Oct012008

Welcome to The Great Housing Bubble

What they are saying about The Great Housing Bubble

“…The cover is perhaps the clearest representation of what Roberts’ book really is: a clearly-communicated, often satirical, and at some points very stern, no-nonsense account of why home prices soared, fomenting the nation’s housing bubble, leaving couples across the nation struggling to stay afloat on their mortgages.Home Page Image

…In a market already flooded with books on the housing crisis, The Great Housing Bubble scores points by focusing on explanation and less on inundating a reader with the sort of heavy-handed quantitative analysis that only a few economists can love. While some figures are necessary, the book’s message is never bogged down.

Instead, Roberts presents multiple facets of the real estate market by taking the reader through the fundamentals and broad concepts of real estate economics. He then weaves psychology-based theories with structural factors of the bubble to offer a deeper, more detailed insight into how and why the housing bubble inflated and burst the way it did….”

Paul JacksonCEO, Housing Wire Magazine and HousingWire.com

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Preface

I work as a development consultant in the real estate industry in Southern California. My education and experience has acquainted me with a variety of real estate markets, but residential real estate is the one with which I am most familiar. I am not a realtor or a mortgage broker, and my livelihood, though dependent upon the real estate industry, it is not dependent upon facilitating a home-sale transaction. What is presented here is both historical account and unbiased analysis. My observations of the residential real estate market are not tainted by any need or desire to convince anyone they should buy a house. In fact, one of my motivations for writing about the Great Housing Bubble is to convince people not to buy a house when prices are inflated and save them from financial ruin. It saddens me to watch homebuyers get caught up in the bubble mythology and enter into a financial transaction that will have a strongly negative impact on their financial lives. People who have already made that decision cannot be helped except at the expense of a naïve buyer. Sellers have the marketing machine of the National Association of Realtors to help them. Buyers have few sources of unbiased information to assist their decision. Part of the purpose of this writing is to educate both buyers and sellers on the realities of the residential real estate market.

One of the difficulties of writing a book on the Great Housing Bubble in 2008 is that the bubble has not played itself out yet. There is a necessary change in tense required when speaking of events prior to 2008 and those projected to occur during and after 2008. Someone reading this in 5 years may look back on it as history, but for those of us living it now, it is a history not yet lived. Much of what is presented here may not come to pass, or it may not happen in the way hypothesized in this book. History will judge whether this is prescient, or if it is “a tale told by an idiot, full of sound and fury, signifying nothing.” [1]

Irvine Housing Blog

I discovered Real Estate Bubble Blogs in November of 2006. [2] Many were in existence much earlier, but I was not a big reader of blogs prior to this time. I first discovered the Irvine Housing Blog when my wife found a series of interesting posts on people who were attempting to sell properties for a quick profit (flipping,) and they were getting burned. I was quickly hooked. From the blogroll (links to other blogs) I was able to locate several other bubble blogs, and I quickly became a regular reader and commenter on several blogs in this community.

In February of 2007, I was asked to write for the Irvine Housing Blog. I had a great deal of pent-up energy for writing about the housing bubble. Over the months that followed I wrote a series of analysis posts which became the structure of this book. Daniel Gross, a freelance writer published in Slate Magazine, the Washington Post and Newsweek, characterized the writing as follows (Gross, The Real Morons of Orange County, 2007): “IrvineHousingblog, brilliantly drives home the same point with daily dispatches. The blog is a guide to the seventh circle of real estate hell–people who buy houses on spec with no money down. A typical entry chronicles the purchase price, tracks down the amount of debt on the property, and then calculates how much each party–the buyer, the first mortgage holder, the second mortgage holder–stands to lose assuming the seller receives the asking price.”

The Reservoir of Schadenfreude

The readers of the Irvine Housing Blog have a voracious appetite for profiles of losing properties. They are not alone. Why do people get so much pleasure from seeing would-be real estate moguls lose a great deal of money? I can think of no other human endeavor that has engendered so much pleasure in the misfortune of others by otherwise caring, compassionate people. In my opinion, the outpouring of schadenfreude we are seeing as the housing bubble deflates is a mixture of Greek tragedy and bad karma. In short, bubble participants should have seen it coming, and they are getting what they deserve.

