What they are saying about The Great Housing Bubble
“A very well-written and thoughtful analysis of what went wrong in
the housing world and how we can avoid this problem in the future.
Lawrence Roberts has a great understanding of the subject and does an
excellent job communicating his ideas to the reader.”
Jim Randel – Best-selling author, Confessions of a Real Estate Entrepreneur
What is a Bubble?
A financial bubble is a temporary situation where asset prices
become elevated beyond any realistic fundamental valuations because the
general public believes current pricing is justified by probable future
price increases. If this belief is widespread enough to cause
significant numbers of people to purchase the asset at inflated prices,
then prices will continue to rise. This will convince even more people
that prices will continue to rise. This facilitates even more buying.
Once initiated, this reaction is self-sustaining, and the phenomenon is
entirely psychological. When the pool of buyers is exhausted and the
volume of buying declines, prices stop rising; the belief in future
price increases diminishes. When the remaining potential buyers no
longer believe in future price increases, the primary motivating factor
to purchase is eliminated; prices fall. The temporary rise and fall of
asset prices is the defining characteristic of a bubble.
The bubble mentality is summed up in three typical beliefs:
- The expectation of future price increases.
- The belief that prices cannot fall.
- The worry that failure to buy now will result in permanent inability to obtain the asset.
The Great Housing Bubble was characterized by the acceptance of
these beliefs by the general public, and the exploitation of these
beliefs by the entire real estate industrial complex, particularly the
sales mechanism of the National Association of Realtors.
Speculative bubbles are caused by precipitating factors.[1] Like a
spark igniting a flame, a precipitating factor serves as a catalyst to
begin the initial price increases that change the psychology of market
participants and activates the beliefs listed above. There is usually
no single factor but rather a combination of factors that stimulates
prices to begin a speculative mania. The Great Housing Bubble was
precipitated by innovation in structured finance and the expansion of
the secondary mortgage market, the lowering of lending standards and
the growth of subprime lending, and to a lesser degree the lowering of
the Federal Funds Rate. All of these causes are discussed in detail in
later sections.
Real Estate Only Goes Up
The mantra of the National Association of Realtors is “real estate
only goes up.” This economic fallacy fosters the belief in future price
increases and the limited risk of buying real estate. In general real
estate prices do increase because salaries across the country do tend
to increase with the general level of inflation, and it is through
wages that people make payments for real estate assets. [ii] When the
economy is strong and unemployment is low, prices for residential real
estate tend to rise. Therefore, the fundamental valuation of real
estate does go up most of the time. However, prices can, and often do,
rise faster than the fundamental valuation of real estate, and it is in
these instances when there is a price bubble.
Greed is a powerful motivating factor for the purchase of assets. It
is a natural response for people to desire to make money by doing
nothing more than owning an asset. [iii] The only counterbalance to
greed is fear. However, if a potential buyer believes the asset cannot
decline in value, or if it does, it will only be by a small amount for
a very short period of time, there is little fear generated to temper
their greed. [iv] The belief that real estate only goes up has the
effect of activating greed and diminishing fear. It is the perfect
mantra for creating a price bubble. [v]
Buy Now or Be Priced Out Forever
When prices rise faster than their wages, people can obtain less
real estate with their income. The natural fear under these
circumstances is to buy whatever is available before there is nothing
desirable available in a particular price range. This fear of being
priced out causes even more buying which drives prices higher. It
becomes a self-fulfilling prophecy. Of course, the National Association
of Realtors, the agents of sellers, is keen to exploit this fear to
increase transaction volume and increase their own incomes. If
empirical evidence of the recent past is confirming the idea that real
estate only goes up, the fear of being priced out forever provides
added impetus and urgency to the motivation to buy.
Just before the stock market crash signaling the beginning of the
Great Depression, Irving Fisher, a noted economist at the time, was
quoted as saying “Stock prices have reached what looks like a
permanently high plateau.” [vi] Of course, stock prices dropped
significantly after he made this statement. This sentiment is based on
the idea that inflated prices can stay inflated indefinitely. However,
when valuations cannot be pushed up any higher, prices cannot rise at a
fast rate. In residential real estate markets, the rate of price
increase would only match inflation because wages and inflation are
closely correlated. If the rate of price increase does not exceed
ordinary investments, people lose their enthusiasm for residential real
estate as an investment, and they begin to look for alternatives:
people choose to rent rather than own. Also, when the quality of units
available for rent at a given monthly payment far exceeds the quality
of those available for sale at the same monthly payment level, people
choose not to bid on the property and they rent instead. One sign of a
housing bubble is a wide disparity between the quality of rentals and
the quality of for-sale houses at a given price point. People choosing
to rent curtails the rapid rise in prices and thereby lowers the demand
for real estate. This puts downward pressure on prices, which
eliminates the primary motivation speculators had for purchasing the
asset. Greed created the condition of rapidly rising prices which in
turn spawns the fear of being priced out. When greed ceases to motivate
buyers, prices fall.
