April 06, 2007

Irrational Housing: Insiders out Early and The Duesenberry effect.

Markets operate under the assumption that key players act rationally in most circumstances. Their premise is such that market stability is based on people acting to a set of according rules. Much has been debated about this because economics as a science is cold and aloof; it is a matter of simply stating the facts. Yet we have learned in the recent housing mania that market psychology and behavioral economics play a large role in how people interpret risk and what constitutes an investment. As most bubbles in the past, such as John Law’s Banque Générale and the South Sea Bubble, many bubbles burst and leap into another bubble. Why is this? The argument goes that in a bubble profit is a major driving force distorting stable growth for radical cancerous increases that are only supportable for a short time. After the glut of speculation is complete, those with a profit that cashed out on time feel the hunger for continued gains. This desire precipitates another bubble in whatever form it may be; technology stocks, real estate, commodities, or foreign investment. Either way, the pattern is such were a few successful insiders gut the system, leave burns on the psyche of a general public only to save up long enough to let the emotional scars to heal. Then they jump into the fire again with their resources ready to be distributed to those at the top again.

It is a disturbing gamblers rush to the top because those that enter a Ponzi game late will have a fate that is predestined. Those that enter the game early will have great success at the expense of those that enter late; after all what you earn is predicated on an infinite number of entrants and as a society we have finite resources and participants. Once this is realized the game is over and those left with no chair realize the music has stopped playing. During the 1990s we had unprecedented growth in the stock market. Returns of 25% a year were more the rule than the exception. The economy was blistering red to the point that Alan Greenspan claimed that we were seeing “irrational exuberance.” For AG to say something along those lines is amazing given the fact how he championed adjustable rate mortgages and lowered the Fed rate to the point that money was practically free. During the early part of this decade, we saw an enormous growth in housing gains. Let us take a look at a few reference points:

California Median: 1999

California Median: 2005

Growth in Percent




Nationally the picture isn’t so drastic but we do see tremendous growth as well:

US Median: 1999

US Median: 2005

Growth in Percent




While this data may not come as a surprise, it is useful to use these measure as a guide to frame the mania we are currently in. Housing is consuming a large part of American’s discretionary income and has become a major source of financing spending on consumer goods. This relationship is important to note. Since income is not keeping up with housing costs and other expenses, the ability to withdraw home equity and create additional streams of credit has given consumers the ability to sustain this bubble for a longer period. In many high cost metropolitan areas housing is now consuming 40 to 50% of a family’s net income, a far cry from the conservative 28% which most financial experts suggest. As we are facing a housing led recession, will consumers adjust their spending habits in accordance with declines in home equity? I argue that they will not because of the Duesenberry Effect and the relationship is not a direct one.

Duesenberry Effect

Loss of productivity does not necessarily go hand in hand with a loss of appetite for high consumption. No one will doubt that as a society, we are the world’s large consumers. Our saving rate is negative. The average credit card debt an American carries is $9,200. The Duesenberry Effect argues that once folks get accustomed to a way of life, for example Plasmas and BMWs, a $1 decrease in productivity does not equate to $1 reservation from spending. If anything, on the way down things will accelerate because people will try to maintain their style of life regardless of the loss of income or equity in their home. It is a fall from grace. Financial prudence isn’t the forte of the American public and this massive readjustment and recession will cause a lot more pain than many are envisioning.

No rational argument can demonstrate that a stagnating home market and wages will force individuals to readjust their spending habit. If our national trade deficit is any indicator, we are only becoming more hungry on ways to finance our appetite via credit. The reason the subprime implosion is so crucial and important is because this funding source is now evaporating. Wall Street is not happy with Collateralizing any more funny money debt; the idea of mixing feces in a large sea of good money. Investors gathered that if the pool of funds was large enough, bad and risky debt would be hedged into the matter and mixed in to the point that any drop would be supported and not noticed. This was all in good when the subprime market was tiny. But given that we have over $1.2 trillion in subprime debt originated in the past two years, we are now swimming in a black pool of our own consumption.

Insiders Out. Public In.

