Mistaken beliefs about sustainable appreciation drove housing bubble demand

This won’t come as any surprise to regular readers of this blog, but a new paper confirms the erroneous beliefs about sustainable home price appreciation drove much of the demand from the housing bubble.

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 judgements based on the available data. The theory has an appeal to vanity as everyone likes to believe they have above average financial acumen and that they 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. 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 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.

It Was a Housing Bubble, Stupid

By Shanthi Bharatwaj 03/25/13 – 11:17 AM EDT

NEW YORK (TheStreet) — It appears that hundreds of people involved in securitizing mortgage loans heading into the real estate crisis, had no idea that the United States was in the midst of a housing bubble.

In the aftermath of the housing market collapse in 2008, there has been substantial research and press dedicated to analyzing the root causes of the crisis.

While some have blamed external factors such as a prolonged period of low interest rates and affordable housing policies, the popular view, especially among policymakers in Washington, has been that poorly designed incentives — bonuses come to mind — led Wall Street to take excessive risk in the mortgage market, leading to the collapse of the housing bubble and the demise of financial institutions including Bear Stearns and Lehman Brothers.

Recent research has increasingly suggested that securitization — the process of packaging loans into securities that could be sold to investors — may have been a major contributor to the bubble. Banks were arguably reckless in their lending, because they did not retain mortgages in their books and could pass on the risk to investors.

Investors also unwittingly believed that they were protected from the downside because they thought they held a diverse pool of mortgage-backed securities that received triple-A ratings from the rating agencies.

The housing bubble required all of the factors listed above to occur.

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 were given 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.

Still, lawsuits have alleged that many on Wall Street were fully aware of trouble in the housing market but chose to ignore it in their quest for more profit and higher bonuses. They point to emails deriding securitized mortgages as garbage or worse at investment banks such as Morgan Stanley, Goldman Sachs and Deutsche Bank.

Another hypothesis, that a distorted belief that housing prices would continue to rise, led to terrible choices all around, has also been floated, though it gets a lot less credit.

That’s a shame because 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.

A new paper by Ing-Haw Cheng, Sahil Raina of the University of Michigan, and Wei Xiong of Princeton University, suggests that both poorly designed incentives and overly optimistic beliefs about housing prices among people involved with loan securitization, may have inflated the bubble. Preliminary findings from the report were first published in 2012, and the final results were published on March 12.

The researchers analyzed whether mid-level managers who were involved in issuing and investing in mortgage-backed securities – the very heart of the mortgage boom — were actually aware of the housing bubble. Based on an analysis of the personal home purchase transactions of 400 mortgage securitizers, it looks like they weren’t.

“Our analysis shows little evidence of securitization agents’ awareness of a housing bubble and impending crash in their own home transactions,” they concluded. “Securitization agents neither managed to time the market nor exhibited cautiousness in their home transactions. They increased, rather than decreased, their housing exposure during the boom period through second home purchases and swaps into more expensive homes. Our securitization agents’ overall home portfolio performance was significantly worse than that of control groups.”

We saw that with real estate agents and mortgage brokers here in Orange County. The North Korea towers and many homes in Ladera Ranch were purchased by speculating real estate agents. Those most intimately involved with the insanity were some of the biggest participants. In fact, this contributed to the public’s perception of real estate being a safe investment because insiders were putting their money where their mouth was. They were all shocked to find they were wrong, and never forget the bulls and bubble deniers were completely and totally wrong.

The researchers stress that their conclusions “do not contradict the existing evidence that bad incentives caused loan officers and securitization agents to relax lending standards in the subprime borrower market.”

The paper does suggest that Wall Street may have relaxed credit standards without expecting it to have an impact on the wider housing market.

This is the mistake repeated over and over again on Wall Street. For example, the subprime business model simply doesn’t work. However, when starting from zero, introducing subprime loans increases the borrower pool and causes prices to rise. As prices rise, subprime lenders lose less money when their loans go bad, so the model expands. This goes on until the limit of the buyer pool is reached, then prices either flatten or go down, the default losses go up, and subprime lenders go out of business. As subprime lending dries up, demand is removed from the market, and prices fall further. The point is that the business model only works because its impact on the wider housing market masks the underlying risk.

The research suggests that these players were caught up in the bubble when making decision about their personal finances. “Our evidence suggests that certain groups of agents – those living in bubblier areas, working on the sell side, or at firms with greater exposure to subprime mortgages – may have been particularly subject to potential sources of belief distortions, such as job environments that foster group think, cognitive dissonance, or other sources of over-optimism.

No kidding.

And “professionals” in the real estate industry aren’t open to hearing about the error of their ways.

Changing the compensation contracts of Wall Street agents alone, for example through increased restricted stock holdings or more shareholder say on pay, may be insufficient to prevent the next financial market crisis,” according to the paper.

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.