Can unrealistic beliefs about appreciation cause a housing bubble?

It takes more than a manic desire to inflate a bubble. The ability to deliver capital to the market is also an essential element.

Many people who believe in the wisdom of the markets subscribe to the efficient markets theory. It postulates that market participants have equal access to good information and they make rational judgments based on the available data. The theory appeals to vanity as everyone likes to believe they demonstrate above-average financial acumen and make rational decisions.

Unfortunately, that isn’t the world we live in.

People often fall victim to groupthink, pick and chose what data to believe and what to ignore, and seek the perceived safety of the herd when making financial decisions. The housing bubble was defined by one fallacious belief that overrode all reason: house prices only go 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. Real estate prices do generally increase because salaries across the country tend to increase with the general level of inflation, and people use those higher wages to buy houses.

When the economy is strong and unemployment is low, prices for residential real estate tend to rise. Therefore, the fundamental valuation of real estate goes 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 may be a price bubble.

Greed is a powerful motivating factor for the purchase of any asset. People naturally want to make money by doing nothing more than owning an asset.

The only counterbalance to greed is fear. However, if a potential buyer believes house prices cannot decline in value, or if they do, 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.

Five factors needed to inflate a housing bubble

Greed and buyer foolishness is needed to inflate any financial bubble because people must be enthusiastic about paying unreasonable prices, or the bubble wouldn’t inflate, but greed and foolishness aren’t always present in financial markets. For these traits to take hold, something must spark the flame.

First, a financial mania needs a precipitating factor, something that causes the first unexpected rise in prices that gets people excited about the asset class. For housing, it was the iniital price boost caused by the lowering of interest rates in response to the 2001 recession.

Second, the infrastructure must be in place to deliver huge amounts of capital. That’s where securitization fits in. Securitization allows lenders to package up millions of loans into financial instruments large investors can buy and service. Without securitization, the flow of capital would be much slower because origination would be the responsibility of the investors themselves — like banks did in the old days. Securitization allowed the separation of origination from capital investment allowing many thinly capitalized companies to underwrite billions of dollars in loans.

Third, a new type of “innovative” financial product that delivers large amounts of capital to buyers is required to fill the securitization sausage grinder. The Option ARM filled this role. Using negative amortization and teaser rates, lenders could underwrite loans with loan balances twice as large as what the borrower could sustainably carry. The proliferation of the Option ARM was largely responsible for inflating prices.

Fourth, for a rally to really get out of control, new buyers must be constantly brought to market. The only way to do that is to lower (or eliminate) barriers to qualification. Lenders certainly did that. Anyone who applied was given a loan. They didn’t need a job, income, assets, or good credit. They needed a pulse and a pen, and they obtained as much money as they wanted — and that’s not much of an exaggeration.

Fifth, you need a ready and willing populace to embrace higher prices. Rational people recoil at higher prices, and sales volumes normally fall. Not so with real estate. Since higher prices made everyone rich (see One man’s mortgage debt is an entire neighborhood’s equity), the more prices rose, the more desirable real estate became. Then lenders started doing cash-out refinances at 100% value to give homeowners free money as others drove up the price. This idea saw it’s fullest fruition in California.

All five of the factors I listed above were necessary to inflate a housing bubble. If any one of them were missing, prices wouldn’t have risen to become a full-blown housing bubble.

Animal Spirits

Without the false beliefs of the housing bubble, rational buyers would not have embraced higher house prices, and the bubble would have deflated on low sales volumes before it ever got started. It’s a mistake to claim bubble buyers were irrational. They were rational people who were completely mistaken and perhaps foolish; however, based on what they believed, their decisions were rational. Of course, the same can be said of the people behind the Salem witch trials too. Rational doesn’t make right.

I wrote the last chapter in my book on how to prevent the next housing bubble (see Preventing the Next Housing Bubble – Part 1, and Preventing the Next Housing Bubble – Part 2). Fortuantely, many of the measures I described were implemented in the new qualified mortgage rules. We are reflating the old bubble with low interest rates now, but it will be much more difficult to inflate a new unstable one in the future.

As long as there is greed on Wall Street, there is potential for financial bubbles. No matter what safeguards we put in place, greed will find a way to overcome them. However, we must remain vigilant or we will create other, costlier financial bubbles that inflict financial pain on millions.