Schadenfreude is not a spiritually uplifting emotional response. Most religious traditions would counsel us against it. In Buddhist teaching, people are taught to cultivate feelings of compassion for the misfortune of others–feeling empathy and sadness for the slings and arrows of outrageous fortune when they impact another. [3] The near enemy of compassion is pity: it masquerades as compassion, but it has an element of separateness which detracts from the sense of Oneness with all things. Joy is good: Sympathetic joy, the joy in the happiness of another, is another pillar of a spiritual existence; however, joy in the misfortune of another–schadenfreude–is not a skillful behavior leading to happiness. Even knowing that, many of us feel this joy anyway. Why is that?

I recognized financing terms were creating artificially high prices early on. By 2004, I was telling people I knew that this was a problem which would cause a market crash. Most people looked at me like I was crazy. “Real estate always goes up,” I was told. “The government would never allow prices to crash,” I was told. “If you do not buy now you will be priced out forever,” I was told. This is the intoxicated language of real estate junkies who have overdosed on the real-estate-appreciation kool aid. If these statements had been offered in a defensive manner of someone who is being made to realize they made a serious mistake, I could have felt sympathy for them; I would have been able to disarm their defensiveness and helped them see the light. However, what I generally got was a smug assuredness of someone who truly believed he was right and I was wrong; not just that I was wrong; I was a stupid, cowardly fool who did not have the brains or the bravery to take the free money being given out. This was particularly surprising given my line of work. It was as if a patient after getting a diagnosis of cancer told the doctor that the physician did not understand the tissue growth was a natural, healthy process. The buyers caught up in the Great Housing Bubble did not recognize the financial cancer even when an expert in the field told them how dangerous it was.

During the bubble rally, those of us who chose not to participate were labeled as “bitter renters.” It was suggested we were envious of the good fortune of homeowners as their property values rose, as they took on insane amounts of debt, and as they blithely financed a lifestyle well beyond their means. This was undoubtedly true for some, but in my opinion, this is not the primary reason so many derive so much pleasure from the misfortune of those now suffering from declining property values. These same people who chided us for being envious actually wanted us to be envious: they wanted us to know they were the winners in our competitive society; they wanted us to view them as superior. This act of putting themselves above us created a separation which prevented us from feeling sympathetic joy for their good fortune, and it prevented us from feeling compassion for them when they fell.

In our collective unconscious which manifests in our dreams and our mythology, water is often symbolic of our emotions or our emotional state. Have you noticed people are often categorized as deep or shallow? If you are in debt you often feel “underwater.” Anger is much like water: if not given an outlet, it will fill a reservoir until it reaches a breaking point and is expressed in a flood of emotional rage. Each encounter with a pathologic, kool-aid-drinking housing bull during the bubble rally has added to this reservoir, and reveling in failed flips is an outlet for this pool of toxic emotional waste.

There is an element of tragedy in every disaster, but financial bubbles are some of the most interesting because they are completely man made. They are created by the accumulation of individual decisions of buyers who are motivated by greed, foolish pride, and a false sense of security. Each of these people should have known better. Many of them were warned of their impending doom by those who saw trouble brewing, and yet, many chose to go down the path to the Dark Side. Newton’s Third Law states, “For every action, there is an equal and opposite reaction.” The Law of Karma states, “For every event that occurs, there will follow another event whose existence was caused by the first, and this second event will be pleasant or unpleasant according as its cause was skillful or unskillful.” It became obvious as the crash began; the behavior of buyers during the bubble rally was not skillful. Whether it is Newton’s Third Law, Karma, or a Calvinist form of retributive justice, as this bubble deflates, many of the participants in this bubble are about to experience a great deal of hardship. Like many others, I will enjoy their suffering until my reservoir of schadenfreude is emptied. For the sake of my own personal spiritual well being, I hope this happens soon so I can regain my normal emotional balance and rekindle my feelings of compassion for my fellow human beings.

