fact you could have an asset that is negatively correlated to inflation that could be utilized as a hedge if there are no constraints on short-selling.

    2. bought_high

      If you put down $600,000 on your house – then yes, you lose to inflation if the house stays even.

      But if you put down 3%, then you only lose the inflation rate time your down payment – not the value of the house.

      The real losses are the realtors and other fee-based parasites.

  3. OCGolfCourse

    Geez… Looks like the market won’t go up until past 2012 according to just these figures!!

    I always wonder how low the price will actually go back to… 2002? 2000?

    1. AZDavidPhx

      You could very well see both. Real Estate is very local, indeed.

      Some properties may be able to fetch their 2002 equivalents while others drop back down to their 2000 equivs.

      Nicer homes in more desirable areas I would guess 2002. Other less desirable places could see higher declines with the speculative fervor gone.

      1. OCGolfCourse

        To be honest, I hope that it happens soon because I’m ready to buy a house. If I see no signs of recovery though, I won’t pull the trigger…

  4. lendingmaestro

    The biggest factor on these charts is time.

    5 years from peak to trough in the 70/80’s bubble and then 4 years to hit a new peak. Total of 9 years peak to peak.

    6 years from peak to trough in the 80/90’s bubble and then it’s off tho the races. A new peak should have formed sometime around ’01-’02 but that’s when all hell broke loose.

    If the Peak was in summer ’06 that puts our trough “bottom” clear out in 2012 and beyond. This is the 1st real estate bubble to incorporate the securitization of mortgages. That is why the market went to the moon in the early 90’s. that’s why lenders started cutting guidelines.

    We’ve got a LONG way to go.

  5. lendingmaestro

    went to the moon in the early 90’s….should read…went to the moon in the early 2000’s

    1. alan

      We went to the moon in 69…

      40 years later we haven’t been back…

      So housing prices went to the moon in 2003…

      Are you saying that housing prices wouldn’t be back until 2043?

  6. IrvineRenter

    It takes almost a year from reset to foreclosure and final sale in the market, and that is assuming they quit trying to make payments immediately. Based on the chart, I would say we will not see this toxin purged from the system until 2012-2014.

    1. Lisa

      Most of us probable will feel the “Inflation Adjusted Median Home Prices 1968-2006 chart” can’t explain why the prices go so high, right?
      After I read “Cash Proof: How to Profit From the Coming Economic Collapse” this weekend, the reason is very simple, the inflation actually is running 8% a year since 2001.

      I feel we should adjust the chart based on the real inflation rates (8%) not federal data (3%).
      This will better explain housing bubble.

    1. WaitingToBuyByAndBy

      I couldn’t agree more. Seeing prices drop makes me antsy. We’ve got to keep our cool.

      It would be tragic to avoid drinking the kool aid for so long and then end up a knife-catcher.

      1. Walter

        I am in the same boat. Trying to tell the wife we need to wait. Although do consider that buying now will most likely save you hundreds of thousands of dollars compared to if you bought in 2005-2006. So even buying now, the real tragedy is for the seller.

  7. Schadendude

    Lisa is right. Peter Schiff understands the predicament we’re in better than anyone.

    The government has incentive to promote inflation while understating it since all of it’s unfunded liabilities track to CPI.

    Good times.

    1. IrvineRenter

      The reported CPI will be as low as the AARP will allow. Once the CPI fails to reflect the actual cost of living of seniors, there will be a major political movement to change it. Until then, the government will fudge the figures to its advantage.

      1. John

        Remember, all these CPI, housing bubble etc allowed Bush reelected on 2004 and hence AG re-nominated as Fed chair.

        It just likes they score 59 on the test, but they show the score from a mirror as 95 instead.

        1. Schadendude

          True, but tweaking CPI predates Bush by almost 3 decades. I agree that it will take a major political movement to change currency manipulation, but I’m ever more fearful that the populace by and large lacks the understanding or the will to act. The degree of indiginous ignorance around the subject of macro economics continues to astound me.

  8. WaitingToBuyByAndBy

    Hey IrvineRenter,

    In the DTI chart, it looks like Irvine owners have a smaller DTI ratio than the rest of the county or the state. Am I reading that right?

    I was expecting the opposite, that Irvine owners would need higher DTI ratios to afford the more expensive prices found in Irvine.

    If I read the chart correctly, it suggests Irvine owners can afford higher prices because they are higher-earners. This is my greatest fear: that I’m a poor man renting in a rich man’s world.

    Btw, great analysis as usual.

  9. lawyerliz

    In Florida, the only drop I remember was in the mid 80s, and a slight drop in the mid 70s, hardly anything. It’s been straight up except for the 80s glitch til Aug9, 2007. Well, not straight up, gradually rising until it went parabolic.

    Thing is, who will you be borrowing from in 2012, if the banks are going under? It is very, very hard to get a mtg here. Even if you have 30% down and the house is only 3x income, if the banks have no money, where is going to come from?

    1. Mikee

      There are two wild cards at work here that make “all real estate local” -Demographics and Lending practices.

      In places like Florida, NC, California, Pheonix, etc, we saw the positive/positive aspect of these two creating the bubble we see today.

      Now, in Florida, we still have increasing demographics. People are retiring, selling their (comparably) expensive homes up north and buying an empty nest home in FLA. Also, the foreign money (I am in Europe curently and everyone here asks me about buying in FL!)
      That exuberance is now tempered by the restrictive lending (and insurance, too!) The banks are holding off on the lending, so the cheap money is making it harder to buy.

      But the demographics mean the demand is still there. Somewhat. The second home market may slow down, and the empty nesters may change their demand from a golf course 3/2 to a rented villa instead. The bank must lend at some point if the demand is there.

      I think they overbuilt in FL (esp BFE Orlando,and Tampa, Miami condos), and gave out mortgages that weren’t supported by the income. So, we’ll see a downturn. But it’ll be less than most areas. And recover quicker. It’s just the type of market it is.

      CA on the other hand??

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