There is something about bubbles we don’t understand

According to the Central Statistics Office, residential house prices in Dublin rose 22 per cent in the year to May. The last time Irish house prices were rising so fast was between 2002 and 2005, the years immediately before the crash. This is sparking talks of a new price bubble – mostly, so far, around the dinner table.

That doesn’t have to be a new bubble, and you will note that these prices remain well below their pre-crash peaks.  Still, prices seem to be moving pretty fast in the market.  It remains my view that some regions of the U.S. did not have a real estate bubble at all, and that for these regions it is the price bust which is the anomaly, not the initial run-up.  It is an interesting question what percentage of the world that might hold for.

The FT story is here.


"it is the price bust which is the anomaly"
Cue Scott Sumner on the missing concept of the "anti-bubble".

"There is something about bubbles we don’t understand." Yes. For example: how common are they? The Red Queen can sometimes believe in six bubbles before breakfast.

I thought everyone knew the housing bubble in the US was localized. In your backyard it was plainly obvious. NoVa built like mad, while Baltimore did not. PG county did not have the building boom, but saw prices inflate with synthetic demand from sub-prime loans. On the West Coast SoCal had a completely different bubble than NoCal. New England had a similarly varied experience.

Baltimore (where I live) may not have built much, but there was still a speculative market in which would-be house flippers bought and rehabbed existing houses in what was deemed potentially gentrifying areas. Hence housing prices did rise above market rates in those areas, and when the bust ca,e many of these properties ended up in foreclosure.

if I had a nickle for every prediction of XYZ being a bubble...

As anyone that invests in real estate will tell you , it's all about location. The Bay Area keeps going up because of huge demand stemming fomr huge inflow of dollars, technological epicenter, and scarcity. Dublin is desirable due to the small geographic area, nice climate, geopolitical stability, biotech boom and tax haven. .

I don't understand your argument. Prices in Dublin went up, then down, and then up again, but its location never changed. What did?

@Ricardo - what changed in Dublin? Very tight monetary conditions in 2008 led to collapse in both demand and supply. A lot of potential buyers either couldn't raise the money or were too scared or worried about the economy to buy. Now conditions have eased somewhat the demand has come back. On the supply side a lot of owners could not afford to sell except above a certain price. Interest rates fell so low that they have no problem servicing their mortgage but crystallizing their loss by selling would have given them a big cash hit. So they held on to their house and did not sell, and rented out if they wanted to move. The result was that supply became very constrained, basically only estate sales and new builds. Planning permission problems prevent quick expansion in supply to make up for the loss in existing housing sellers. This effect causes a sort of hysteresis in housing markets. There is also the anchoring effect which is especially strong for houses, especially in cities like London and Dublin where most houses are one-offs. The previous price paid becomes a strong signal to both buyer and seller about the value of the house.

This site gives some data on the falls in mortgages for instance in the UK - There were 1/3rd as many approvals in 2012 as in 2007. Gradually approvals are increasing now, but supply remains constrained.

Did the Bay Area keep going up from 1990 to 1996?

Did the Bay Area keep going up from 2006 to 2012?

No doubt the Bay Area has done well over a thirty year horizon or longer, but not everyone buys with that time horizon, and buying at the wrong time can be and has been catastrophic.

You are also cherry picking the most lucrative area in the country as an example. I can point to hundreds of metro areas that havent fared so well.

Im also not sure that the compound average growth rate of the Bay Area since 1990 surpasses the break even point (net of depreciation, maintenance, taxes, owners equivalent rent, interest on principal, etc).

That and the Bay Area operates like a reservation instead of a market.

Nice connection with the prior post on reservations.

I think I read that about two-thirds of all housing in SF are rentals. Id be interested in seeing whether this is cash flow or capital gains investing. They have rent control and strong tenancy laws more generally. They also have a property tax cap that encourages long term holdings since the early 80s. Lots of tech growth as he says above, and nice geography.

Ive actually heard the opposite, that renting in SF is going away due to the rent control and tenancy laws that you mentioned.

The market is about 50% all-cash Chinese buyers who buy and rent out without the expectation of a reasonable cash return.

"The market is about 50% all-cash Chinese buyers"

Really? That seems amazing. Is there a source that supports that figure?

