The Real Estate Bubble: What Happened and What Can We Learn From It?

by Joe Plemon on July 26, 2010

Authors Wiedemer, Wiedemer and Spitzer gained great credibility when their first book, “America’s Bubble Economy" accurately predicted the upcoming real estate meltdown two years before it happened. “Aftershock", their second book, further explains not only what happened to the real estate market, but gives stark warnings of other bubbles which have yet to pop.

Explore with me why the real estate bubble formed, why we should have recognized it, and what we should be learning.

What is a bubble?

Our authors define a bubble as “an asset value that temporarily booms and eventually bursts, based on changing investor psychology rather than underlying, fundamental economic drivers that are sustainable over time."

Why we should have recognized the real estate bubble.

Most agree that bubbles are not easy to spot, especially while they are still inflating. Those who have already bought into the bubble are mesmerized by the increasing prices without realizing that these prices have no economic basis for sustainability. However, once a bubble has popped, an financial autopsy can usually discern what happened.

In this case, however, our authors spotted the real estate bubble while prices were still escalating and correctly predicted its pop. How did they know? Really, it is quite simple: income was lagging way behind rising real estate prices. According to the Case-Shiller Home Price Index, home prices rose nearly 100 percent between 2000 and 2006 while the inflation-adjusted wages and salaries of the people buying the houses went up only 2 percent for the same period (based on Bureau of Labor Statistics). If home prices double while incomes only increase 2 percent, something is going to pop. It did.

Why did the real estate bubble form?

According to “Aftershock", innovations in the mortgage industry made the housing bubble possible. These “innovations" were variances of getting buyers into the house with low introductory interest rates, such as 1 percent or 2 percent for the first few years and then transfer to a normal adjustable rate mortgage at that time. This is the same strategy credit card companies, satellite TV companies and cell phone providers have been using for years: hook the customer at a low rate and then raise his rates at some future date. Such arrangements allowed buyers to purchase more expensive homes, often with the idea of selling them later for a big profit when home prices continued to climb.

One such innovation was rightly called a suicide loan. The owner had a choice each month of paying a full payment (interest and principal), or an interest-only payment, or – I hope you are seated – a smaller payment that covered only a portion of the interest! Of course the unpaid interest would be added to the principal of the loan, increasing the debt to sometimes 110 percent or 120 percent of the original loan amount. More than 80 percent of those who took on this type of loan paid the lowest option possible, resulting in default rates of nearly 90 percent.

The point is this: when inventive finance vehicles allow people to borrow more money, they will. Knowing that more money is flowing into the housing market, the seller will raise his price and get it. After all, the buyer assumes that his new purchase will magically continue to escalate in value. Eventually, as we already noted, housing prices rose 100 percent while incomes only rose 2 percent. That one simple statistic explains why we had a bubble and why it was destined to pop: there simply wasn’t enough income flowing to the owners to pay the inflated house prices they had agreed to.

What caused the real estate bubble to pop?

Allow me to quote our authors: “The most important thing to understand about the current housing crunch is that it’s not a subprime mortgage problem whose contagions spread to other mortgages; it is a housing price collapse." They further explain that the fancy loans would not have been a problem if housing prices had continued to rise indefinitely; if the borrower had trouble with his payments, he could always cash in some of his growing equity to get caught up. However, when housing prices start declining, all of the low introductory adjustable rate loans are doomed. These subprime loans, therefore, are not the cause of the housing collapse; they are simply the first to get hit. Eventually, as prices continue to fall, even homeowners with normal loans will also fall victim to these declining values.

What can we learn?

We already know that bubbles are easier to understand after they pop. However, I wish we could learn to keep our wits about us when values of anything keep spiraling upward. The old saying, “if it sounds too good to be true, it probably is" makes a lot of sense.

Are there other bubbles on the horizon?

That is a topic for much more discussion. The quick answer is yes. As I read and learn, I will share my thoughts. In the meantime, just read the book “Aftershock" for some great insights into where our economy has been, where it is headed and what we can learn.

One more thing: lest you think this is a sponsored post, it isn’t. I am simply sharing some well thought out info from a fascinating book.

Creative Commons License photo credit: brew ha ha

Want to read more on bubble economy? Check out these recent posts:

Is Gold the Next Bubble? at Beating Broke

Some Past Financial Bubbles at My Journey to Millions

A Reminder of What It Was Like During the Housing Bubble at 20’s Money

Please share your thoughts. Agree? Disagree? What do you think is the next big financial bubble in America?

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