patrick.net

What were people thinking?

1992-1995 was a cyclical low as the nation adjusted to higher taxes and defense industry freezes, realignments, and base closures, and the general after-effects of the S&L crisis, etc.

In the 90s the general trend was falling gas prices, big-box retailing and outsourcing production to China making retail more efficient, the rise of the internet and email, and, equally importantly, declining interest rates.

The 30 year mortgage entered the decade at 10% and left at 7.5%. All things equal, that increased buying power a lot. $2000/mo would buy a $230,000 house in 1993 and a $300,000 house in 2000. Of course, since houses don't grow on trees, what happened was this increased buying power just pushed the $230,000 price level up to $300,000 in all areas with demand exceeding supply.

So real estate was moving up in the 1990s (especially in the dotcom areas but I won't get into that).

Then the 2001 recession hit and interest rates went from 7.5% to under 6%. This doesn't seem like much but it increased buying power another 20% or more -- what bought a $300,000 house in 2000 could buy $375,000 in 2003. And so prices adjusted upwards as buyers bid up the price of homes.

Even the Bush tax cuts had an effect IMO. The $1000 child tax credit paid for the kid's bedroom -- $1000/yr may not sound like much but it can service $30,000 in mortgage debt.

Then something magical happened. Countrywide, WaMu, and hundreds of other lenders that are no longer with us made a concerted effort to really increase their loan volumes. They had many tools in their bag to do this.

Qualifying buyers on an introductory two-year teaser rate and not the actual rate the loan will reset to. This increased buying power substantially, especially in the lower segments, and prices adjusted upwards as more buyers took advantage of this and other ways the lenders lowered customary lending standards.

For more well-heeled borrowers, lenders started handing out "Pay Option" loans like candy. This was worse than teaser rate, buyers could buy a house and pay less than the interest burden for the rest of the decade if not longer. This loan product REALLY juiced the market, as real estate was going up, up, up and the more house you bought the more you would make when you flipped it. Buy 10 houses like Casey Serin, the lenders have money coming out of their ears (thanks to Wall Street's services in packaging and reselling these loans) and want to fund your loan.

Where was Wall Street getting this money? Dunno, but this chart:

http://research.stlouisfed.org/fred2/series/M3

describes the external dynamics quite well. Money was being borrowed & lent out, borrowed & lent out, ever and ever more & more.

"Flip this House" and other shows pounded in the message that real estate was the New Economy. Buy now and make an easy $100,000 next year. Interest rates were held low right through 2005. When they started creeping up in late 2005/2006 (moving from low 6% to high 6%) the market plateaud.

Salinas, CA was a ground-central for loan abuse, and this curve:

was the norm. (This is the house my parents rented in the 70s and 80s for $400/mo, -- 3B/1b, nothing special).

3X price appreciation from 2000-2006. Salinas had it all -- dotcom wages (for people making the hour+ drive), restricted supply (city surrounded by lettuce fields that the City Fathers weren't going to develop), plus the lower interest rates, predatory subprime lending on the Mexicans, negative am loans (40% of loans were negative-am in Salinas at the peak).

But this is only half the story, really. The core thing to understand about the peak was these rising valuations were pushing A LOT of money into people's pockets. When oil goes up, most people get poorer. When real estate goes up, most people get richer. Either the comfort of knowing they have hundreds of thousands of equity in their home (which frees up spending), or actually borrowing against that equity by refinancing. Since interest rates were heading downwards 2001-2005, it was possible to take a lot of money out of the house without significantly raising the monthly debt burden load. Also, if 10%-18% credit cards were being paid off, it was possible to pull even more money out of the house without increasing household monthly debt burden.

This cash-out financing was the engine pulling the economy 2004-2007 IMO. At the time I couldn't figure out why times were so good for so many people, little did I know then that HUNDREDS OF BILLIONS of dollars was being pumped into the economy through borrowing against the phantom home equity.

http://www.calculatedriskblog.com/2009/03/q4-mortgage-equity-extraction-strongly.html

From 2003 through 2006 $400B to $600B a year was being spent into the economy this way. On a $10T GDP, that may not sound like much, but $500B/yr is TEN MILLION middle-class jobs at $50K per.

To explain what people were thinking, there was a good book written on this back in the mid-19th century.

http://en.wikipedia.org/wiki/Extraordinary_Popular_Delusions_and_the_Madness_of_Crowds

I know it was not nearly as bad here in the Midwest as it was in CA, FL, NV, AZ. What were people thinking? What compelled average-income or above average-income people to borrow money they could never hope to pay back?

