Perspective: A new theory for housing bubbles

By Sean O'Toole, Wednesday, September 22, 2010.

Inman News

Home-price trend line from 1890-2006. Source: "Irrational Exuberance."

Almost everyone has seen the chronological home prices chart that accompanied the second edition of Robert Shiller's book, "Irrational Exuberance."

What everyone notices at first glance is, of course, the steep increase in prices during the latest housing boom when compared to previous cycles. But when I first saw it something else caught my eye.

What I noticed immediately was that if you bought a house in 1955 and sold it in 1999, the house actually lost value. Seems ridiculous. Those of us in California immediately think this couldn't apply to us, given the price increases we've seen over the years.

But it can, and it does. The thing about this chart is that it has been adjusted for inflation. The reality is that most of what we think of as home-price appreciation is really inflation. In other words, it's not the value of the house going up, but the value of the dollar going down.

The second thing I noticed about this chart was the dramatic price increase in the 1940s, and the home-price bubbles in the '20s, '30s, '70s and '80s.

While much research has been done on these price increases and bubbles, I began to suspect one simple cause that in hindsight is blatantly obvious ... and has nothing to do with irrational behavior on the part of buyers, as some have concluded.

In the early 1920s, mortgage debt tripled due to lax lending standards. In the '30s, you had the creation of the Federal Home Loan Banks, the FHA and Fannie Mae. The GI Bill was passed in the late '40s, introducing government-subsidized, 100 percent financing for returning servicemen. Freddie Mac was created in the early '70s and Ginnie Mae issued the first mortgage-backed securities -- both were hailed at the time as making homeownership more affordable.

In the 1980s, adjustable-rate mortgages were introduced at the same time interest rates began to drop. In the late '90s and the beginning of this decade, we had the Taxpayer Relief Act of 1997, the Gramm-Leach-Bliley Act, the Commodity Futures Modernization Act (these last two worked together to shift mortgage default risk off the banks and ultimately on to taxpayers, allowing lenders to make ever more aggressive and exotic loans), and finally the lowering of interest rates by the Federal Reserve.

That's right. Every single significant increase in home prices in the last 100 years was immediately preceded by government intervention or stimulus. The evidence is irrefutable. Every time the government works to make housing more affordable, prices rise.

This actually makes perfect sense. Buyers always have, and always will, buy as much home as their banker tells them they can afford. If you make home financing more affordable, you increase the amount buyers can pay. But instead of getting more home for their money, prices simply rise to reflect the change.

Worse yet, with the exception of the GI Bill in the 1940s, each subsequent rise in home prices after government efforts was short-lived and immediately followed by a steep decline.

With my new thesis in hand, I attempted to apply it to the most recent housing-price bubble. The chart below shows median home prices in California from 2000-09, together with median incomes, and the home price one could afford based on the most aggressive, but popular, loan product available at the time.

Amazing. Prices doubled, yet the payment one could get at those ever-increasing prices remained relatively flat. Furthermore, payments didn't drop much once the market crashed.

Hopefully at this point you are seeing a bigger picture. Home-price appreciation is largely just inflation, and housing bubbles are a recurring failure of our government to learn from its past mistakes. Rather than looking at the big picture, government officials and our representatives continue to jeopardize our future with the latest quick fix to a problem they don't seem to understand.

Whether through tax benefits, subsidized financing or regulatory easing, expect prices to rise with the onset of our government's next grand experiment in making homes "affordable." Just remember that you now know what comes next.

Sean O'Toole is founder and CEO of foreclosure data company ForeclosureRadar.com.