Tuesday Morning: Irvine Blogger Goes Inside the Mind of the Bubble

Those of you who believe it's a bubble will want to clip and save this item, which comes courtesy of the Irving Housing Blog. As you can see, it's a map of the "Psychology of a Bubble":

"The above graph is an excellent depiction of the psychological stages of a market bubble. It is fairly easy to put time frames to each of these stages as displayed by our local housing market:
    •     Take off: 1998-1999
    •     First Sell Off: 2000
    •     Media Attention: 2001-2002
    •     Enthusiasm: 2003
    •     Greed: 2004-2005
    •     Delusion: 2006
    •     Denial: 2007
    •     Fear: 2008
    •     Capitulation: 2009-2010
    •     Despair: 2011-2013
    •     Return to the Mean: 2014

Obviously, the past is easier to document than the future, so we may reach future stages sooner or later than shown above, but we will reach them."

Where are we now? "Right now, we are in the denial stage. Prices have not dropped enough to cause real fear. Denial is apparent in polls like this one ...  where 85% believe their home will rise in value during the next five years, and 63% believe a house is a good investment. That is serious denial."

What do we think? L.A. Land is in the Greenspan camp, which holds -- in a rather wimpy fashion -- that bubbles reveal themselves only by popping. That is, until it pops, you don't know for sure if it's a bubble.
And -- though it is true we have been accused many times of being a bad listener -- we haven't heard the distinct sound of a pop in L.A.

Your thoughts? Comments? Insights?
Thanks for the link: Patrick.net
Graphic: Hofstra economist Jean-Paul Rodrigue via Irvine Housing Blog

Comments

[Joseph]

Okay, but how does simple supply and demand fit into all of this? Sure, prices have dropped and might drop some more, but people still need a place to live. People still want to upgrade houses and/or neighborhoods. People still have to move because of a job or bad commute. Eventually, all the illegals who will eventually get amnesty will want to buy a house. Prices can ,and probably will come down, but to say we're going to have a bubble-NASDAQ-like-.com-in-2001 sell off in SoCal housing misses the basic point: lots of people want to live here, no one is building new houses inside the core metropolitain area, people have kids and need that extra bedroom, and so on. I suppose for a true bubble scenario to play out, wouldn't most buyers sit on the sidelines as prices come down? So, using the above example, no one, or very few people are going to buy houses in 2008-2013? Of course, the silver bullet is interest rates, ever increasing interest rates would kill the market. That said, if people see a steady increase in interest rates they might just decide to buy now as their mortgage just gets more expensive the longer they wait.

Anyway, way too many variables but the basics of supply and demand really don't point to some catastrophic bubble. Sure, the days of 20% annual appreciation are over for now.

[jung]

good point joseph. But higher rates means lower prices... which means lower property taxes... lower rates means prices increase with property tax increase as well... I don't know about most people but I'd buy when rate is little higher... Also demand is always there but now most people just cannot afford current prices. I also believe that prices will eventually go even higher as low income families are forced out of LA and more better paid families move in

[golfproz]

Real estate did not go up 300% in the last 10 years because everyone wanted to live in SoCal. It went nutz because of speculation and all those stupid mortgage companies offering 1% loans. It went up 300% it can easily come back down (to where is should be). Now that 20% returns are gone, the speculators are gone. Which means most of the people buying real estate just want a house, an affordable house. With the median income at about 60K the average house is well out of reach without the "creative" financing of the past few years. There's just not enough people in LA making 200K a year to buy all those 700K 1000sqft 1950 post war crackerboxes.

Local real estate tanked 20 years ago and it will tank again. I fully expect my house to be worth far less in a couple of years and that's fine with me because when I do move up, the home I buy will be far less expensive and my taxes will be less.

[Mousebender]

For a place to live, move, commute from, or upgrade--for any reason, people don't have to buy; they can rent.

Check what market rents and market home prices are in any one neighborhood in LA. Run the numbers. Find the per-month after-tax bottom-line cost of buying a home in LA today, and compare it the rent for an identical house. Today the per-month cost of owning is 50% to 75% higher than the cost of renting. In a down-trending market, there is very little reason to pay a hefty premium above monthly rent *and* incur the costs of lost equity.

The days of buying and making the costs back in equity appreciation are over for now. These will be the new market conditions until the gap between ownership costs and rental costs narrows significantly. This could happen through either inflation of rent (which is slow these days) or decrease of ownership costs--through either further decrease of interest rates (unlikely) or decrease of home prices.

