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Visualizing the Real Estate Bubble

Posted: 26-12-2008 | Views: 178

The Great Housing Bubble can be visualized with a simple thought experiment. Imagine a room with 100 people representing the pool of subprime borrowers. These are new entrants to the market. They were previously unable to buy due to bad credit, lack of savings, and other reasons. All of them are told they are going to bid on an asset that never goes down in value, and they will be given the ability to borrow unlimited funds (stated-income "liar loans") The only caveat is the borrowed money must be paid back when the asset is sold (not that they care, they already have bad credit). Imagine what happens?

People start to buy the asset, and prices rise. Others in the room seeing the rising prices come to believe that the value of the asset never declines, and they join in the bidding. As the bidding drives prices even higher, a manic quality takes over the bidding and people compete with each other, often bidding higher than the asking prices. Nobody wants to be left out. There are fortunes to be made. Greed drives prices upward at a staggering rate. As the last of the 100 people buy, prices are very high, everyone has made money, and it looks as if prices will continue to rise forever . . .

Then something strange happens: there is nobody left to make a purchase. (A key indication of the end of a speculative mania is a huge decline in sales, as was witnessed over 2006 and 2007). Transaction volume drops off dramatically, and prices stop their dizzying ascent. Nobody is particularly alarmed at first, but a few of the more cautious sell their assets to pay off their loans. Since there are no more new buyers, the first selling actually causes prices to drop. This is unprecedented: prices have never declined! Most ignore the problem and comfort themselves with the history of rising prices; however, a few are spooked by this unprecedented drop and sell the asset. This selling drives prices even lower. Now those who still own the asset become worried, some continue to deny that there is a problem, and some get angry about the price declines. Some of the late buyers actually owe more than they paid for the asset. They sell the asset at a loss. The lenders now lose some money and refuse to loan any more money to be secured against the asset. Now there are even fewer buyers and a large group of owners who all want to sell before prices drop any lower. Panic selling ensues. Everyone wants to sell at the same time, and there are no buyers to purchase the asset. Prices fall dramatically. This asset which was sought after at any price is now for sale at any price, and there are few takers. People in the market rightfully believe the asset will continue to decline. Owners of the asset have accepted the new reality; they are depressed and despondent.

In any group of people, there are always a few who do not believe the "prices always rise" narrative. Some recognize that asset prices cannot rise indefinitely and cannot stay detached from their fundamental valuations. These people witness the rally and the resulting crash without participating. They wait patiently for prices to drop back to fundamental values, and then these people buy. As these new buyers enter the market, prices stop their steep descent and market participants start to hope again. It takes a while to work off the inventory for sale in the market, so prices tend to flatten at the bottom for an extended period of time; however, just as spring follows winter, appreciation returns to the market in time, and the cycle begins all over again.

With a huge influx of capital into the secondary mortgage market when the Federal Reserve lowered interest rates in 2001-2004, the industry was under tremendous pressure to deliver more loans to hungry investors seeking higher yields. This caused the already-low loan standards to be all but eliminated. All of the worst "innovations" in the lending industry occurred during this period: Negative Amortization loans, Stated-Income loans (Liar Loans,) NINJA loans (no income, no job, no assets,) 100% financing, FICO scores under 500, and one-day-out-of-bankruptcy loans among others. The joke was if borrowers could "fog a mirror" or if they "had a pulse," they could get a loan for as much as they wanted to buy a house. It is not hard to envision the impact this had on house prices.

What is written above is true of any asset whether it be stocks, bonds, houses or tulips. In this case, it is the local housing market, and the room of new buyers represents subprime borrowers, but the concepts are universal. One phenomenon somewhat unique to the housing market is the forced sale due to foreclosure (stocks have margin calls). Even if the psychological factors at work during the panic could somehow be quelled, the forced sales from foreclosures would drive down prices anyway. True panic is not required to crash a housing market, only dropping prices and an inability to make payments. Subprime lending was one of the leading causes of the Great Housing Bubble, and its implosion exacerbated the market decline.

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