Once prices begin to fall, the fear of being priced “out” forever
changes to a fear of being priced “in” forever. A buyer who overpaid
and over-borrowed will be in a circumstance where they owe more on
their mortgage than the property is worth on the open market. They
cannot sell because they cannot pay off the mortgage. They become
trapped in their homes until prices increase enough to allow a
breakeven sale. This puts the conditions in place to reverse the cycle
and causes prices to drop precipitously.
Confirming Fallacies
There are a number of fallacies about residential real estate that
either affirm the belief in perpetually rising prices or minimize the
fears of a price decline. These fallacies generally revolve around a
perceived shortage of housing or a belief that the higher prices are
justified by current or future economic conditions. These
misperceptions are not the core mechanism of an asset price bubble, but
they serve to affirm the core beliefs and perpetuate the price rally.
They Aren’t Making Any More Land
All market pricing is a function of supply and demand. One of the
reasons many house price bubbles get started is due to a temporary
shortage of housing units. [vii] This is a particular problem in
California because the entitlement process is slow and cumbersome.
[viii] Supply shortages can become acute, and prices can rise very
quickly. In most areas of the country, when prices rise, new supply is
quickly brought to the market to meet this demand, and price increases
are blunted by the rebalancing of supply and demand. Since supply is
slow to the market in California, these temporary shortages can create
the conditions necessary to facilitate a price bubble.
The fallacy of running-out-of-land plays on this temporary condition
to convince market participants that the shortage is permanent. The
idea that all land for residential development can be consumed ignores
one obvious fact: people do not live on land, they live in houses, and
land can always be redeveloped to increase the number of housing units.
Basically, builders can build “up” even if they can’t build “out.” If
running-out-of-land were actually a cause of a permanent shortage of
housing units, Japan and many European countries where there is very
little raw land available for development would have housing prices
beyond the reach of the entire population (Japan tried it once, and
their real estate market experienced a 64% decline over a 15 year
period until affordability returned). [ix] Since prices cannot remain
permanently elevated, it becomes obvious that the amount of land
available for development does not create a permanent shortage of
dwelling units.
Over the long term, rent, income and house prices must come into
balance. If rents and house prices become very high relative to
incomes, businesses find it difficult to expand because they cannot
attract personnel to the area. In this circumstance, one of two things
will happen: businesses will be forced to raise wages to attract new
hires, or business will stagnate and rents and house prices will
decline to match the prevailing wage levels. [x] During the Great
Housing Bubble, many businesses in the most inflated markets
experienced this phenomenon. The effect is either a dramatic slowing of
population growth or net outmigration of population to other areas.
Everyone Wants To Live Here
Everyone believes they live in a very desirable location; after all,
they choose to live there. People who make this argument fail to
understand that the place they live was just as desirable before the
bubble when prices were much lower, in fact, probably more so. What is
it about their area that made it two or more times as desirable during
the bubble? Of course, nothing did, but that does not stop people from
making the argument. [xi] There is a certain emotional appeal to
believing the place you chose to call home is so desirable that people
were willing to pay ridiculous prices to live there. The reality is
prices went up because people desired to own an asset that was
increasing in price. People motivated by increasing prices do not care
where they live as long as prices there are going up.
Prices Are Supported By Fundamentals
In every asset bubble people will claim the prices are supported by
fundamentals even at the peak of the mania. Stock analysts were issuing
buy recommendations on tech stocks in March of 2000 when valuations
were so extreme that the semiconductor index fell 85% over the next 3
years, and many tech companies saw their stock drop to zero as they
went out of business. Analysts even invented new valuation techniques
to justify market prices. One of the most absurd was the “burn rate”
valuation method applied to internet stocks. [xii] Rather than value a
company based on its income, analysts were valuing the company based on
how fast it was spending their investor’s money. When losing is
winning, something is profoundly wrong with the arguments of
fundamental support. The same nonsense becomes apparent in the housing
market when one sees rental rates covering less than half the cost of
ownership as was common during the peak of the bubble in severely
inflated markets. Of course, since housing markets are dominated by
amateurs, a robust price analysis is unnecessary. [xiii] Even a
ridiculous analysis, if aggressively promoted by the self-serving real
estate community, provides enough emotional support to prompt the
general public into buying. There is no real fundamental analysis done
by the average homebuyer because so few understand the fundamental
valuation of real property. Even simple concepts like comparative
rental rates are ignored by bubble buyers, particularly when prices are
rising dramatically and such valuation techniques look out-of-touch
with the market.