The financial value of home ownership is as an investment and as a hedge against increasing rents. Today, even recognizing intangible considerations, these factors are not worth paying the differential between ownership costs and rent.

[Cal]

The "Bubbles only appear after popping" thesis is a bit weird since Greenspan himself was talked of the Internet bubble before it burst.

What economist are saying, I believe, is that they can see these excesses happen but they dont know if this is due to a fundamental shift or is in fact a bubble.

When looking at housing the question starts and stops with lending. Has securitization fundamentally changed the way lenders lend money (it has) and is the lending criteria of the past few years the exception or the new normal (I believe it to be the exception).

Based off of these two items I think housing will remain somewhat higher than historic norms but less than it is currently at now.

If you look at the Case/Shiller index over time and notice the large increase in prices after WW2 many people say this was due to the rapid housing formation after WW2, which was true but would only explain a bump up not a fundamental higher price. What it is really is a fundamental shift in how houses were financed (much wider use of longer term mortgages due to the GI Bill) that changed the housing landscape.

We see something similiar now but people believe that the increased risks that we see lenders take (with diminishing instead of increased compensation for risk as time went on) are fundamentally sound and part of housing forever. Obviously this isnt true (as we've seen since February due to the credit contraction of the secondary market) , the only questions that aren't answered is just how far it will contract and how many motivated sellers will there be during the time it is contracting.

Case shiller chart from NY Times:
http://graphics8.nytimes.com/images/2006/08/26/weekinreview/27leon_graph2.large.gif

ARM reset chart from Credit Suisse:
http://www.bubbleinfo.com/storage/ivy%20arm%20reset%20schedule.png

"Mortgage liquidity Du Jour " research note from Ivy Zelman of Credit suisse:
http://www.billcara.com/CS%20Mar%2012%202007%20Mortgage%20and%20Housing.pdf

The links are for a bit further reading a depth on what has happened and what is coming. The current market cannot be explained by simple supply and demand based on historic metrics, it is all about liquidity (cheap money with very little restrictions on how to get it) provided by the secondary market. Follow the secondary market and you will know where housng is going.

[Dan]

This is the best visual aid I've ever seen to explain how "irrational exuberance" develops and takes hold of a market. While it describes housing, it works well in other markets as well. Does anyone remember Pokemon Cards?

[bill]

As I think was mentioned earlier, the median home price in california is currently about 10 times the median household income. Historically, that figure has been around 4 times. Unless the easy-money lending practices of the past few years are a permanent feature of the mortgage loan industry, it's hard to believe that such a high price-to-income ratio can be sustained. Many people are now putting one half or more of their salaries toward their monthly home payments. They may be able to keep up as long as the job market stays strong, but I think we'd see a bloodbath if unemployment starts rising. Also, California is experiencing net outmigration, a trend that has been gathering steam over the past five years. Those leaving are being replaced by an influx of immigrants, most of whom I suspect can hardly command the high salaries that would support such high home prices. One consequence, based on what i've seen, is that two or more families are buying houses together. I've seen it in the neighborhoods of several people I know.

[tom borland]

Because of LA's status as a world class or destination city on par with the likes of NYC, London, etc., I think prices will always be high no matter if the average or median family can afford it. This is being played out in cities all over the globe - look at London, Mexico City, Buenos Aires, Sydney, Paris, etc. All of these cities have much tighter access to mortgages, higher rates, or no financing at all, yet the prices of the average house or flat are way beyond the reach of most people's incomes. I think what we are seeing in SoCal is one more example of the economic polarization of society. People will always want to live here, they will probably just get by with less. London is an excellent example of this.

[smokey]

Um.......did someone compare LA to London and New York?

[Randy Adams]

I agree that the economic basics of housing in Southern California right now compel a correction. While this area will indeed remain more in-demand than many other cities, that demand is being exaggerated. Los Angeles is not NYC or London. Sorry.

One factor I have not seen mentioned in comments to this blog is the "house-flipper tax break" enacted during the Clinton years. This single change to the tax code accounts for probably 70% of the above-trend appreciation which has occurred across the country over the past decade, including in Los Angeles. As a tax policy, the home-sale capital gain tax exemption was a bad move as it does not encourage anything genuinely valuable to the economy or local communities: it has rewarded speculation in a basic stable of life, housing. Sadly, I can't see any chance of putting this mischeivous genie back into the bottle.

