Tuesday, April 12, 2005

Housing bubble will pop

By Robert J. Shiller

The upward momentum of home prices in cities such as Los Angeles, Las Vegas, New York or Boston has seemed so incredibly strong that it has been hard to imagine what could stop it. But we have to exercise our imaginations a little more. The reality is that double-digit price increases cannot go on indefinitely because they would eventually put home prices out of reach of ordinary mortals.

What do most people think might stop the momentum? Interest rate increases come to mind first. These factors can certainly play a role, but often they are not enough. After the boom of the 1970s, even after the 30-year mortgage rates surpassed 16 percent in the spring of 1980, Los Angeles home prices still managed to go up another 10 percent for the succeeding year.

An economic recession also comes to mind. Certainly, the busts after the last two booms, in the late 1970s and the late 1980s, were accompanied by recessions. But in reality, the direction of home prices does not correspond very accurately to times of recession.

So what really causes price drops?

Bubbles grew and burst long before there was a Federal Reserve setting interest rates, long before the United States was collecting data on recessions.

It is useful to think back to the first major real estate bubble in Southern California, which took place in the 1880s. This bubble, which peaked in early 1887 and afflicted all of the region, notably Los Angeles, is well documented in the Los Angeles Times of that time: "People poured in by thousands and prices of land began to climb. Everybody that could find an office went into the real estate business. ... Desk room was hired in stores, in hallways, wherever room could be found. ... Tracts of lands were cut up into lots, the further enormous rise in values was predicted, auction sales were announced ... rattle off the lots and have another sale.''

So what brought this bubble to an end in the fall of 1887? It cannot have been the Fed raising interest rates - there was no monetary authority then. Nor was it a major economic disruption. There was a short national recession from March 1887 to April 1888, but not a notable one.

We do see a change in attitude, an increasingly vocal list of doubts, reflected in the press accounts in the fall of 1887.

In November 1887, the Times quotes a salesman for a Southern California real estate firm operating in Chicago: "Everybody has heard about the boom in (California) real estate, but they want to know what there is behind it. ... (They ask) You think then that the present growth in Southern California will continue?' Most assuredly.''

The Boston Evening Record wrote in the fall of 1887: "In almost every suburban town around Boston, parties are being made up of people who are going to Southern California, there to spend the winter or to settle permanently. ... But to those who are selling out their property here in the East with hope of making a fortune in California real estate within a year after they reach that latitude, the Record offers the advice to go slow.' Southern California may be the most perfect garden on Earth, but the way things have been going there for the past three years is pretty good evidence that the slump is coming before long.''

In less than a year, this floating of doubts about the boom morphed into a sense of real disillusionment.

In November 1888, the Times wrote after the bust: "We must avoid the rotten methods, inflation, unhealthy speculation and ephemeral booms. ... We believe this is now the feeling of nine-tenths of our people. ... The wild scenes of twelve and fifteen and eighteen months ago are in no danger of being soon repeated. Possibly we may never look upon their like again. If so, so be it!''

Well, we are looking upon a real estate boom again, and we are likely to observe the same end to speculative feeling, at least before many years have passed. Human nature is unchanged.

In a bubble, high prices are sustained only by the expectation of more high prices. That is what makes a bubble a bubble, prone to bursting. The reason we cannot expect a soft landing today is that right now people are willing to pay these very high prices only because they expect them to go up even more in the future. Prices can't just level off, because when people no longer expect them to go up, some of them will not want to hold at the high price.

13 Comments:

At 7:36 AM, Anonymous Anonymous said...

The more recent real estate bust in the "Oil Patch" of the late 1980s would be a better scenario to study. I think Mr. Shiller would find some interesting causes there. Many of us lost our shirts in OK, during that time.

 
At 7:07 PM, Blogger Cirrus Pilot said...

I built a few homes in Northern California in the mid 1980's. I saw very little increase in prices. We sold our home for $189,000 in 1997, it is easily worth $750,000 in this inflated market today. Personal incomes cannot sustain this. This price runup is supported by the banks willingness to extend credit to people who only a few years ago would not have been considered for loans.

Sadly, many of the current homebuyers are to young to really remember a market that had no appreciation or in fact depreciation.

Some of these poor souls may actually believe the advertising that shows banks as your friend and helper in obtaining a home. When the market cools, they will coldly throw families into the street and blame everyone but themselves for the mess.

I have seen this and am sure we will see it again.

 
At 2:32 PM, Anonymous Shinndig said...

I don't buy the "soft landing" argument. If you look to the individuals who are stating such remarks, most of them are in the real estate business anyway. I highly doubt any major figure in the real estate industry is going to say, "There's going to be a crash" because it would create quite a stir and panic that would resonate throughout the entire economy.

 
At 12:55 AM, Anonymous Anonymous said...

I am quite glad now that I didn't buy anything a couple of years ago because I had credit cards to pay at the time. Even if prices were still going up then, I wouldn't like to be stuck in something losing value over time. We're talking BIG money here, and with interest rates to pay. I feel better off paying back my credit cards and sticking to low rent. Let's face it, we're all renting in a way, because once we move out to another house, someone else moves in and either they are renting from a landlord, or renting with a mortgage to the bank. For anyone who bought in 2005 I sincerely hope you can sit it out for as many years as it takes until all this stabilizes.

 
At 1:36 PM, Anonymous San Diego cosmetic surgeon said...

Here in San Diego real estate, the average home has seen it's value drop in the double digits!

Plus, the bulk of the adjustable loan have yet to adjust! So, this is going to be VERY bad!

 
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