It did not occur to me until writing this post that people can sell their houses to the bank for a profit by simply convincing the bank to make them a loan. Nice idea. I am surprised more people are not doing it.
From Redfin, “STUNNING. .SHOWS BETTER THEN THE MODEL. .FULL 5 BEDS-COULD BE 6 W/ HUGE UPSTAIRS BONUS/OFFICE) GOURMET KITCHEN W/ BLACK GRANITE, CHERRY CABINETS W/ GLASS DISPLAY, 6 BURNER MONO STOVE. .FML LIVING W/ FIREPLACE (USED AS DINING RM)SEP. FML DINING RM. .DESIGNER PAINTS, CROWN MOLDING, WAINSCOTTING FANS, WINDOW CASINGS, CHAIR RAILS. .FP IN LIVING, FAMILY & MASTER. .HUGE ROMANTIC MASTER SUITE W/ FP. .FABULOUS LG FAMILY RM. W/ ENTERTAINMENT CENTER & FP. .EX LG PROF. LAND/HARDSCAPED PRIVATE YARD. .CUL DE SAC. . GUARD GATED. .
Between the CAPS LOCK and the abbreviations (& FP. .EX LG PROF. ), this description is practically unreadable.
“SHOWS BETTER THEN THE MODEL.” This kind of BS is annoying.
GOURMET KITCHEN — You did notice our new award, right? Thanks Shhhhh.
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At 221 days on the market, this house is obviously overpriced, but that isn’t the story here. These people have already sold the house to Bank of America and made a $500,000 profit — sort of. Bank of America issued this homeowner a $500K HELOC in July of this year. How did they get an appraisal for $1,550,000 to obtain the HELOC? WTF was Bank of America thinking?
I don’t know if this HELOC has been maxed out, but if it isn’t, it should be. This house is not going to sell for a profit, and Bank of America has graciously consented to give these people $500,000 for the right to foreclose in a second lien position which will probably be entirely wiped out by the first mortgage during foreclosure. These people have every incentive to take the money, go to Vanuatu (a notorious tax haven,) and hide the cash in a safe deposit box in a bank there. Yes, it is illegal and immoral, but not any more so than the others who have defaulted on their loans. If the banks are really this stupid, they deserve what is coming to them.
I’m dreaming dreams, I’m scheming schemes, I’m building castles high. They’re born anew, their days are few, Just like a sweet butterfly. And as the daylight is dawning, They come again in the morning!
I’m forever blowing bubbles, Pretty bubbles in the air, They fly so high, Nearly reach the sky, Then like my dreams They fade and die. Fortune’s always hiding, I’ve looked everywhere, I’m forever blowing bubbles, Pretty bubbles in the air. When shadows creep, When I’m asleep, To lands of hope I stray!
A financial bubble is a temporary situation where asset prices become elevated beyond any realistic fundamental valuations because the general public believes future price increases justifies current pricing. 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 prices will continue to rise facilitating even more buying. Once begun, this reaction is self-sustaining, and the phenomenon is entirely psychological. Once the pool of buyers is exhausted and the volume of buying declines, prices stop rising, and 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:
1.The expectation of future price increases.
2.The belief that prices cannot fall.
3.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.
Robert Shiller, in his book Irrational Exuberance, argues that speculative bubbles are caused by “precipitating factors.” Like a spark ignites a flame, a precipitating factor serves as a catalyst to begin the initial price increases that change the psychology of market participants and activate 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 FED funds rate.
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. 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. 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. 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.
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.
The fallacy in this reasoning is easy to identify: who exactly is pricing out whom? When a housing unit becomes available for sale, it must be purchased by someone. The potential pool of buyers will put in competing bids to obtain the property. Unless very wealthy people start wanting to live in small condominiums, there will always be a housing unit available for someone willing to put in a competitive bid. At some point, the available housing stock gets bid up so high that people choose to rent rather than own. 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 chose not to bid on the property and chose to 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.
Confirming fallacies
There are a number of fallacies also believed by the general public with respect to 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 beliefs 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. This is a particular problem in California because the entitlement process is slow and cumbersome. 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 don’t live on land, they live in houses, and land can always be redeveloped to increase the number of housing units. 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. Since this is not the case, 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. During the Great Housing Bubble, many businesses in the most inflated markets experienced this phenomenon. The effect is a 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. What is it about their area that made it two or more times as desirable during the bubble? Of course, nothing did, but that doesn’t stop people from making the argument. 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. 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. Even a ridiculous analysis, like the ones produced by Gary Watts, 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.
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. Even when confronted with hard data showing the everyone-is-rich argument to be fallacious, people still claim it is true. One of the unique phenomenons 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. 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 above. 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, and official public policy under the last several presidential administrations was the expansion of home ownership. When everyone involved is saying things are different and when the activity is profitable to everyone involved, it is not surprising events got out of control.
Who Cares?
Why should anyone care about financial bubbles? The first and most obvious reason is the financial fallout is stressful. People buying into a financial mania too late, particularly in a residential housing market, will end up in foreclosure and most likely in a bankruptcy court. Stock market bubbles will only cause people to lose their investment. It may bruise their ego or delay their retirement, but these losses generally do not cause one to lose their home 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.
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.