Figure 1: Ratio of House Price to Income in California, 1980-2006
When rental cashflow models fail, which they do during the rally of
a housing bubble, the arguments justifying prices turn to an owner’s
ability to make payments. The argument is that everyone is rich, and
everyone is making enough money to support current prices. It seems
people began believing the contents of their “liar loan” applications
during the bubble, or perhaps they counted on the
home-equity-line-of-credit spending to come from the inevitable
appreciation. [xiv] Even when confronted with hard data showing the
everyone-is-rich argument to be fallacious, people still claim it is
true. One unique phenomenon of the Great Housing Bubble was the exotic
financing which allowed owners the temporary luxury of financing very
large sums of money with small payments. There was some truth to the
argument that people could afford the payments. Unfortunately, this was
completely dependent upon unstable financing terms, and when these
terms were eliminated, so were any reasonable arguments about
affordability and sustainable fundamental valuations.
It Is Different This Time
Each time the general public creates an asset bubble, they believe
the rally in prices is justifiable by fundamentals. [xv] When proven
methods of valuation demonstrate otherwise, people invent new ones with
the caveat, “it is different this time.” It never is. The stock market
bubble had its own unique valuation methods as described previously.
The Great Housing Bubble had proponents of the financial
innovation model. Rather than viewing the unstable loan programs of the
bubbles with suspicion, most bubble participants eagerly embraced the
new financing methods as a long-overdue advance in the lending
industry. Of course, it is easy to ignore potential problems when
everyone involved is making large amounts of money and the government
regulators are encouraging the activity. Alan Greenspan, FED chairman
during the bubble, endorsed the use of adjustable rate mortgages in
certain circumstances (Greenspan, Understanding Household Debt Obligations, 2004),
and official public policy under the last several presidential
administrations was the expansion of home ownership. [xvi] When
everyone involved was saying things were different and when the
activity was profitable to everyone involved, it is not surprising
events got completely out of control.
The Importance of Financial Bubbles
Why should anyone care about financial bubbles? The first and most
obvious reason is that the financial fallout is stressful. People
buying into a financial mania too late, particularly in a residential
housing market, will probably end up in foreclosure and most likely in
a bankruptcy court. In contrast, stock market bubbles will only cause
people to lose their initial investment. It may bruise their ego or
delay their retirement, but these losses generally do not cause them to
lose their homes or declare bankruptcy like a housing market bubble
does. In a stock market collapse, a broker will close out positions and
close an account before the account goes negative. There is a safety
net in the system. In a residential housing market, there is no safety
net. If house prices decline, a homeowner can easily have negative
equity and no ability to exit the transaction. In a housing market
decline, properties become very illiquid as there simply are not enough
buyers to absorb the available inventory. A property owner can quickly
fall so far into negative territory that it would take a lifetime to
pay back the debt. In these circumstances bankruptcy is not just
preferable; it is the only realistic course of action. It is better to
have credit issues for a few years than to have insurmountable debt
lingering for decades.
The real problems for individuals and families come after the
bankruptcy and foreclosure. The debt addicted will suddenly find the
tools they used to maintain their artificially inflated lifestyles are
no longer available. The stress of adjusting to a sustainable,
cash-basis lifestyle can lead to divorces, depression and a host of
related personal and family problems. One can argue this is in their
best interest long-term, but that will be little comfort to these
people during the transition. The problems for the market linger as
well. Those who lost homes during the decline are no longer potential
buyers due to their credit problems. It will take time for this group
to repair their credit and become buyers again. The reduction in the
size of the buyer pool keeps demand in check and limits the rate of
price recovery.
Summary
The Great Housing Bubble, like all asset bubbles, was driven by the
belief in permanent, rapid house price appreciation, an unrealistic
perception of the risk involved, and the fear that waiting to buy would
cause market participants to miss their opportunity to own a house.
These erroneous beliefs were supported by groupthink; if everyone else
believes it, it must be true. As with any mass delusion, it is
difficult to see beyond the comforting fallacies to understand the
deeper truth; however, it is essential to do so because the cost in
emotional and financial terms of getting caught up in the mania is very
high. Foreclosure and bankruptcy are bad for individuals, bad for
families, and bad for society.
[1] Robert Shiller in his book Irrational Exuberance (Shiller, Irrational Exuberance, 2005)
discusses precipitating factors at length from pages 31 -54. Most of
the factors he mentions are macro-factors or more specifically related
to the stock market.
