The opening of The Great Housing Bubble succinctly described the real estate bubble:
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:
- The expectation of future price increases.
- The belief that prices cannot fall.
- 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. 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. …
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. 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. 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. 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.
I went on to list other false beliefs such as:
- Buy Now or Be Priced Out Forever
- They Aren’t Making Any More Land
- Everyone Wants To Live Here
- Prices Are Supported By Fundamentals
- It Is Different This Time
But those are what I termed confirming fallacies because they all support the central premise that real estate prices can only go up.
August 03, 2012|Leon Neyfakh
In the years since the start of the biggest American financial crisis in generations, the reasons for the meltdown have begun to harden into conventional wisdom. Everyone agrees on the root of the problem: a housing market that ballooned wildly, then collapsed. But exactly where to place the blame is a matter of dispute. Conservatives tend to point the finger at the individual homeowners who took out loans they were incapable of paying back—and ultimately, at the government that pushed for looser lending standards in the first place. Those who lean left point squarely at the financial industry, which flooded the market with deceptive mortgages and then sold the risk off in the form of complicated new securities.
Then there’s Paul Willen, a research economist at the Federal Reserve Bank of Boston.
Willen, a 44-year-old father of two who lives in Brookline, moves through the world in a state of dismay and occasional fury at the fact that absolutely no one—not the media, not the public, and not his fellow economists—seems to understand the truth about what happened. Since 2008, Willen, a mortgage specialist, has pored over troves of data and emerged with a powerful, counterintuitive conclusion: that the real reason everything ended so badly wasn’t adjustable rate loans, or government housing policy, or esoteric financial instruments. Rather, it was a single underlying assumption that almost everyone in the market, from bankers to home buyers, shared: that American house prices would continue to go up indefinitely.
Willen has spent the past four years trying to persuade people of what he sees in the data: that everyone in the drama acted perfectly rationally. Under the assumption that the real estate market would continue its steady rise, it made sense for families to buy homes they couldn’t afford, and it made sense for bankers to buy up subprime mortgages. This belief —Willen thinks of it as a mass delusion—fueled an immense bubble that could not be reliably identified for what it was.
This delusion didn’t make sense, but it is true that people were acting rationally based on the foolish fallacies they eagerly embraced.
If he’s right, then the finger-pointing that’s occurred since the crash—the belief that the various actors should have understood that housing was overvalued, that credit was being extended too freely, that somehow the Fed could have cooled it down—is beside the point. Rather, Willen argues, we should humbly come to terms with the frightening fact that when economic delusions take hold, none of us may be able to tell that we’re being swept up in them.
That’s just wrong. Being caught up in a mass insanity does not relieve any of the players of responsibility for their actions. It may explain it, but it does not justify it. Many of man’s greatest atrocities were committed by people just following orders or doing what the group was doing. Rioters are not excused just because everyone else was doing it.
Since 2008, Willen has been pressing his theory about the crisis in a series of academic papers and lectures. But while his job at the Fed gives him access to policy makers in the central bank, he has found himself firmly in the role of outsider in his own field. Critics say he underplays the extent to which the crisis was made more grave because of reckless decisions by lenders and bankers, and some suggest it’s a cop-out—a way to spin the problem so that no one, especially the Fed, has to take any blame for what went wrong.
Yes, that is exactly how his statements can be interpreted. If that is his intent, shame on him.
A number of the economists Willen has singled out for criticism declined to weigh in for this article. But one of them, Stijn Van Nieuwerburgh, who heads the Center for Real Estate Finance Research at NYU’s Stern School of Business, said in an interview that he thinks Willen is essentially dodging the question of the bubble’s causes.
“The assumption is that this happened for some random reason,” he says, “unrelated to regulation, unrelated to supervision, unrelated to anything….Economists like to call this a sunspot—something that came out of nowhere.”
In Van Nieuwerburgh’s view, the bubble does have a cause. “The Federal Reserve Bank, as well as Congress, were gradually, slowly but surely, relaxing their oversight of the financial sector,” he said. “And just to give you one number: There were something like 700 laws passed in Congress over this period, all of which made it easier for people to access their home equity, made the regulations on banks less, made the regulations on mortgage borrowers less, and so forth. And this obviously is the story that the Fed, including people like Paul Willen, who work for the Fed, don’t want to tell.” …
Yes. Nobody at the fed wants to take any responsibility. Doesn’t their excuse sound like the dog eating their term paper?
This point of view puts him on the pessimistic side of a longstanding debate. One side says it’s possible for policy makers to identify bubbles while they’re happening and try to “prick” them so they don’t cause big problems. The other says economics simply can’t detect a bubble until after it has burst, and that all we can hope for is a quick recovery afterwards.
It’s true that economists as a group are very poor at identifying bubbles. As a group, most economists have no idea what they are talking about. Few if any understand the linkage between the incentives of individuals and the macro impact the herd of individuals create.
The debate cuts to the heart of what economics can tell us about value. To say a bubble exists is to argue that the price of something, like a house, has wildly exceeded its true value. But a basic tenet of economics is that the value of an asset is whatever people will pay for it: It’s impossible to say an iPhone isn’t “worth” $300 until the day comes when nobody will buy it for that much.
