How Big Was the Bubble?
The Size of the Bubble
Figure 1 – Median Home Prices 1968-2006
The Great Housing Bubble was an asset bubble of unprecedented proportions. Between 2000 and 2006 Home prices increased 45% nationally, and in California home prices increased 135%. Had this amazing price increase coincided with a period of high inflation, it may not have been indicative of a price bubble, merely the general increase in prices of all goods and services; however, inflation was low during this period. The inflation adjusted price increases nationwide were 23% and in California it was 100%.
Figure 2 – Inflation Adjusted Median Home Prices 1986-2006
There are many variables that impact house prices, and some of the variability in prices over time can be attributed to changes in these variables; however, since most houses are purchased with lender financing, and since lender financing is linked to income, the price-to-income ratio is the best metric for evaluating long-term housing price trends. The price-to-income ratio does not need to be adjusted for inflation as both prices and income will rise with the general level of inflation. Most of the fluctuations in the ratio are based on changes in financing terms, in particular interest rates, and of course, irrational exuberance.
Figure 3 – National Ratio of House Price to Income 1975-2006
When measured against historic norms of house price to income, the degree of price inflation was staggering. Nationally, the ratio of house price to income increased 30% from 4.0 to 5.2. The only way this can occur is if 30% more debt is serviced by the same income. Some of this increased ability to service debt is explained by lower interest rates, but most of increase came from people choosing to take on larger loads due to the irrational expectation of ever increasing house prices coupled with loose lending standards which enabled the populace to take on these debts. The national trends were small compared to the frenzied activities of bubble markets in California where most markets saw their house price to income ratio double.
Figure 4 – Ratio of House Price to Income in California, Orange County and Irvine 1986-2006
Buyers were never forced to buy, it was always a choice. During the market rally, greedy buyers motivated by rising prices and fueled by loose lending standards were able to bid prices up to ridiculous levels. None of them were forced to buy. The exotic financing was not a result of high prices; it was the cause of high prices. Those who were financially conservative and did not take on debt under terms which put them into bankruptcy were competing with those afflicted with a spending pathology. In retrospect, it was a competition they were better off losing. By late 2007, the market balance shifted from favoring sellers to favoring buyers. The once greedy buyers were becoming desperate sellers, their dreams of riches from perpetual appreciation was in tatters. Many were forced to sell due to their inability to make their mortgage payments. Those that hung on were homedebtors with 50% or more of their income going toward paying off an asset which was declining in value. It was not a set of circumstances to be envied.