In each bubble, there is a privilege being in the know. Those that have insight and the fortitude to jump out early make out like bandits. Examining insiders selling of companies like Toll and New Century Financial, we see that large percentages of top officers sold at peak prices in 2005 and 2006. In addition, selling out of these positions is easier than liquidating a piece of real estate which all subsequent monetary value is derived from; there is no NEW without housing and there is no Toll without people purchasing homes. Many wonder why bubbles go on longer than they should. Again this assumption relies on the fact that markets always act rationally. But in a mania, the market is anything but sane. Mania, as in acting without direction, highlights an amazing ability for stupid money to chase to stupid products by stupid people. It is inevitable that people will and are getting burned for their financial indiscretions. The media will portray these poor individuals as being burned by big bad corporations hungry for a profit. They came too late to the party and unfortunately they were not able to flip a 800 square foot home for $50,000 in 6 months. As we know from studying mob psychology if everyone around us is going crazy and we remain stable, we will start sensing that we are out of our mind. At some point we decide to join the mob and follow the herd. That is why after a bubble has burst, many ordinary people realize that the game could not go on forever. Bubbles are also fueled by credit expansion and perception of quick wealth. Monetarist would have you believe that controlling the flow of money is key to sustainability. Well as you can see, now that the Fed has raised rates back up people are still hungry for housing; even if it means getting negative-amortization-no-doc-1-percent-teaser suicide loans. Essentially this act of financial irresponsibility is the “I’ll double down on 16 with a casino margin because I know a 5 will come out.” And why not? For the past 7 years we have been in a historical global credit expansion fueled by housing. When your home is your Joe or Susie Bank, why worry about money when you can look in your basement and find $50,000 nestled next to your family heirlooms.

At this point there is no silver bullet. Rampant excess in the forms of the previous stock bubble and the current housing bubble will need to be purged. Simply put, the recession we intervened on in 2001 with easy money will come back with a vengeance either in 2008 or 2009. The course of action is already set and financial institutions have made their mint only to loot the market when it crashes. They are out and the public is in. Will enough people have the ability to get out on time? Probably not. We have an unsupportable Social Security system, a costly war, and inflation. Inflation? If you still believe the CPI is an accurate indicator of inflation than you probably believe war is peace and hate is love. The main items that consume your income are housing, healthcare, education, food, and energy. Do you think there is no inflation? Once this permeates into the markets and if there is a global fear, the Fed will be forced to raise rates or face a crashing dollar. They have come out publicly many times that their goal is to have a stable dollar. Trying not to sound like the "Architect" in the Matrix, Ergo the housing market is done.

Insiders have cashed their chips. Many in the public are looking at yesterday trying to predict tomorrow. This upcoming recession will undress the ability of Americans to cut back in the face of a contracting economy. Do you think this is going to happen?


sed said...

One big question for me is whether this will be a US-only recession/depression or whether it will turn into a global one. Is the US debt/non-production economy actually decoupled from the world's producing economies (China, India, etc). With savings, they may have built up sufficient steam to operate without us. They hold all our debt (dollars). Or will they just panic like we will.

IrvineRenter said...

The Duesenberry Effect is alive and well in my opinion. An acquaintance of mine is a financial planner, and he believes Southern California is due for a bloodbath. He says 90% or more of his clients are hopelessly overextended. The housing ATM has largely been shut off, and they are all maxing out their credit cards waiting for next year when house prices start going back up again so they can pay down the credit cards with their HELOCs again. He said this is way more common than anyone suspects. He foresees an avalanche of foreclosures and bankruptcies. He said "you can't believe how frustrating it is to explain to people what they need to do in order to get their finances in order, and they simply won't do it." I guess you can only lead a horse to water.

Dr Housing Bubble said...


It will be global. Take a look at housing prices in Australia and the UK. China and Japan are reliant on the credit bubble to keep going so they can grow their US Treasury reserves. We're all interconnected on this one.


I think your acquaintance is right. The story of the tortoise and the hare comes to mind right now. The spending public used up all its financial resources in the 15 mile of the marathon, now they are spent. What people need to be doing is hedging their bets for a downturn. I've told this to people and they respond "why would I go for 12% returns when I can get 25%+ returns in real estate?" Even if they have real estate you should always diversify; but a large number of our population have the majority of their net worth connected directly to housing. Doesn't take a genius to know what will happen when prices go down.

Dr Housing Bubble said...

A lighter side of the housing bubble:


Sometimes you have to maintain perspective.

Anonymous said...

I remember in 2001 that, here in SoCal, houses were being bid on with prices of 50 to 75K over the asking price. I was talking to some RE people on the golf course and we all agreed that those people were fools. Little did we know that they were the "insiders".
That said I have a few friends that "invested" in RE in 2005. They are "lazy" investors that don't have the time to follow the economy or markets but expect large returns. They also believe in the mantra of "RE never goes down". I think they'll be getting some schooling soon.

eric said...

California Median: 1999
California Median: 2005
Growth in Percent $178,160 to $548,400 = 207%

Shouldn't that be 307%

Dr Housing Bubble said...


It is 207%. You can verify it online with percentage calculators.

All of you need to check out this mortgage ad:

mortgage ad

The content is mature but talk about using talent to sell mortgages.

Kevin said...

$548,400 - $178,160 = $370,240

370,240/178,160 = 207.8%

sed said...