[AnnS]

but the basics of supply and demand really don't point to some catastrophic bubble. Sure, the days of 20% annual appreciation are over for now.
Posted by: Joseph

Uh Joseph? They answer is they most certainly do say prices are going down, down, down…... Less than 5% can buy the median priced house in LA/southern CA. Median is the house priced right in the middle – 50th percentile. That means that 95% of the population can not buy that house. The rules of the market say that only 50% of people should not be able to afford that house – not 95%. There is this extra 45% who are shut out of the market. Tough to sell 50% of the houses (median price and up) to 5% of the buyers. That means there are far more houses at any price range than there are buyers. The rules of the market say when supply exceeds demand, prices have to come down so enough buyers can afford it.

The only way that 30-40% of buyers got into the market was through ARMS and interest-only and other weird things. This was a very bad thing because it allowed prices to artificially inflate beyond what buyers could normally afford.

A large part of the upward swing of prices was fueled by speculation. On average, 40% of the residential property sold in 2005-2006 was bought by investors trying to get in on the bubble.

The frenetic rise in prices outstripped increases in income by many many many times over. You can’t have a house jump from $250,000 to $750,000 and not have the income of the buyers increase proportionately – and income did not rise at the same rate.

Odds are prices will probably drop around 40% from 2006 over the x few years (adjusted for inflation.)

Mousebender has the right of it. What the value of a house (or condo) is must be related to its rental value. If you can rent a house for $1000 but to buy it costs more than 5% higher, stop and think. Take the rent, subtract the property taxes and the insurance and structural upkeep (roof, water heater etc) to arrive at the amount left to pay the mortgage. Take the number and figure out how much mortgage that will pay over 15, 20 or 30 years – and THAT amount is what the property is worth. Say it comes out to be a payment of $1100 and a mortgage of $192,000. The value of the property is $192,000 - not $192,000 plus your down payment. Adding on the down payment to stretch the value only means you are worse off than if you had stuck the money in a jar and put it in the closet because now you can’t access it without selling the house and it is not earning any interest/increase in value.

[john]

Joseph,

Read the inventory reports. This has nothing to do with supply and demand. You're telling me prices in the Antelope Valley doubled because they are running out of land and people actually want to live there?

This is about irresponsible lenders, buyers and overnight flippers. Prices are way out of line with the fundamentals.

And yes, many buyers are RIGHT NOW on the sidelines. Look at the inventory reports for SoCal. If the 90's are of any indication, we will definitely see very few sales the next half decade or so. Those who buy now are going to see their equity drain away like a leaky faucet.

[Paul]

AnnS,
I would like more details on your calculation if possible.
Right now, i'm paying $2400 per month rent for 4 bed/2bath 2000sqft 1955 house in the valley. If i were to buy same house next door, it will cost me about $700,000 and that translates to $4500 plus $750 property is $5250. Now assume tax savings of about 1/3 of the interest to be about $700-1000 per month (depends on tax bracket) also take away fixes, repairs, etc for this amount to to say wash the tax benefit with property tax. So apx 4800-5000 is the next comparable expense to buy this house. Now, who can really convince me that i would better pay $5000 a month over $2400 for a piece of roof to sleep under. Wouldn't the smart person in case he can actually afford, take the $2600 over the rent and put it in some safe savings account/CD/money market getting %5-6, and continue doing that until payment gets closer to his rent money. Even if rent goes up, but interest paid is going down so interest ride off is also getting down. property tax always goes up...and all this is just based on fixed rate mortgage. It will be much worse if it is adjustable/interest only/etc. This way even if that person did that for 30 years. He would accumulate about $1 Million before interest inflation calculations, and if you assume that the interest he gets in the bank is more than inflation, he will retire with todays $1 Million value and without headache.
Assuming that the projections are correct, and median house should cost 4 times the median income plus-minus,and today in so-cal it is 10. So either our wages are due to increase 2.5 times for median $60K to $150k or house prices would need to go down at least 1/2.
Lastly, i would rather buy the house in two years for $400,000 with interest of 10% and pay $3500 monthly than buy the house today for $800,000 with interest of %6 and pay $4,800...

[bill]

I think the rising home prices in LA, New York, London and Sydney, etc., have been fueled by the same phenomenon...a worldwide glut of easy money. These cities have always been expensive relative to other parts of their respective countries, but the price increases of the past five years are unprecedented. nobody can say for sure what will happen, but all signals are pointing to stagnant or falling prices for the forseeable future. if i had to put my money where my mouth is, i'd find another investment and sit tight for a while.