Conclusion
The Great Housing Bubble, like all asset bubbles, was driven by the belief in permanent 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 a host of fallacious beliefs embraced by everyone involved. As with any mass delusion, it is difficult to see beyond the fallacies to 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 never positive outcomes.
I found this blog entry on Calculated Risk. If you did not see it, it brilliantly and concisely demonstrates the problems facing the market in the foreseeable future.
In the ’90s, as prices fell in California, foreclosure activity (using Notice of Defaults NODs) increased. Prices bottomed in 1996, as foreclosure activity peaked.
Now imagine what will happen over the next few years as house prices fall. Foreclosure activity is already at record levels (2007 estimated on graph). Yet, as prices fall, foreclosure activity will probably continue to increase – the activity will be literally off the chart!
It is pretty difficult to but a bullish spin on that one.
Does everyone remember this original post, Weeping Desert Willow? It was the most viewed post ever on this site. Well, we have an update. This property went back to the lender on 10/18/2007 for $1,030,658. All told the bank lost $164,605 so far. They will likely lose more as they sell it in the resale market and pay a commission.
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Today’s property is a perfect example of how negative amortization loans given to people who can not afford the payments destroy property values.
In this one section of street in the Villages of Columbus there are three properties for sale: 27, 28 and 30 Desert Willow (links on the numbers.) Two of them are adjacent and the third is directly across the street. They are all of similar size and character, and the sellers paid similar amounts for them.
However, the seller of today’s featured property got behind on his payments and went into default. As a final effort to get out of this property, he put it for sale at a drastically reduced price. The neighbors can’t be too pleased.
From Redfin, “Incredible 5 Bedroom, almost new with many upgrades. To appreciate thi s home you must make an appointment to SEE IT IN PERSON. Near Schools, park and shopping. Perfect family home. Too many upgrades to list.”
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As you can see from the financing details, this is a short sale, and it almost certainly will not be approved by the lender. It is not uncommon in these situations for the second mortgage holder to get wiped out, but rarely will the first mortgage holder take a loss. They would rather foreclose, buy the property for the amount of the first mortgage and go through their loss mitigation procedures. It is possible they think it will cost them less this way, but I doubt it.
Just for the sake of Schadenfreude let’s calculate the theoretical loss on this property: There was a closing on 5/3/2006 at which Lennar walked away with $1,286,863. If this house sells for its asking price, and a 6% commission is paid to a broker, there will be $799,000 left to pay off the various parties. That is a total loss of $487,863. First, the owner will lose $91,600, then the 2nd mortgage holder will lose $251,634, and finally the primary mortgage holder will lose $144,629.
This can’t be good news for the owners at 27 Desert Willow hoping to get $1,188,000 for their house, or the owners at 30 Desert Willow hoping to get $1,279,000? Once a similar property sells for $850,000, what chance to they have of getting their wishing price?
On Sunday’s post on Home Sales Data thru 7-16-2007, I posted this chart with the increased insurance premium lenders are being charged to insure the most stable subprime borrowers. The reason this insurance is becoming so expensive is because of situations like this one where primary mortgage holders are getting burned, and insurers are having to pay off claims.
This is also why mortgage interest rates are going to rise. Future borrowers are going to have to pay the increased insurance costs and make up for the losses on these loans made during the bubble.
It only gets worse from here.
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I would like to thank EvaLSeraphim for pointing out this property and helping me with some property data.
This property went back to the lender on 11/9/2007 for $506,429. Apparently the seller bought the property with a $460,000 negative amortization loan with a 1% teaser rate. I don’t see a second, so it appears the $125,000 downpayment was consumed by the negative amortization on the loan and the dropping property values.
Beds: 2 Baths: 2 Sq. Ft.*: 1,050 Year Built: 1999 Stories: 2 Type: Single Family Residence View: Hills Neighborhood: Northwood $/Sq. Ft.*: $567 MLS: S476148 Status: Active on market On Redfin: 42 days
In my opinion one of the most notable features of this bubble has been the increase in price of entry level housing product. I suspect this is a result of sub-prime lending and/or exotic financing terms. Back when you could not afford to finance more than 3 or 4 times earnings, entry level housing was priced at $200,000 or less. During the rally when 10 to 12 times earnings could be easily borrowed, $200,000 properties where bid up to $550,000. Nobody was actually making any more money, they were just borrowing a lot more. Once the limit of borrowing was reached last year, the rally fizzled. Now that credit is tightening, those who bought at the top are having difficulty finding buyers. The result of all this borrowing is properties like the two I am featuring today.
First, I want to say this is one of my favorite neighborhoods in Irvine. It features architecture reminiscent of a small English village with quaint cottages. There are few visible garages, the sidewalks are detached from the street, and the trees make for a great street scene. It is very close to Canyon View Elementary in Northwood. If prices were not ridiculous, I would buy in this neighborhood.
These two flips are showing signs of stress. They are overpriced and hoping a greater fool comes along to save them. 206 Garden Gate Lane has been on the market nearly 100 days. If they get their asking price of $655,800 assuming a 6% commission, they will lose $8,548.
The flipper at 54 Paisley Place gets their asking price of $595,000 assuming a 6% commission, they will lose $15,700. Does anyone want to go up there and pay well over $500 per square foot for some 8 year old properties when you could buy 75 Chantilly, a nearly new, much larger 2 bedroom over in Woodbury for $370 per square foot? I think I will pass.