Most (two-thirds, or more) of the total housing stock of the City and County of San Francisco is rentals. Most of those properties won't change status in the next ten years. They might change hands, from one investor to another, but they'll stay rentals, many with the same tenants. The ones which *will* change hands are the ones where a single housing unit (or a two-unit property easily converted to a single unit) can be sold separately. You can't buy a 6-unit (or 60) apartment building and convert it to owner-occupied housing, but you can buy a rental house, evict the tenant (for $15,000 or so) and live in it. Those will be the units "lost" to the rental market.

Due to the rent and eviction control laws in San Francisco, and the Ellis Act (which implements the 13th Amendment in the housing market), there's a strong incentive for owners of one and two-unit rental properties to sell to buyers who will live in the house. A resident owner will be willing to pay a premium over what an investor would pay, in general, and the investor's cash flow calculations may be based on rents set well before the boom, while the potential resident owner will be comparing his mortgage costs to potential current rents.

Come, come now. There are national and international factors that affect real estate prices in every region of the country and then there are local factors that affect specific regions. There can be interactions between these factors that magnify the effect of either individually.

States like Washington had a real estate bubble, but it was smaller than, say, California or Georgia.

Global capital imbalances affected the whole world, which is why Minnesota and Ireland both had a boom/bust cycle. Low interest rates for a prolonged period fueled price growth in the US. Centralized housing incentives had varied effects depending on the size and scope of local efforts. And of course location mattered. Some areas have endemic price volatility.

People who say we didnt have a residential and commercial real estate bubble and bust probably dont leave their office much. Once we overbuilt, there was no way possible for monetary policy to prevent the crash. You can't un-ring a bell. Long-lived assets displace future demand and the derived demand for inputs for the duration of their existence. Destroying the oversupply may fix the income statement but that ravages the balance sheet with distributional consequences.

It's possible for tight monetary policy to cause a crash. Who's to say that isn't what happened?

I live in a city where locals have been saying it's been overbuilt for decades. Yet, so far, no price decline. So it's not obvious what is overbuilt, and a crash is not evidence of a previous bubble, unless you tautologically define a crash as what happens when a bubble bursts.

Yes. All else equal in equilibrium tightening CAN lead to a crash such as the early 80s recession. The calculated benefit was inflation control.

Tightening monetary policy can certainly prick a bubble, but that doesn't "cause" the crash - the unsustainable expansion does.

With a vast oversupply of houses supported by debt financing, something had to give - either house prices or the value of the debt. Expansionary monetary policy would have inflated away nominal wage and price rigidities and spread the pain broadly, but that only changes the distributional consequences.

The ability of cheap debt to fuel production can only take you so far, so fast, and there are costs. Unwinding the Fed's balance sheet won't be cheap or easy.

There's a bubble in bubbles. Time to short them and go long.

I'd expect real estate markets to work differently in areas that are land-locked, as compared with ones where there's still plenty of open but buildable land. In the latter, land prices will remain low and prices will be constrained by new construction, which will be limited only by availability of labor and materials.

But in an area that's already fully built-out, especially one with strong regulation (which often makes it difficult-to-impossible to demolish existing buildings) there's not only the supply-and-demand situation, but the possibility of a "buy before it's all gone (or beyond your budget)" mania to create an actual bubble.

Both types of housing markets get lumped together in housing statistics, even though they behave differently.

Presumably one sign of a housing bubble would be the amount of speculation. Are builders building without firm orders? Are people buying more with an eye toward resale than to obtain a place to live?

You are generally correct.

California coastal cities are virtually land locked by climate and terrain, not isolation per se. San Francisco is, of course, a quintessential example of your point. Oakland, less so. The Central Valley had a huge bubble that burst. Did people really think they would maintain 2 hour plus commutes?

Things were crazy here in Chicagoland too, and we arent technically landlocked. I suppose the Lake creates a meaningful obstacle. Coastal states generally got hit hard.

…and prices in the Chicago area are basically right back up to where they were before the crash. Bubble? Recovery? Healthy economic expansion? Who knows. I can't predict the prices of any capital asset.

It remains my view that some regions of the U.S. did not have a real estate bubble at all

How about the possibility that the bubble wasn't in real estate but in mortgage backed securities? The idea that financial engineering, which was an innovation, had somehow created magic mortgages where no one was at risk set off a bubble in mortgage loans, not houses themselves. Granted some areas had rapid increases in home prices too but that was more a side effect of the true bubble.