Introduction

Why did house prices fall? This is the fundamental question to most Americans, and to those who lent them money. Most homeowners did not care why residential real estate prices rose; they assumed prices always rose, and they should simply enjoy their good fortune. It was not until prices began to fall that people were left searching for answers. This book examines the causes of the breathtaking rise in prices and the catastrophic fall that ensued to answer the question on every homeowner’s mind: “Why did house prices fall?”

Even though the decline is nowhere near over in 2008, already the Great Housing Bubble witnessed the largest decline in house prices since the Great Depression. The asset bubble for the Great Depression was the stock market while the asset bubble for the Great Housing Bubble was residential real estate. The title of the book, the Great Housing Bubble, is an allusion to the Great Depression of the 1930s. Both of these dramatic events were the result of a wild expansion of credit and a subsequent crash in asset prices that stressed the banking system and led to a dramatic economic slowdown. [iv]

The book is arranged into 10 chapters. The first 4 chapters provide background information and are used to define terms and provide a broad conceptual understanding of residential real estate economics, chapters 5 through 8 discuss the structural and psychological factors that inflated and deflated the bubble, and the final two chapters describe methods of coping with the housing bubble. Chapter 1 is a general description of financial bubbles as a psychological phenomenon and the unique beliefs of residential real estate bubbles. Chapter 2 details the financing environment surrounding residential real estate. It defines and categorizes the types of borrowers and the types of loan programs available, and it illustrates how financing impacts the wealth of individual owners and the economy as a whole. Chapter 3 summarizes the mathematics determining the value of residential real estate and examines issues pertaining to the rent-versus-own decision, and chapter 4 delves into the fine points of determining the value of individual lots and raw land. Chapter 5 illuminates the credit bubble (which was largely responsible for the real estate bubble) with rigorous detail on the structure of the secondary mortgage market and how the expansion of credit through this market inflated the housing bubble. Chapter 6 looks at the housing bubble, its various measurements, and explains why the bubble burst. Chapter 7 is a review of the psychology of real estate bubbles. Financial bubbles are primarily psychological phenomenon, and the various aspects of investor psychology are explored to see how they shape the market. Chapter 8 is a projection of future house prices based on the data and conditions as they existed in early 2008. Chapter 9 contains advice for both sellers and buyers who plan to be active while prices are declining. Chapter 10 is a review of the causes of the bubble and proposals for reforms to prevent residential real estate bubbles from happening again.

The examples and data used in the analysis are national in scope, and they are also focused on the local residential real estate market in Irvine, California. The Great Housing Bubble is a national phenomenon; however, the national statistics soften the extremes and make the rise and fall look less remarkable. In some local markets, the price changes are truly extraordinary, and it is through examining these markets that the story of the bubble is best told. A fine exemplar of the Great Housing Bubble is Irvine, California. Irvine is a large, master-planned community of over 200,000 residents. The high incomes of Irvine residents are reflected in the rental rates for properties which are consistently near the highest in the nation. High incomes and rents translate into high real estate prices, even at the bottom of down cycles. When reviewing the properties in Irvine and the price tags attached to them, it is not uncommon for outsiders to believe a decimal point has been misplaced. The lessons learned from the Irvine experience are universal. Though many the examples from this work focus on Irvine, this is a book about the Great Housing Bubble of which Irvine was both a catalyst and one of its biggest participants.

Table 1: Top Subprime Lenders 2006

Rank Lender Market Share %
1 Wells Fargo 13.0%
2 HSBC Finance 8.3%
3 New Century 8.1%
4 Countrywide Financial 6.3%
5 CitiMortgage 5.9%
6 WMC Mortgage 5.2%
7 Fremont Investment 5.0%
8 Ameriquest 4.6%
9 Option One 4.5%
10 First Franklin 4.3%
11 Washington Mutual 4.2%
12 Residential Funding 3.4%
13 Aegis Mortgage 2.7%
14 American General 2.4%
15 Accredited Lenders 2.3%
Top 15 Lenders 80.2%
Source: Inside B&C Lending

 