[Steve]

The RE in SoCal is always changing and the over all trend is always up. It happened in the early 90s and will happen now. It goes up 300% in 5 years and then goes down 20% in 2 years. For those who say rent instead, you are out of your mind and the reality is you will go no where finincially. How about this for a brilliant solution, just move. The job in LA is a joke and will be gone in 5 years, you now move where you can afford a house and pay it down. A side benefit is you will probably have a better quality of life, rather then spending the rest of your liiving days on the 405 in the 24hr gridlock dodging bullets. Why do so many stay?

[david]

most people who bought in the last five years did not grow up in LA. remember the late 80's well it took 20 years to get over that burst, but only those of us who experienced it first hand can remember

[Cal]

I was rereading "The Four Pillars of Investing" by William Bernstein last night, he has a chapter on bubbles.

The four conditions he says are necessary for a bubble:
"1. A major technological revolution or shift in financial practice
2. Liquidity- i.e., easy credit.
3. Amnesia for the last bubble. This usually takes a generation.
4. Abandonment of time-honored methods of security valuation, usually caused by the takeover of the market by inexperienced investors."

He goes through history and talks about various bubbles, it's a fun read.

[Martin Kane]

There was no such thing as a 20-year burst that started in the 1980's. Actually, after dramatic price increases from 1985 through early 1990, prices began declining. Denial about real estate market realities ceased overnight, when the short Iraq/Kuwait war (in early 1991) started. The Southland (with the U.S.) endured a recession for the next three years.

The 1994 Northridge earthquake actually brought our economy back to life (thanks to billions of insurance dollars and relief aid). Prices declined again after the earthquake because of new complications. But those losses were corrected within two years.

The market saw rough seas for about five or six years (again, from 1991 to mid-1995). I have since regretted I didn't snatch up a few of those $50,000 one bedroom condos that banks were stuck with following the quake. They increased eight and nine-fold.

I agree with most of the rationale I see in the stream of comments above. The supply and demand factor and the popularity of Greater Los Angeles as a place to live and work strongly suggests the region is right up there with favorite cities worldwide. Can we begin to compare Los Angeles to New York and London? Absolutely! The dream factory identified as Hollywood, major media, industry, commerce, culture and the Pacific were created here.

On the other hand, mortage interest rate hikes, simple affordability factors, dishonest mortgage loans that will default and inventory increases will cause price declines. Those one bedroom condos may now be down to about $250,000 for just a little while. And that's when all those Chicken Littles who complain a lot and predict the worse should buy. Admit it, Chicken Little. You know you want to buy. You're rooting for the financial downturn of the Southland majority: the homeowner. The socio-political-economic implications of this kind of grousing will likely cause that greatest impact of all.

Another major contributor to the decline with be the Internet, the most significant "invention" of our lifetime. We never had exposure to the level of information that is now at our fingertips. It's all good. But the Web is also an instrument of propoganda true and false. With this real estate downturn, the Internet will create many new precedents.

Nothing is certain except one stream of thought. What comes down must come up. It's the historic imperative!

To all the Chicken Littles out there, your predictions (and largely high hopes so that you may buy too) may be right. For a time. This period most certainly is not a time to buy. However, do not discount the Southalnd's diverse econnomy and desirability. Our population keeps growing, our economy is more diversified than virtually any other city in the U.S., and there are few new housing starts. Equilibrium will occur. Just make sure you get into the market when the fire is hot because the window of opportunity will not be ever-lasting.

[frank]

I remember the late 80's quite well-the market crashed primarily due to the end of the Cold War and the departure of aerospace industry jobs as a result.

The damage was worst in places like OC and SD, where the economy was primarily aerospace-oriented...

Thousand Oaks, by comparison, went flat due to the growth of Amgen and other companies moving in to cancel out the loss of jobs from aerospace...

The main difference now, especially in the coastal areas, is that unemployment is still low-3 to 4 percent-which means that in areas like I am in south Orange County, the market is flat-there are few subprime loans in our area since most of the residents are upper-middle class professionals with stable jobs and considerable equity in their homes. However, if you go 1/2 hour or so east, the signs of subprime mortgage problems are evident.

And from what i read here, areas like west LA and Newport Beach are in the middle of another boom...

I would worry in my area if companies like Cisco/Linksys, Toshiba, and Broadcom started laying off people-which is not happening...

