Archive for 2008

Psychological Stages of a Bubble Once a bubble starts to form, it will go through several identifiable stages: enthusiasm, greed, denial, fear, capitulation, and despair. Each of these stages is characterized by different speculator emotional states and different resulting behaviors. There are outside forces that also act on the market in predictable ways in each one of these stages. Most often, these outside factors serve to reinforce the market’s herd behavior and exacerbate changes in price. Precipitating Factor There is often a precipitating factor causing the initial price rally that pushes prices above their supported fundamental values. A bubble rally is usually kicked off by some exogenous event, but it may occur simply because prices have been rising and investors take…[READ MORE]

Bubble Market Psychology Financial markets are driven by fear and greed: two basic human emotions. Rationality and careful analysis are not responsible for, or predictive of, current or future price levels in markets exhibiting bubble pricing as the emotions of buyers and sellers takes over. [1] The psychology of speculation drives bubble markets, and because of the nature of fear and greed, most speculators are doomed to lose their money. In contrast, true investors are not subject to the emotional cycles of the speculator, and they are more able to make rational decisions based on fundamental valuations. Of course, many investors also miss the excitement of a runaway price rally in a speculative bubble. The Great Housing Bubble was inflated…[READ MORE]

The Bubble Bursts When a bubble in a financial market pops, it does not explode in spectacular fashion like a soap bubble; it is more comparable to a breached levee which releases water slowly at first. [1] Once the financial levee is ruptured, the equity reservoir loses money at increasing rates. It washes away the imagined wealth of homeowners who bought late in the rally or used home equity lines of credit to fuel consumer spending until the reservoir is nearly empty and the torrent turns to a trickle. Ultimately, the causes of failure are examined, the financial levee is repaired, and the reservoir again holds value, but not until the dreams and equity of many homeowners are washed away. Denial runs…[READ MORE]

The Housing Bubble Affordability Limits Affordability is a measure of people’s ability to raise money to obtain real estate. It is often represented as an index that compares the cost to finance a median house price to the percentage of the general population with the income to support this house price. For instance, in Orange County, California, in 2006, only 2.4% of the population earned enough money to afford a median priced home. When affordability drops below 50%, there is a problem in housing; when it drops to 2.4% there is either a severe shortage of housing, or a housing price bubble. Most often, it is the latter. Figure 23: Affordability / Demand   One way to envision affordability is through supply and…[READ MORE]

The Housing Bubble Prices went up a large amount during the Great Housing Bubble, but what makes this price increase a bubble? To answer this question it is necessary to accurately measure price levels and review historic measures of affordability to establish these price levels are not sustainable. [1] Measuring house prices is not a simple task, and there are many methods market watchers use to evaluate market prices. These include the median, the average cost per square foot, and the S&P/Case-Shiller indices. Price levels in financial markets represent the collective result of individual actions. There are techniques to measure the actions of the individual market participants and their impact on house prices. These measures are debt-to-income ratios and price-to-income ratios.  The amount of…[READ MORE]

The Credit Bubble Visualizing the Bubble With a huge influx of capital into the secondary mortgage market when the Federal Reserve lowered interest rates in 2001-2004, the industry was under tremendous pressure to deliver more loans to hungry investors seeking higher yields. This caused the already-low loan standards to be all but eliminated. All of the worst “innovations” in the lending industry occurred during this period: Negative Amortization loans, Stated-Income loans (Liar Loans,) NINJA loans (no income, no job, no assets,) 100% financing, FICO scores under 500, and one-day-out-of-bankruptcy loans among others. The joke was if borrowers could “fog a mirror” or if they “had a pulse,” they could get a loan for as much as they wanted to buy a house. It is…[READ MORE]

The Credit Bubble The Great Housing Bubble was not really about housing; it was about credit. Most financial bubbles are the result of an expansion of credit, and the Great Housing Bubble was no exception. Housing just happened to be the asset class into which this capital flowed. It could have been stocks or commodities just as easily, and if the government gets too aggressive in its actions to prevent a collapse in housing prices, the liquidity intended to prop up real estate prices will likely flow into some other asset class creating yet another asset price bubble. The root causes of the Great Housing Bubble can be traced back to four interrelated factors: Separation of origination, servicing, and portfolio holding in the…[READ MORE]

Valuation of Lots and Raw Land The valuation of land used for residential housing is mysterious and often misunderstood. [1] The valuation of lots and raw land requires a detailed knowledge of construction and marketing costs as well as a good estimate of the sales price of the final product: a residential housing unit. In short, the value of a lot is the total revenue (sales price of the home) minus the costs of production and the necessary profit. Land value is a residual calculation. Irvine, California, has been almost entirely developed by a single land owner, The Irvine Company, as a large, master-planned community. The development has been wildly successful. The median income of buyers on The Ranch is 30%…[READ MORE]

Investment Value The United States Department of Labor Bureau of Labor Statistics measures the Rent of primary residence (rent) and Owners' equivalent rent of primary residence (rental equivalence). They make this distinction because a house has both a consumptive purpose and an investment purpose. The consumptive value is measured by rent or rental equivalence. There is legitimate financial reason to pay more than the rental equivalence price. The normal rate of house appreciation–not the unsustainable kind witnessed during the Great Housing Bubble–can provide a return on investment. The source of this added value is the leverage of mortgage financing and the hedge against inflation obtained through a fixed-rate mortgage. The investment premium, which is about 10%, is less than most people think. The rental…[READ MORE]

What they are saying about The Great Housing Bubble "The author, Larry Roberts, is best known for his daily posts as IrvineRenter on the Irvine Housing Blog. Long before Lehman crashed, Fannie Mae was taken over, and even before home prices were dropping nationally, he was one of the few voices presenting real information on the housing bubble. The author's background is in new housing development in Southern California. It was a good start to understanding how things worked. Supplemented by knowledge from countless posters at the housing blog, he has been able to show why home prices couldn't stay elevated. Price to income ratios, price to rent ratios, and other factors detailed in the book showed how far out…[READ MORE]

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