The epicenter of the Great Housing Bubble is located in Irvine, California. One of the primary causes of the bubble was the lowering of lending standards and the extension of credit to people who could not handle the responsibility: Subprime borrowers. The word “subprime” has become indelibly linked to the Great Housing Bubble. It is one of the causal factors that make the bubble unique, and the collapse of subprime is widely regarded as the pin-prick which began the bubble’s deflation. Irvine, California, is the center of the subprime universe. Three of the top ten subprime lenders, New Century, Ameriquest, and Option One, are (or were) headquartered in Irvine. Most subprime lenders have processing offices in Irvine due to the large number of trained personnel living in the area. Irvine’s New Century Financial, formerly the second largest subprime operator, is heralded as the poster child of the bubble. The company name “New Century” implies a new era and a new paradigm. It embodies the fallacious beliefs and ideas that inflated the Great Housing Bubble.

Volatility in real estate prices is not new to California. During the 1970’s, real estate prices detached from typical valuations of three-times yearly income seen in the rest of the country. Once residents realized they could push up prices in their real estate markets to dizzying heights, they have been doing it ever since. Greed springs eternal. The Great Housing Bubble is the third such bubble in the last 30 years, and it is the largest of all. The detachment from traditional measures of valuation was so extreme that it is difficult for many to comprehend. Each time the bubble bursts, the crash is incorrectly blamed on some outside force, and each time the rally is thought to be different than the rally in previous cycles. It never is.


[1] “Out, out, brief candle! Life’s but a walking shadow, a poor player that struts and frets his hour upon the stage and then is heard no more: it is a tale told by an idiot, full of sound and fury, signifying nothing.” Macbeth Quote (Act V, Scene V). (Shakespeare, 1603)

[2] Partial list of prominent real estate bubble and related blogs:

The Irvine Housing Blog – http://www.irvinehousingblog.com/
Patrick.net – http://patrick.net/housing/crash.html
The Real Estate Bubble Blog – http://www.thehousingbubbleblog.com/index.html
The House Bubble – http://housebubble.com/
Implode-o-meter – http://ml-implode.com/
Bubble Markets Inventory Tracking – http://bubbletracking.blogspot.com/
Housing Doom – http://housingdoom.com/
Southern California Real Estate Bubble Crash – http://www.socalbubble.com/
Calculated Risk – http://calculatedrisk.blogspot.com/
Housing Panic – http://housingpanic.blogspot.com/
Professor Piggington – http://piggington.com/
Dr. Housing Bubble – http://drhousingbubble.blogspot.com/
Bubble Meter – http://bubblemeter.blogspot.com/
The Real Estate Bloggers – http://www.therealestatebloggers.com/
Housing Bubble Casualty – http://www.housingbubblecasualty.com/
Housing Bubble Bust – http://www.housingbubblebust.com/
Real Estate Realist – http://www.realestaterealist.com/
Housing Wire – http://www.housingwire.com/
Sacramento Area Flippers In Trouble – http://flippersintrouble.blogspot.com/
Seattle Bubble – http://seattlebubble.com/blog/
Westside Bubble Blog – http://westside-bubble.blogspot.com/
Marin Real Estate Bubble – http://marinrealestatebubble.blogspot.com/
Sonoma Housing Bubble – http://sonomahousingbubble.blogspot.com/
New Jersey Real Estate Report – http://njrereport.com/
New York City Housing Bubble – http://nychousingbubble.blogspot.com/

[3] Much of the author’s personal study of Buddhism comes from the writings and recordings of the author Jack Kornfield (Kornfield, The Roots of Buddhist Psychology, 1996), (Kornfield, The Inner Art of Meditation, 1993), (Kornfield, A Path with Heart: A Guide Through the Perils and Promises of Spiritual Life, 1993), (Kornfield, After the Ecstasy, the Laundry: How the Heart Grows Wise on the Spiritual Path, 2000). The audio recordings of the Roots of Buddhist Psychology have been particularly influential.

[iv] The stock market experienced a 500% gain in a five year period before its infamous crash. Much of the reason for the wild increase in pricing was very low margin requirements. People were allowed to buy 10 times as much stock as they had money due to 10:1 margin trading. This expansion of credit through the broker’s margin is what drove prices up, and when prices started to fall, margin calls cascaded through the market and resulted in a crash.