The idea with MBS was that the mortgages made the securities magic, not vice versa.

There was a bubble in both.

MBS is a perfectly sound financial instrument when they are properly priced. Yields on MBS were signalling far more risk in the mortgage market than lenders were accounting for. Regulators underpriced the risk of MBS in capital ratios, leading to buying coordinated through the whole financial system. A global savings glut made MBS extremely attractive compared to treasurys.

I hate jargon, but this really was a Perfect Storm.

There was a bubble in more than "both."

There was a national real estate bubble.
There was a subprime liar loan bubble instigated by mortgage originators looking to sell any and every mortgage to financial services firms for packaging and tranching.
There was a fraud bubble by ratings companies mismarking MBS risk (S&P, Moody's).
There was an MBS bubble fueled by financial services firms chasing alpha.

Finally there was a "disgustingly overpaid and misaligned incentives" CEO bubble where CEOs were incentivized to take outlandish gambles, leading to the nuclear meltdown of Lehman Brothers, Bear Stearns and Merrill Lynch.

Do you have data on delinquency rates for MBS's? I have heard that actually the A rated tranches actually did OK, but have never actually seen the data.

According to Wikipedia:

"Between autumn of 2007 and the middle of 2008, agencies downgraded nearly $2 trillion in MBS tranches. By the end of 2008, 80% of the CDOs by value rated "triple-A" were downgraded to junk. Bank writedowns and losses on these investments totaled $523 billion."

If triple-A rated securities turned out to be junk, I can't imagine that single-A tranches would be worth anything.

More info here:

In terms of real estate, I would argue that a price/rent ratio gives you the best indication of a real estate bubble. IIRC at its peak a Dublin apartment that would rent for $800/month would sell for $1 million. That's a bubble.

I'd agree, but with caveats. The proper relationship between price/rent ratio depends on things like property taxes, long term real interest rates and maintenance costs (which are lower when more of the value is in the location than the physical structure). The math is hardly even complicated. So a price/rent ratio in SF does not have to match Atlanta, for example.

I believe you are correct, but them we can only judge a bubble in SF by its own history.

We are all technical traders now.

Yes, but with the caveat that various tenant friendly laws make a big difference.

If you can't get rid of a tenant, price alone isn't the determining factor.

That alone explains spanish rental prices vs. sale prices pre-2007.

I read that somewhere about Spain, but I can't for the life of me remember the source.

I think that bubbles have less to do with price levels and more to do with how purchases are financed. If purchasers chase rising prices with sub-prime 100% mortgages, then house prices only have to level off for some of the most recent buyers to be in trouble and for their forced selling to drive prices down again.

But if house purchases are financed in cash, or with mortgages that have a healthy cash deposit and reasonable loan to income ratios, then buyers are not so likely to be shaken out of recent purchases, so prices leveling off or falling slightly does not lead to panic selling.

Why not both? Access to easy credit makes higher bids possible. A home seller might not know or care whether the higher offers are the result of one wealthy and motivated bidder with cash versus a subprime borrower with a negative amortization loan financed by FHLB advances and MBS, no money down, and a cyclical job. Affordability features and the liquidity boost of the secondary market made a multiplicity of higher bids possible.

I won't mind being the winning bidder at Christies with your credit card.

That's a bit of a jumble. Very few home buyers are qualified to value a property, so what they do instead is measure affordability. If they purchase with cash or with a healthy cash deposit, then they can ride out fluctuations in prices. All the really matters to them is if they can meet the monthly payment.

On the other hand, if they financed the purchase with a liar's loan, or with a mortgage they can't afford - hoping to "flip" the house - or with an ARM that later settles at a higher interest rate, then they are much more sensitive to price, and can be forced out of a house that a more conservative purchaser can keep.

Fluctuations in prices do not render a house unaffordable for a buyer (once he has bought the property). Assuming the buyer's income has not changed the mortgage payments do not change when the property appreciates or depreciates. The problem was that in too many cases the properties were not affordable from the first (and were purchased for speculative purposes not as a home to live in) with the expectation that the buyer might take losses in the short-term, but would cash out big when he sold the property later. The end of price appreciation doomed these buyers and sent the properties into foreclosure. This was eventually compounded by the tsunami of job losses after the Lehmann collapse which soon ended up becoming the dominant reason for default.

