Apr232013

Faith in home price appreciation is religion in California

Kool aid is flowing again. Last week, I read the following comment that encapsulates the religious faith of most Californians,

Besides, OC real estate has been and will continue to be desirable. It’s also very cyclical and I knew there would be another cycle coming much sooner than the bears predicted. This place has never had “flat” home prices… ever.

Apparently this commenter had faith in the successful efforts of market manipulators and the herd behavior of California buyers. The last year has done much to reaffirm the faith that was sternly tested by a 40% decline.

The problem with blind faith is that it doesn’t ask “why.” Faith just accepts things as is and doesn’t demand an explanation. Unfortunately, with financial markets, the “why” matters.

California had a housing bubble in the 1970s because lenders adjusted to a high-inflation environment by abandoning long held debt-to-income ratio standards. They allowed borrowers to take on debts much larger than they could afford based on the belief the borrower would get 10% raises every year which would make the house payment affordable after a year or two of extreme austerity.

The bubble in the late 80s was inflated by a combination of high debt-to-income ratios and early affordability products stoked by a false fear of being priced out.

The bubble in the 00s was inflated by a proliferation of affordability products, most notably Option ARMs, and a complete abandonment of underwriting standards. And over the last 30 years, mortgage interest rates declined from 18% to 3.5% allowing people to leverage their incomes to ever-larger mortgage balances.

The causes of the previous three bubbles were all recently banned by new qualified mortgage regulations, and since we are at the bottom of the interest rate cycle, mortgage rates are likely to rise. If these regulations remain in place, and if interest rates rise, the “why” that inflated previous bubbles won’t recur again (we hope). Further, with a large overhang of properties in cloud inventory, a long period of flat prices once we reach the previous peak seems more likely than not.

So why do people cling to their beliefs about boundless home price appreciation in California?  Rapidly rising prices makes homeowners wealthy and it gives Ponzis boatloads of free spending money. People believe because they want to believe.

Faith in home price appreciation

Wikipedia defines faith as “a belief in the trustworthiness of an idea that has not been proven.” Religious faith is a collection of beliefs based on ideas which are neither testable or provable. If you accept the core beliefs of a religion on faith, you generally get a feeling of peace and well being that serves to reinforce the “correctness” of the acceptance of faith. Most religions build on these core beliefs and assemble a series of ancillary beliefs for guiding human behavior known as religious dogma. California has a major cultural “religion” that cuts across traditional denominational lines — the religion of real estate.

Baptism into the real estate religion is a metaphorical drinking of kool aid. The fundamental belief of this religion is a belief in the “higher power” of market forces — real estate values always go up. Once you accept this fundamental belief, the dogma of real estate can take over. The dogmatic practices of real estate include buying at any price and borrowing any sum you can.

Since real estate always goes up, it doesn’t matter how much you pay because you can always sell later for more money. Value has no meaning.

Also, since you can pay back any borrowed sums when you sell, it doesn’t matter how much you borrow or under what terms. Debt is something to be serviced not retired. It is foolish to borrow under terms which pay down a mortgage because equity appears through appreciation. There is no need to build equity through retiring debt. Besides, paying down debt is a slow process, and building equity through appreciation is much faster and requires less sacrifice.

The lure of kool aid intoxication is very strong. It appeals to our fantasies of unlimited wealth and spending power.

People who accept religious tenets often face a crisis of faith at some point in their lives. Any core religious idea that can be empirically tested will face its ultimate challenge. The collapse of The Great Housing Bubble proved that real estate values do not always go up, and in fact, real estate values can decline significantly.

John Spong wrote a book titled “Why Christianity Must Change or Die” in which he devotes a chapter to the Jewish exile to Babylon. It was a cultural crisis of faith where many of the fundamental beliefs of Judaism were challenged. California’s religion of real estate faced a similar crisis. The fundamental belief in endless house price appreciation was challenged, and all the associated beliefs were similarly called into question. If not for the moral hazard of market intervention, the false beliefs of California’s real estate religion would have been snuffed out. Unfortunately, to everyone’s long-term detriment, manipulations rekindled the flame.

Right now with prices rising rapidly, people wonder why they ever lost their faith in permanent and rapid house price appreciation. Loanowners put too much faith in house price appreciation. Many lamented the Day the Market Died, many continue to cling to Southern California’s Cultural Pathology, and many are signing up for a renewal of the The California Social Contract. Has kool-aid intoxication survived? It appears so. The armies of realtor missionaries has set out to convert a new generation.

God help us.