[ii] According to data from the US Census Bureau and The US
Department of Labor, wage growth since 1976 has averaged 4.62% and
inflation has averaged 4.42%.
[iii] From 2002-2006 in Irvine, California, the median house price increased by an amount each year equal to the median income.
[iv] Karl Case and Robert Shiller noted that a buyer’s willingness
to pay high prices depended in part on their perception of risk of
price decline (Case & Shiller, The Behavior of Home Buyers in Boom and Post-Boom Markets, 1988). Very few buyers in the markets they surveyed during the coastal boom of the late 1980s though prices could go down.
[v] Psychologists have noted narrative-based thinking is extremely important in human decision making (Shiller, Historic Turning Points in Real Estate, 2007). When realtors or anyone working in sales creates a compelling narrative, it is very effective in motivating buyers.
[vi] The author could not find the source for the widely cited quote
from Irving Fisher where he said, “Stock prices have reached what looks
like a permanently high plateau.” It is held as the standard for
incorrect market prognostications.
[vii] Robert Shiller has noted there is a tendency among investors
to overestimate how unique an investment they favor is. These investors
fail to take into account the supply response to higher prices (Shiller, Understanding Recent Trends in House Prices and Home Ownership, 2007).
Supply shortages are never permanent. The ends of booms are almost
always associated with an unexpected glut of supply. Also, the idea of
there being “not enough land” was cited in surveys going back to 1988 (Case & Shiller, The Behavior of Home Buyers in Boom and Post-Boom Markets, 1988).
[viii] William Jaeger studied the issue of land use control limiting
local housing supply in his paper The Effects of Land-Use Regulations
on Property Values (Jaeger, 2006). His
conclusions are as follows: “Land-use regulations can affect property
values in a variety of complex ways. In the context of laws like
Oregon’s Measure 37, requiring that landowners be compensated if
regulations reduce property values, the economic effects of land use
regulations on property values have been widely misinterpreted because
two very different economic concepts are being confused and used
interchangeably. The first concept is “the effect of a land use
regulation on property values” which measures the change in value when
a regulation is added to many parcels. The second concept is “the
effect of an individual exemption, or variance, to an existing land use
regulation,” which measures the change in value when a regulation is
removed from only one parcel. The effect of a land-use regulation on
property values can be positive or negative, whereas removing a
land-use regulation from one property can be expected to have a
positive effect. Indeed, many land-use regulations actually increase
property values by creating positive “amenity effects” and “scarcity
effects. “As a result of these differences, a positive estimate for
removing a land-use regulation cannot be interpreted as proof that the
other concept was negative. Despite this, a positive value for an
individual exemption to a land-use regulation continues to be
interpreted as proof that compensation is due under Oregon’s Measure
37. Indeed, this mistaken interpretation may be partly responsible for
public sentiment that land-use regulations tend to reduce property
values.”
[ix] In the paper, Asset Price Bubble in Japan in the 1980s: Lessons for Financial and Macroeconomic Stability (Shiratsuka, 2003),
the author reached the following conclusion, “Japan’s experience of
asset price bubble is characterized by euphoria, that is, excessively
optimistic expectations with respect to future economic fundamentals,
which lasted for several years and then burst. Under such
circumstances, policymakers are unlikely to take an appropriate policy
response without evaluating whether asset price hikes are euphoric or
not, and forecast a correct path for the potential growth rate. In so
doing, it is deemed important to assess the sustainability of financial
and macroeconomic stability.” The paper is more history than analysis,
but it provides a good background understanding of the Japanese housing
and stock market bubble.
[x] Karl Case and Robert Shiller mentioned a report in the Harvard
Business Review that spoke of businesses in boom regions were unable to
attract labor due to the high cost of housing. (Case & Shiller, The Behavior of Home Buyers in Boom and Post-Boom Markets, 1988)
[xi] Karl Case and Robert Shiller noted (Case & Shiller, Is There a Bubble in the Housing Market, 2004)
overwhelming agreement with the statement “Housing prices have boomed
in [city] because lots of people want to live here.” Another recurring
idea in the “everyone wants to live here” meme is the “rich Asians are
buying.” This fallacy is promoted in every real estate bubble. (Case & Shiller, The Behavior of Home Buyers in Boom and Post-Boom Markets, 1988)
[xii] Michael Wolff wrote the book Burn Rate: How I Survived the Gold Rush Years on the Internet (Wolff, 1998) describing the strange investor behavior of the internet startup era.
