Today I wanted to discuss the 2008 housing bubble, just to give an example of what happens in a bubble, which is important to understand when investing since bubbles happen from time to time and it is good to stay out of them.
In a bubble, the price of something gets way out of whack with fair market value, and people begin buying and paying ever higher prices simply because they begin to think the increase in price will go on forever, or at least long enough to make a profit. At some point, people start to think that prices really aren’t that crazy – that “something is different this time.” Bubbles almost always require that some form of credit be available since that allows people to pay far more than they could afford to if they had to actually provide cash. It is also easier to release money psychologically if you don’t actually have to earn it in the first place.
The housing bubble started when people began to move from high cost states like California and New York to low-cost states like Nevada, Arizona, and Florida. Because they were selling houses that were worth $500,000-$1 million or more and could buy comparable homes for $200,000, they thought nothing of bidding a few tens of thousands of dollars above asking price to ensure that they got the house. This caused the price of houses to start to rise.
Like with anything that starts going up in price, speculators appeared and started doing the math and projecting lines. If a house went from $200,000 to 210,000 in a few months, obviously it might do the same thing again and one might be able to make 20-35% returns each year. They therefore started buying houses as “investments,” which were really speculations. (In investing, the odds are very much in your favor. In speculating, they are even or even a little against you.) Because there were now more people buying houses, and people willing to pay above asking price, houses continued to move up in price.
As prices increased, it became difficult for average people to be able to afford to buy a house. Normally this would have stopped the expansion early, but banks came up with sophisticated (read, “if you use this, you’re an idiot”) new loans. Rather than needing to pay 20% down as had been the case for years, you could simply take out two loans and put nothing down. Once houses go so high in price that people couldn’t afford the payment even if they didn’t need to put anything down, banks went to interest only loans where you did not need to pay the principle for the first five years or something. Then they went to adjustable rate mortgages where the interest rate was lower for the first year or two and then reset . The greatest innovation of all was the option ARM, where you could actually pay less than the interest each month, meaning that the total amount you owed actually went up with time!
Note that the banks were taking out the very safety measures that had made home loans fairly safe. By requiring a 20% down payment, you only made loans to people who had shown that they could save money and insulated yourself from small fluctuations in home prices since the homeowner would still have equity, and therefore a reason to keep making the payments, even if prices declined by 19%. By making sure the homeowner could afford to make a payment that would actually pay off the loan, rather than just making interst payments, the banks made sure people could actually afford to pay off the loans. Once they started taking out all of these safety measures, they were making their business far more risky.
Speculators in particular took advantage of the option ARMs since they would allow them to pay as little as possible each month for houses they held, allowing them to buy several houses. Someone with no money in the bank could buy ten houses and pay for them with a couple of thousand dollars each month in mortgage payments. As this continued, television shows about house flippers were made which glorified this new past time.
For people who just wanted a house, they began to feel a push to buy, even if the prices were high. They felt that if they didn’t get into a house now, they would never be able to afford one since the price just kept going up way faster than did their pay. They took out option ARMs or interest only loans. They knew that they could not afford the payment in a few years when the interest rates reset, but they figured the house would be worth a lot more at that point and they could just refinance. Maybe they could even take out a bit of equity and go on vacation or pay off some credit cards.
Like all good bubbles, this one was blatantly obvious (look at some of the articles in the Wall Street Journal from the summer before the crash – they had an article on it about every day), but it went on a lot longer than you would expect it to. When it did burst, also like all good bubbles, prices collapsed and greed turned to feelings of being cheated. Prices started to fall back down to reasonable levels – perhaps even a bit below there for some markets.
Tomorrow I’ll discuss the banking/investing house side of things.
Please contact me via email@example.com or leave a comment.
Follow me on Twitter to get news about new posts: @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.