The Housing Bubble

A Saturday topic starting with this Bloomberg editorial by Noah Smith. “According to mainstream theory, bubbles are not driven by speculative mania, greed, stupidity, herd behavior or any other sort of psychological or irrational phenomenon. Inflating asset values are the normal, healthy functioning of an efficient market. Naturally, this view has convinced many people in finance that mainstream theorists are quite out of their minds.”

“The problem is, mainstream theory has proven devilishly hard to disprove. We can’t really observe how investors in the financial markets form their beliefs. So we can’t tell if their views are right or wrong, or whether they’re investing based on expectations or because of changing risk tolerance. Basically, because we can usually only look at the overall market, we can’t get into the nuts and bolts of how people decide what prices to pay.”

“But what about the housing market? Housing is different from stocks and bonds in at least two big ways. First, because house purchases are not anonymous, we can observe who buys what. Second, housing markets are local, so we can see what is happening around them, and thus have some sort of idea what information they are receiving.”

“In a new paper, economists Patrick Bayer, Kyle Mangum and James Roberts make great use of these features to study the mid-2000s U.S. housing boom. Their landmark results ought to have a major effect on the debate over asset bubbles. Bayer et al. find that as the market overheated, the frenzy spread like a virus from block to block. They look at the greater Los Angeles area — a hotbed of bubble activity — from 1989 through 2012. Since they want to focus on people buying houses as investments (rather than to live in), the authors looked only at people who bought multiple properties, and they tried to exclude primary residences from the sample.”

“They found, unsurprisingly, that the peak years of 2004-2006 saw a huge spike in the number of new investors entering the market. So what was making all these newbie investors start buying houses? The researchers found that one big factor was nearby investment activity. In other words, if lots of people were buying investment properties nearby, it made other people in the area much more likely to buy an investment property. When properties were flipped — bought and then resold quickly — it had an even bigger effect in terms of drawing nearby people into the housing market.”

“This is strong evidence that people were copying their neighbors’ behavior. When people saw other people buying and flipping houses, they started doing it themselves. That stands in stark contrast to the predictions of standard theories of investor behavior, which say that investors only care about the future income that they can earn from their investments.”

“Even more startlingly, Bayer et al. found that housing investors who mimicked their neighbors ended up performing worse than other investors. That is a good indicator that copycats weren’t learning any new information about the fundamental value of housing.”

“What were they doing? One possible answer is herd behavior. Economists have studied herding in financial markets, but their theories are generally unwieldy and their results — until now — have been inconclusive. Psychological effects, such as greed, or FOMO — fear of missing out — are other possibilities. These kinds of effects are regularly cited by financial market participants, but are rarely used in academic finance theory.”

“The Bayer et al. research may change that. The ability to look into local housing markets, and observe investors and transactions directly, is a bit like the introduction of the microscope in biology — it opens up a whole new world of evidence. In the past, finance theorists debated back and forth about market data, and what it implied about investor behavior. Now, thanks to the increasing availability of high-quality data, they can look at that behavior directly.”

“The lesson appears clear: Bubbles exist. Investors aren’t just rational, patient, well-informed, emotionless calculators of risk and return. Now the job is to figure out what really makes them tick.”

The Christian Science Monitor. “If you’re shopping for a house in one of the country’s hottest real estate markets, where the supply of houses is low and demand is high, you may find yourself in a bidding war, with multiple offers pushing prices ever higher. Add low mortgage rates into the mix, and buying a home can feel like you’re in the middle of ‘The Hunger Games,’ competing in a fierce battle to win the house you love.”

“The best move you can make before writing any offers is to hire an experienced, professional real estate agent. Having someone on your side who knows your local market thoroughly — and can guide you through these sometimes tough negotiations — means you’ve got heavy backup when you enter a bidding war. We talked to some real estate agents from around the country about strategies to help you come out on top.”

“Get a preapproval letter from your lender. That way you can pounce quickly when you find the home you want. Use an escalation clause. It’s essentially a contract addendum that states you’re willing to increase your offer incrementally up to a certain limit if other offers come in that match or top your initial bid. Limit the contingencies. Sellers have the upper hand in a multiple-bid situation, and they want offers that are clean and concise.”

“Write a ‘love letter’ to the seller. ‘I definitely ask my buyers to write a letter and explain how much it would mean to them to get the house,’ says real estate agent Eileen O’Reilly with Keller Williams Realty in Burlingame, California. ‘I even have them add a couple of photos of them and their kids or pets. I’ve had selling agents tell me that it was the letter and the complete offer packet that won my clients the listing.’”

“Other Realtors agree. ‘A love letter definitely helps,’ says Paige Martin, a Realtor with Keller Williams Realty in Houston. ‘Even more important is your online reputation as a buyer. Most good seller’s agents will google potential buyers to see if they’ve been in a lot of conflicts or if they have a stable job. While this won’t overcome a large difference (in your bidding price), it will definitely help at the margin.’”

The Associated Press. “The National Association of Real Estate Brokers, a historically black organization, was founded 69 years ago to promote equal access to housing. The organization has launched a five-year campaign to increase by 2 million the number of African-Americans who own homes nationwide. ‘The main thing is that black home ownership does matter,’ said association president Ron Cooper, a Los Angeles real estate broker.”

“Black Americans have the lowest home ownership rate of any ethnic group at 41.9 percent, according to a Census report issued in January. That’s down from 49.1 percent in 2004. ‘We lost quite a bit of equity wealth. We need to rebuild it,’ Cooper said of African-Americans. ‘The message is that the pursuit of home ownership of black Americans is still a noble pursuit. The American dream is within our reach; we just got to reach for it.’”

“The brokers last month held their first midwinter conference in Oakland, California, where skyrocketing home values are preventing renters with modest incomes from buying. ‘There’s a high rate of gentrification going on in the city of Oakland,’ Cooper said. ‘A 1,200-square-foot house is going for a half a million dollars. It’s really kind of pricing us out.’”

“The biggest barriers to home ownership in Memphis are the debt and credit problems of so many families. ‘We go through a lot of clients before we can get one that’s qualified to move on into home ownership,’ said First Tennessee Bank’s Community Reinvestment Act (CRA) officer, Keith Turbett. First Tennessee partners with the nonprofit Operation Hope to provide free financial literacy workshops in Memphis. The bank also offers its Hope Inside program, basing two financial counselors at branches to offer free, one-on-one financial counseling whether the recipients are customers or not.”

“‘African Americans are denied (loans) almost twice as much as whites,’ Turbett said. ‘We’ve seen average (credit) scores of almost 53 points less for African Americans than for whites. So we recognize we have a credit problem.’ Generally, credit scores range from 300 to 850. ‘We feel the 700s is an average, good credit score to shoot for that usually gets you in any loan,’ Turbett said.”

“For the average person, buying a home is the ‘first step to increasing wealth,’ said Regina Hubbard. She’s a broker with Fast Track Realty and was the 2013 president of the Memphis Area Association of Realtors. ‘If you were not born into it, then home ownership is the first step to get there,’ she said. ‘Renting will help the landlord get there, but it won’t help you.’”