[Cal]

Martin Kane

A) "*snip* This period most certainly is not a time to buy. *snip*" , that is all you had to say.

and

B) "You're rooting for the financial downturn of the Southland majority: the homeowner. " - Los Angeles County homeownership rate - 47.9%

http://quickfacts.census.gov/qfd/states/06/06037.html

Thanks for playing.

[Matthew]

The simple fact of the matter is that housing in Los Angeles has virtually nothing to do with housing. It has to do with investing and the concept of value. It is akin to buying stocks. How many people who buy and sell stock actually known anything about the companies they are investing in? Most people know (or rather “think” or “believe”) that their stock is a “good investment.” But what makes anything valuable? Something is only as valuable as someone else is willing to pay. While owning a home has always been an investment to a degree, the investment aspect was a secondary benefit. The primary benefit was living in a nice home. Now, the primary aspect is investing and it doesn’t so much matter if the place is a 60-year old starter home in a “so-so” neighborhood that needs serious fixing. What seals the deal however is when you turn to the labor market info and see what people are actually making and compare that to the housing market. The average Angeleno makes less than $40,000 a year while the median home is over a half million dollars! How is that not a bubble?

[Jane]

In regards to going where you can afford.

In regards to going to Iowa or Indiana or somewhere reasonable that's just not an option for many people in LA. If you have a last name with too many vowels or consonants, this is pretty much it.

I don't exactly want to go to Texas and be asked 20 times a day if I'm Vietnamese or how in WW2 their grandfather went to Japan...don't really care, this place is insane, but I can't see me go anywhere else. What if I have a son or something and I'm in Iowa, that would be horrible. Some parts of the country aren't as open minded as LA...I laugh typing that, but it's true. The cheaper a place is the more ignorant people tend to be. There is always a catch darn...

Unless you are 1950s American you can't exactly leave LA or NY or Chicago and go somewhere "reasonable," though you know I don't think I would want to.

The reason LA is so crazy is simply because this is for many people their last chance, it's always has kind of been like that. I think the market will go down, but it will go up again, there is always a scam. When their are hungry people whether figutatively or literally their is air getting pumped up somewhere.

Jane

[www.BeterVillage.com]

Bubble, Bubble, Boil and Trouble.

From Richard Green's blog:

"From today's Washington Post: [6/26]

When Edward P. Lazear, chairman of the White House Council of Economic Advisers, broached the idea of limiting the popular mortgage tax deduction, he said he quickly dropped it after Cheney told him it would never fly with Congress. "He's a big timesaver for us in that he takes off the table a lot of things he knows aren't going to go anywhere," Lazear said.

Lazear, who is otherwise known as a fierce advocate for his views, said that he may argue a point with Cheney "for 10 minutes or so" but that in the end he is always convinced. "I can't think of a time when I have thought I was right and the vice president was wrong."

hmmmm..." Hmmmmmmmmmm......

[Schahrzad Berkland]

Joseph brings up all the myths of housing prices. Let's go through them.
1. Everyone want to live here. Fact: out-migration is high, as people are priced out or sell their homes and take that wad of cash and leave. Out-migration last year was 42K for San Diego, 183K for LA, 8K for Ventura County, and 46K for OC. The Inland Empire gained 65K residents from migration, because housing costs are cheaper there.

2. All those kids need a place to live. Yes, they do, so they stay at home with mom or dad, or they double up with roommates and live 10 to an apartment. This week's National Association of Realtor report shows household formation is down.

3. As lending standards tighten, people will be able to buy homes only at 2.5x income.

How low will prices go when people actually have to qualify for a loan based on their income, instead of on their FICO score brushed with a kiss of good luck?

[Raymond]

These comments were very very good. I think everyone understand what is happening in the SC RE Market. No one can be sure what will happen. I for one is a Chicken Little. Although I own my own house, I want to purchase a bigger one. However, I am not willing to mortgage the rest of my life away just to get that bigger house. If housing prices do not come down at the end of the year, I will just add to my existing house. That takes me out of the market for a new house. How many other home owners are in my situation? Will that affect the market? I would think so since I only purchase things I can afford. Now, I also believe that even if the RE drop by half, it will eventually recover and be worth more than today. I am just not willing to wait 15-30 years for the prices to come back. I am only looking for a place to sleep and raise my family. That is all and I'm not going to mortgage our lifestyle away just for a bigger house.