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?

{ 14 comments… read them below or add one }

Chandler Realtor July 26, 2010 at 3:03 pm

Great post! This is a hot topic right now in Arizona as well.

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Carol@inthetrenches July 26, 2010 at 5:43 pm

Very good post and I look forward to reading the book. My guess is the next bubble to break may be gold. I googled the gold prices a couple months back and was shocked at the spike! Look forward to hearing about other bubbles you may write about.

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joeplemon July 26, 2010 at 6:32 pm

@Chandler,
Thanks. Still a hot topic lots of places as we try to determine where the bottom of the bubble is.

@Carol,
Yes, gold has spiked dramatically. Sounds “bubbly” but gold seems to thrive in down economies. Our authors, by the way, did not predict a gold bubble, but I am going to restrain comments until I digest the book better.

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Evan July 26, 2010 at 9:12 pm

Did they make money off predicting the bubble? Did they have skin in the game?

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joeplemon July 27, 2010 at 6:56 am

Evan,
I appreciate the idea of looking beneath the surface to try to guess whether people have less than pure motives for their actions. I am sure they made money by writing an insightful and accurate book. At the same time, they are homeowners, so they saw the value of their own homes drop when the real estate bubble popped. I don’t have any way of knowing what other skin they had in the game.

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Evan July 27, 2010 at 8:40 am

There are some really really ‘cool’ stories about hedge fund managers (not just economists) that predicted the bubble and put lots of money at it! I was just wondering if this was one of them.

” In the summer of 2007, the markets began to implode, bringing Paulson early profits, but also sparking efforts to rescue real estate and derail him. By year’s end, though, John Paulson had pulled off the greatest trade in financial history, earning more than $15 billion for his firm–a figure that dwarfed George Soros’s billion-dollar currency trade in 1992. Paulson made billions more in 2008 by transforming his gutsy move. ”

Review from the Book – “The Greatest Trade”

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Invest It Wisely July 28, 2010 at 12:17 pm

Housing prices in Canada are still quite high – you would be hard pressed to find a house for less than $300K inside any of the largest cities, unless you are out by the farms.

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Len Penzo July 31, 2010 at 2:04 am

Great post, Joe. Very informative read.

@Carol: I could be wrong, of course, but I hesitate to think gold is a bubble – if only because it took so long to come back from it’s last peak in the early 1980s.

Best,

Len
Len Penzo dot Com

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Naomi July 31, 2010 at 9:56 am

It is loan principal, not principle.

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joeplemon July 31, 2010 at 11:47 am

Naomi,
Thanks for reading and pointing out my mistake. It has been corrected.

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Carol@inthetrenches August 9, 2010 at 4:50 pm

Either way, it will be interesting to watch. My dad bought a small amount of silver during the silver rush, and, I’m still waiting for the price to go back up to what he paid for it. 🙂

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joeplemon August 9, 2010 at 5:14 pm

@Invest it wisely,
Do you think real estate in Canada is in the midst of a bubble? Or are these realistic and sustainable prices? Has real estate in Canada risen at about the same rate as income? (the discrepancy between the two was a huge factor tipping off our bubble in America, as pointed out in the post).

@Len,
Thanks for the good word. Always appreciated.

@Carol,
Precious metals do fluctuate in value don’t they?

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Invest It Wisely August 9, 2010 at 6:42 pm

Hi Joe,

I don’t think that it’s necessarily a bubble that will burst, but there is no rationale for prices to keep increasing at the same pace. In cities such as Toronto and Montreal, there is still plenty of land to develop on, and I can only imagine that Calgary and Edmonton have even less restraints.

Consumer debt in Canada is at all time highs, and I believe that the low interests are to blame. The gradual hiking of rates combined with a few mortgage restrictions recently implemented by the government should also help dampen demand a bit. We’ll probably see prices move sideways, or at best, slowly move upwards at the rate of inflation. There isn’t justification for more than that until incomes come back into balance with housing prices.

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Carol@inthetrenches August 10, 2010 at 11:45 am

Very interesting to hear the Canadian perspective. Great topic Joe. Look forward the your next post on the subject.

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