Oct012008

What is a Bubble?

What they are saying about The Great Housing Bubble

housingbubble_cartoon_module“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 RandelBest-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:

  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.

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

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.”