And what about the dot com bubble? Stocks are mostly purchased with cash or limited borrowing yet almost no one asserts you can't have stock market bubbles.

You are forgetting that although stocks *can* be purchased with cash, there is a well-established margin system, and also people can purchase stocks with the "equity" they extract from their homes.

Leverage magnifies the value of speculation and enables purchases otherwise outside the budget contraint. Im not suggesting leverage is the only cause of bubbles. I think they are an enabler and an aggravating factor. Leverage makes bubbles bigger and longer.

It's not the fall heights that hurts. It's the hard landing.

It seems very few understand the multiple causes of what happened between 2000 and 2007. And so, it will be repeated.

There were scores of factors contributing the the US housing bubble. Price is a symptom not a cause.

Quickly: here are real life factors that may cause credit problems/losses for automobile lenders. Information reported in WSJ 7/2/2014: Liberal/loose loan underwriting supported auto sales volume: average loan term reached record length of 66 months, and borrowers with worst credit scores terms were even longer at 71.4 months. Combine that long terms with record low interest rates. Longer terms mean declining collateral values years out. Lowest average FICO (credit) scores in six years. Larger proportion of market was leases, lenders are betting on automobile residual values, current used car sales actually support the lower lease/teaser(?) payments. However, when (not if) rates rise . . . What is not to like?

Because everyone is looking at it through the prism of ideology. Are scientific detachment and the free exchange of ideas dead?

Accounting and finance (real world) concepts don't fit in "ivory tower" models.

If one is selling a kidney to finance a purchase (figuratively speaking?), you are seeing a bubble. I have been told that a lot of purchases in the US today are for cash, so I question a bubble in US real estate (unless the cash thing is actually wrong). How are the purchases in Ireland being paid for?

Why is it largely cash? (Cash is about 40% in some markets and falling)

Cash glut, low opportunity costs from a low rate environment, damaged household balance sheets, impaired credit, and lots of bargains.

Investor demand is mostly satiated. Prices have risen to the point that capital gains investing is no longer profitable net of expenses. Expectations of rising rates soon makes longer term investments less desirable.

The low point in a business cycle is ideal for risk taking. We are way past that now. The economy is already slowing.

The original meaning of bubble, I think, is a mass investment fad where widespread belief in a type of asset's likelihood to appreciate becomes a self-fulfilling prophesy and drives valuations far beyond fundamentals.

These days, though, any sort of purportedly above-fundamentals valuation is called a "bubble". Which greatly dilutes the power of the word, but you can't fight popular usage.

I don't think the Dublin rebound meets the original criteria, but it might meet the latter. You'd need to look at incomes, rents and rental yields, not previous peaks.

But with housing it's very hard to say what "fundamentals" are. Some ratio of area incomes? That still means a neighborhood's "fundamentals" go up when its land prices go up, which doesn't sound very fundamental to me. What's the fundamental ratio of incomes that should go to land rents?

As for Tyler's comments on the US real estate bubble, I certainly agree that many areas had no bubble by the original, and my preferred, definition. But were prices merely above fundamentals? God knows. I doubt though that price drops anywhere were especially "anomalous." Even in a world without bubbles (as originally defined) we would still have financial cycles, and land prices would still be cyclical.

This is a fair description, although you correctly ask for your own criticism. Expectations of prices are a determinant of demand, and when those expectations are unreasonable, there is a bubble. But how do we define an unreasonable expectation? Perhaps, similar to a hypothesis test, when observations begin to deoart from expected values. This may still be uninstructive about when we are in a bubble as opposed to watching the aftermath.

I certainly didn't mean to say there's any objective criteria for judging bubbles before they pop.

I merely meant to distinguish between the classic definition of a bubble, which features mass participation and widespread expectations of appreciation, and the newer, diluted definition, in which anything arguably overpriced is called a bubble, even if there's no mass participation and it's not obvious that everyone's betting on continued appreciation.

The best example of the new definition is the "bond bubble." Sure, bond prices are very high. But that's monetary policy working its way through the financial plumbing, not some mass public bondmania.