But even if the intrinsic or fundamental value of something is unknowable, some economists still believe that it’s possible to determine when the price of an asset has come untethered from reality—that is, to detect a bubble while it’s forming.
One reason I like the rental parity indicator is because it does accurately identify bubbles as they are forming. It takes into account changes in what people are willing to spend on housing, the impact of mortgage rates, and other variables most economists guess at. The last two bubbles are easily identifiable when you compare prices to rental parity. The current overshoot to the downside is also apparent. It will be interesting to see how rental parity fares as an indicator when mortgage rates go up and the other market manipulations end. We may see the first significant decline in rental parity.
If we could do that, then the Fed and the markets actually would be able to make smarter decisions that prevent bubbles. Even Willen is hopeful on that front. “If it was really clear when there was a bubble,” Willen said, “the bubbles would never happen in the first place….So at some point, one could imagine that the economy as a whole, partly through our better understanding of these things, would just become a less volatile place.”
I have my doubts federal reserve economists will agree on the right course of action even if they can agree on a bubble. Some economists will vehemently disagree with their colleagues. Many economists get caught up in their own confirmation biases and interpret incoming data through the filter of what they want to see happen (anyone noticed this in Calculated Risk since he called the bottom?) Reaching a consensus will be difficult. Just look at the problems the Canadians, Chinese, and Australians have admitting to their housing bubbles.
Willen warns that this vision is more fantasy than practical plan. For now, he argues, we need to start acknowledging the limits of what economics can tell us, and come to terms with the fact that next time there’s a bubble, we probably won’t know about it until it’s too late. Until we accept this deeply unsatisfying reality, according to Willen, we risk deluding ourselves into believing we are no longer vulnerable to the problems that led to the 2008 crisis.
“Going forward, what worries me is that sometime in my lifetime, not that far in the future, we will have another house price boom, and people will say, ‘We have nothing to worry about…because we’ve regulated away all the bad things that people did.’ That will be wrong.”
I hope no one believes we have made any progress toward regulating away the roots of the 2008 financial crisis. We have done nothing. We haven’t even dismantled the too-big-to-fail institutions responsible for massive government bailouts. We are encouraging mortgage equity withdrawal as economists hope the “wealth effect” of rising house prices will save the economy. Nothing in the Dodd-Frank law will prevent a future disaster, and we failed to bring back good regulation like Glass-Steagall that might have made a difference. The lobbyists for the financial services industry still own Congress and their regulators. No. We have done nothing to prevent the next disaster. I’m not sure anyone thinks we have.
The former owners of today’s featured REO were responsible borrowers for the most part. In fact, their refinances up through 2005 showed a steady decline in their mortgage balance. Unfortunately, they didn’t maintain this discipline, and the borrowed themselves into foreclosure hell.
- On 11/7/1996 the former owners paid $167,000 using a $158,743 first mortgage and a $8,257 down payment.
- On 9/26/1997 they refinanced with a $158,337 first mortgage.
- On 2/16/1998 they refinanced with a $157,844 first mortgage.
- On11/2/1998 they refinanced with a $156,544 first mortgage.
- On 9/17/2002 they obtained a $60,000 HELOC, but they didn’t use it.
- On 6/5/2003 they refinanced with a $145,700 first mortgage.
- On 9/3/2004 they opened a $200,000 HELOC. They may have used this one because…
- On 11/14/2005 they refinanced with a $400,000 first mortgage.
- On 3/10/2006 they obtained a $108,000 HELOC. There is no telling if they used it.
They withdrew at least $241,257 from the housing ATM machine, and it may have been $108,000 higher. They weren’t heavy hitters by OC standards, but it was still too much debt for their incomes, and they lost their home.
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Proprietary OC Housing News home purchase analysis
$459,900 …….. Asking Price
$167,000 ………. Purchase Price
11/7/1996 ………. Purchase Date
$292,900 ………. Gross Gain (Loss)
($13,360) ………… Commissions and Costs at 8%
$279,540 ………. Net Gain (Loss)
175.4% ………. Gross Percent Change
167.4% ………. Net Percent Change
6.5% ………… Annual Appreciation
Cost of Home Ownership
$459,900 …….. Asking Price
$16,097 ………… 3.5% Down FHA Financing
3.55% …………. Mortgage Interest Rate
30 ……………… Number of Years
$443,804 …….. Mortgage
$115,399 ………. Income Requirement
$2,005 ………… Monthly Mortgage Payment
$399 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$115 ………… Homeowners Insurance at 0.3%
$462 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$2,981 ………. Monthly Cash Outlays
($300) ………. Tax Savings
($692) ………. Equity Hidden in Payment
$18 ………….. Lost Income to Down Payment
$135 ………….. Maintenance and Replacement Reserves
$2,143 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$6,099 ………… Furnishing and Move In at 1% + $1,500
$6,099 ………… Closing Costs at 1% + $1,500
$4,438 ………… Interest Points
$16,097 ………… Down Payment
$32,733 ………. Total Cash Costs
$32,800 ………. Emergency Cash Reserves
$65,533 ………. Total Savings Needed
The property above is available for sale on the MLS.Contact us for a comparative market analysis, a cost of ownership analysis, or information on how you can make an offer today!
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