[xiii] Robert Shiller’s surveys have demonstrated most home
purchasers have little real knowledge or agreement about the underlying
causes of price rallies. Most would cite clichés, images or popular
fallacies rather than hard evidence or analysis of data with
correspondence to prices. (Case & Shiller, The Behavior of Home Buyers in Boom and Post-Boom Markets, 1988)
[xiv] Stated-Income Loans also known as “liar loans” were widespread
during the bubble. People frequently fabricated their income.
[xv] One of the more interesting phenomenon observed in the
scholarly literature during a financial bubble is the number of
analysts who look at the data and are unable to form an objective
opinion about what the data shows them. In the paper Bubbles, Human
Judgment, and Expert Opinion (Shiller, Bubbles, Human Judgment, and Expert Opinion, 2001),
Robert Shiller examines this phenomenon. In his introduction he noted,
“There are many who have been arguing in effect that the market (or
major components of it) has been undergoing a bubble. It would seem
that it is essential to their notion of a bubble that investors’
actions are, in one way or another, foolish. Others sharply disagree
with these bubble stories, and it is precisely this intimation of
foolishness that seems to bother them. It seems to them just
implausible that investors at large have been foolish.” The tone of
many of the journal articles seems rather defensive and dismissive of
the idea of a bubble even when the evidence is clear. One can surmise
this tone is the result of the “foolishness” Dr. Shiller describes. In
his conclusion he writes, “human patterns of less-than-perfectly
rational behavior are central to financial market behavior, even among
investment professionals, while at the same time there is little
outright foolishness among investors. It is hard for writers in the
news media, who describe financial markets, to convey the nature of any
essential irrationality, since they cannot all review the relevant
social science literature in their news article. They are left with
punchy references to pop psychology that may serve to discredit them in
many eyes. That is part of the reason why we have been left with a
sense of strong public disagreement about the nature of speculative
bubbles.” It is amazing to this author how so many academics along with
the general public can completely miss financial bubbles and deny their
existence past the point where it is obvious to everyone. Ben Stein was
the poster child for this behavior during the Great Housing Bubble. One
of the scholarly references showing this dismissal of the obvious is
The great turn-of-the-century housing boom (Fisher & Quayyum, 2005)
by Jonas D. M. Fisher and Saad Quayyum. In it they reach the following
completely erroneous conclusion right at the peak of the bubble, “To
the extent that the quantities can be understood by considering the
underlying economic fundamentals, such as productivity growth and the
evolution of the mortgage market, then the recent growth in house
prices is probably not due to excessive speculation in the housing
market, such as occurs in a bubble. We argue that our findings point
toward the high prices being driven by fundamentals.” Even at the very
peak of the insanity, there are well-educated market observers that
miss the signs or believe the fallacies which serve to inflate the
bubble.
[xvi] Alan Greenspan made the following statements at the Credit
Union National Association 2004 Governmental Affairs Conference,
“Indeed, recent research within the Federal Reserve suggests that many
homeowners might have saved tens of thousands of dollars had they held
adjustable-rate mortgages rather than fixed-rate mortgages during the
past decade, though this would not have been the case, of course, had
interest rates trended sharply upward. American homeowners clearly like
the certainty of fixed mortgage payments. This preference is in
striking contrast to the situation in some other countries, where
adjustable-rate mortgages are far more common and where efforts to
introduce American-type fixed-rate mortgages generally have not been
successful. Fixed-rate mortgages seem unduly expensive to households in
other countries. One possible reason is that these mortgages
effectively charge homeowners high fees for protection against rising
interest rates and for the right to refinance. American consumers might
benefit if lenders provided greater mortgage product alternatives to
the traditional fixed-rate mortgage. To the degree that households are
driven by fears of payment shocks but are willing to manage their own
interest rate risks, the traditional fixed-rate mortgage may be an
expensive method of financing a home.” It is a good thing Alan
Greenspan was our central banker and not a financial adviser. Many
people who “benefited” from the mortgage product alternatives lost
their homes in foreclosure. There is a reason homeowners like
fixed-rate mortgages. How exactly are borrowers supposed to “manage
their own interest rate risks” without using fixed-rate mortgages?
Perhaps if Alan Greenspan had thought that statement through, his
advice might have been different. Daniel Gross wrote about the folly of
this speech in his weekly column on the internet magazine Slate (Gross, Alan Greenspan: ARMed and Dangerous, 2004).
Mr. Gross noted the following, “Greenspan also conspicuously ignored
the non-monetary benefits associated with fixed-rate mortgages.
Homebuyers pay a premium for the ability to lock in a fixed interest
rate – and hence have utter certainty on the size of their payment for
up to three decades. But in return, they receive peace of mind,
security, and the ability to plan.”