I got your meaning. Maybe it isnt clear to me what bubbles are supposed to be. Are they a disequilibrium or are they an equilibrium based on transient and intangible factors such as expectations?

By "fundamentals" of house prices, I think you mean the typical determinants of demand such as income, prices of complements, prices of substitutes, interest rates, loan terms. Im afraid im only a partial equilibrium thinker and there may be GE factors Im missing.

To me, bonds have rallied for three decades because of monetary policy, as you say. When rates rise, bonds will fall. The question is whether aggregate demand picks up fast enough to spur bond demand in optimal portfolios before mass sell offs send yields soaring. I dont see monetary policy as a transient factor; Fed demand has always been part of the equation. Sustainability is another issue. While bubbles are unsustainable in the short run, monetary policy can sustain drives for decades.

Housing prices are up since 2003 almost every where and many are near the peak of the bubble. That is they have recovered almost as much as the stock market has recovered from its crash in 2008-2009. To the extent that people see housing as investments housing prices can also determined by momentum traders so prices overshoot and undershoot their ¨fundimental¨ values

Not in real terms

Besides Cliff's point, more importantly interest rates are way down. Land is a lot like a financial asset: valuation reflects discounted expected cash flows and lower rates mean less discounts.

That said, land prices are again very high relative to incomes in many areas, and that's not good for growth. It's even worse in many parts of Asia.

Tell me again, what is the US inflation rate? What is the growth of the housing supply in response to this bubble?

This bubble isnt in single family housing. All that money has to go somewhere.

Where's Waldo?

The point that the money has to go somewhere, Willi, is just fine. The Fed wants you to bring forward your investment or consumption from future periods to the current period. Again, with inflation so low, and with excess capacity in most industries, may I ask : Where is your Waldo of inflation.

Asset prices fluctuate.

It will be interesting to see if interest rates actually do start to eventually rise back to "normal" levels as the economy recovers what happens to house prices. As I mention above, the current low interest rates mean that most house holders can services their mortgages and thus can afford to wait until prices rise again, either to the point that they can clear their mortgage or to wait until they can build enough equity to get them to the next house on the ladder. But if interest rates increase that strategy may not be viable any more, so there could be more forced sellers which could crash the market again. Of course, if interest rates are rising this means that the economy is booming (otherwise why would CBs raise interest rates) which means that there would be more buyers. Which one of these effects will win, hard to say.

Interest rates can rise without a booming economy. What do you suppose will happen to rates when the Fed unloads its humongous balance sheet at fire sale prices? How about if China is unwilling or unable to sustain its export promotion policy? What if the nation's overleveraged balance sheet, inclusive of alk state and municipal debt, trashes our credit rating?

The question is whether any sustained recovery can cause bond demand to outpace supply. As the other camper said after donning his Reeboks, "I dont have to outrun that bear, I just have to outrun you."

Willits - sure interest rates "can" rise without a booming economy, but I don't see that the Fed sale of its balance sheet will cause interest rates to rise. That balance sheet was essentially all purchased using printed money. The initial printing of the money is the inflationary step (or the purchasing of the assets if you prefer). But that dog did not bark, unless you think the collective multi-trillion dollar treasury market is somehow acting irrationally for an extended period of time. In any event why does the Fed need to sell its balance sheet anyway? Its not like it costs anything to hold it, it actually makes a good return. I would genuinely like to hear some arguments as to the danger of the Feds balance sheet size, I have seen this mentioned quite a few times as a danger but have never seen it explained why.

The one thing that could in my view cause interest rates to rise without a booming economy would be inflationary printing of the Zimbabwe style. I guess this is possible if the US Government suddenly decided to become collectively insane. In that circumstances you could expect houses, as a real asset, to become very favorable assets to hold and anyone currently with a mortgage, as they are fixed in nominal terms, to get a sudden windfall as they are inflated away to nothing (sort of what happened in the 1970's). If you think that's going to happen, load up now on houses leveraged to the hilt.

If a bubble has the unlimited backing of the government does that make it a good investment or a bad investment?

It's been determined that leveraged non-diversified residential real property is god's own perfect investment for the masses. Any downturn in price of that asset class is a national tragedy akin to polio and needs to be countered by concerted government action.

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