IMHO, what happened was television. Teevee discovered the value of all things about housing - buying it, rehabbing it, building it, selling it for a huge profit, etc. Flip this house, flip that house, sell this house...

Mortgage companies made it easier to attain the goal of home ownership, what with interest rates so low and brokers just throwing the money at anyone. Wall Street helped by securitizing the loans. Realtors helped by bringing people to the mortgage companies buyers willing to lie to get into a home while they could "afford" it (also known as suckers). Builders didn't care about the quality, location, or anything else. McMansions weren't a dirty word.

But I truly believe that television -which I love, btw - is the reason that the problem got so big. It marketed the housing bubble, every show seemed to be about it and the message was constant.

Yes, people are really that stupid. I was in Vegas last weekend and there are so many houses for sale that entire neighborhoods are ghost towns. I drove around and saw dead lawns, empty pools (it was 108 degrees in Vegas today & they seem to have evaporated), boarded up windows, etc. I also saw people camping in ditches in out of the way areas. I read somewhere that 70% or more of the houses in Vegas are under water. Vegas is a transient town, so it figures that it would be a high number.

But housing skyrocketed beyond comprehension in bubble areas. I couldn't even fathom how much values increased. Pre-bubble I bought a house and made substantial improvements, sold it at an $80k profit 10 years later. Four years after I sold, it appraised for $450k. The prices were unsustainable. Yet people continued to drink the koolaid for another year after prices began to drop because the teevee shows continued to tell them that housing was a good gamble.

Yes, people are that stupid.

Troy says

To explain what people were thinking, there was a good book written on this back in the mid-19th century.
http://en.wikipedia.org/wiki/Extraordinary_Popular_Delusions_and_the_Madness_of_Crowds

Robert Shillers Irrational Exhuberance 2nd edition does a great job as well.

I'm in a unique situation. I work here in the San Francisco Bay Area, but my home is in Texas. I was born and raised in the upper midwest.

I still can't get over the prices of houses in California. People keep telling me that things are different on the West Coast. Wages are not that much greater then what I could earn back in Texas. So how do people justify these prices? Yes, it's a nice area out here and the weather is great, but still. $$$$$$$. I don't get it.

jvolstad says

Wages are not that much greater then what I could earn back in Texas. So how do people justify these prices?

Compare property taxes for one. California is fixed at ~1.23% for life, with any increases to appraised value capped at 2% a year. That incorporates a significant speculative premium into the purchase price since a decent house is the most inflation-protected asset available. If I buy a $400K house today, the maximum tax I'll be paying in 2040 is $750/mo on a house worth anywhere from $2M to $5M, an effective property tax rate of 0.2%. (This is assuming inflation 2010-2040 matches 1975-2005 of course, and the laws aren't changed)

Property taxes in Texas are infamously high on a millage basis -- 3% is common -- and the appraisal is not inflation-protected.

The rational buyer in Texas has to budget for future tax burdens due to inflation. This (theoretically) limits his bid. California real estate is a privileged asset class, and thus has much more competition to purchase.

Prop 13 also KEEPS residential real estate off the market. It's common for people in the high-price areas to have a house that costs $200/mo in taxes earn $2500/mo in rent. Tough giving that multiple up. Prop 58 extends this privilege to children of the original owner. Awesome.

Also, Texas cities have tons of space to expand into, unlike the high-price locations here in California. (Low-price locations have fallen back to pre-bubble baselines)

jvoldstad.

well said. I agree with you and have to make some compromises to keep my percentage of income housing cost equivalent to that of my Oklahoman cousins.

I think that some reasons for the insanity are, well, some of us grew up here and don't know any different. Kind of like some New Yorkers. Others of us came from even more expensive places like Mumbai or Shanghai or Hong Kong or Singapore. In comparison, the Bay Area in general and the Fortress in particular, look like the Cheap Wild Open Spaces of Texas rangeland compared to those places.

jvolstad says

I still can’t get over the prices of houses in California. People keep telling me that things are different on the West Coast. Wages are not that much greater then what I could earn back in Texas. So how do people justify these prices? Yes, it’s a nice area out here and the weather is great, but still. $$$$$$$. I don’t get it.

JV, Who are these people. I bet they are fresh off the bus. Its all hype created by hypsters and REA. There are too many people in CA who are connected to the RE industry.
... factor in Mortgage and other lines of business.. you get the picture...

California Has a Real Estate Agent for Every 52 Adults
by Tom Royce on May 24, 2006

If you live in California you should have no trouble finding a real estate agent. A new report from the California Department of Real Estate says there is a real estate agent for every 52 adults in the state. This is a 57 percent increase over the last 5 years