Great Ad!!!!

The ad looks real. I guess he's selling mortgages, not a kit to buy mortgages, so it's fantastic to see the Visa and Master Card logos at the end. Let's see, I'll "buy" my house with my visa card, then as the value goes up, I'll borrow on the house to pay the Visa card. Hence, I get the house for free! Awesome. Now I finally understand the whole thing.

Anonymous said...

I have heard Canada considers itself lucky because they do not build American homes. I have also heard that Ottawa is experiencing a RE bubble and is expected to be 18 months behind the U.S. in the bubble rupture. How hard of a hit does anyone expect Canada to take? If the U.S. goes into a total economic meltdown, how bad up North can we expect it to get? Any hope that CA can disconnect from the meltdown?

lendingmaestro said...

The bloodbath that is coming will shock even us.

1.) 1/5th of all mortgages originated in 2006 were sub prime. (80/20 refis and purchases are considered sub prime loans by most lenders.) Those are all 2/28's or 3/27's which means they won't start adjusting until 2008 and 2009. By that time enough equity will have evaporated and they won't be able to refi

2.) A siginificant portion of prime/alt-a loans originated are neg am loans, and a large portion of the public didn't know that when they signed. I talk to at least 3 people a day, no exaggeration, who are in this situation. They also couldn't resist taking out that extra cash on a HELOC because their 1st mortgage payment was so low. Even if they know the loan is neg am they most likely don't know that their "five year fixed payment" will actually recast once the loan balance reaches 110%. Say bye bye minimum payment and say hello to your full PITI payment. You are now going to be sub prime.

3.) elimination of 100% financing and tightening of credit will eliminate the only life raft that these people have in sight. We are going to see a foreclosure epidemic that the world has never known. There are many renter friendly states like CA, MA, that make it hard to kick out a tenant. This makes the foreclosure/short sale process drag on. Many flippers are holding out because they have neg ams right now and can still afford the minimum payment.

The train is starting to roll, but it won't reach terminal velocity until well into 2008-2009

Anonymous said...

I'm up in Canada and I think we will be hit hard too, although it may take a few months to work it's way through the pipeline. Our forestry industry is shutting down as US homebuilders slow. About 77% of out exports go to the US so if you guys crash, we follow. We will have pockets of prosperity like the energy and metals but our forestry and manufacturing industries will be hammered.

IrvineRenter said...

Dr. Housing Bubble,

I linked to you in my latest post: Southern California’s Cultural Pathology.



Come check it out.

olives said...

I thought it was 85 percent of Canadian exports went to U.S. Either way, I'd call that "dependent". I recently read that Canada suffered much worse during the Great Depression due to our dependency on U.S. purchasing our commodities.

Robert Schiller called Vancouver, Canada "the bubbliest city in the world".

I believe our lending standards are almost, if not as bad as in the U.S., although we are "behind" in our "crash" by about a year or so apparently.

I'd say we are all in the same sinking north american/global boat.

wayne said...

When you overlay onto the housing bubble the economics of the baby boom approaching retirement, the situation begins to look pretty ugly. You could argue that stagflation in the 1970s was the price government chose to pay to shoehorn all those boomer college graduates with their high expectations into gainful employment. Now the boomers are beginning to retire with $60k in the 401(k), $9,200 in credit card debt, Social Security and Medicare benefits that are $50 trillion underfunded, and negative equity in an oversized McMansion - because the interest on the mortgage was, you know, tax deductible.

Under the best of circumstances, there would be a dearth of buyers for these empty nests based on simple demographics. Add to this falling home prices, a credit crunch, skyrocketing energy prices and a collapsing dollar, and you the makings of a full-blown disaster.

Anonymous said...

Hello Dr. HB,
Love your site.

I want to own a home, however paying $700,000 for a fixer just doesn't seem right. The house needed lot of work. Maybe over $100,000. My husband and I liked the neighborhood, but that was it.

We almost bought a house for $560,000 about 3 years ago, but we backed out because we would of had to borrow some money to make 20% down payment.(Maybe we should of bought it.)

However, instead of buying a big house, we choose to invest in income properties, and they are working out fine for us. Positive cash flow(not great but positive). We also bought them with 30 year fixed interest rate.

After waiting for three years, we saved some more money, and we were ready to buy. The most we were willing to pay for a home was $700,000. However it just wasn't enough for a nice house in Glendale. I'm only talking about 1600 square feet home in a nice neighborhood.

The problem I have is that I don't get much for $700,000, and to own it would cost us 50% of our net income. I can't justify buying a fixer for that price. In fact there is no gain in quality of life or living space. In fact I get less by owning a home compared to what I'm renting. I'm not counting having to pay 3 or 4 x what I pay in rent.

What is going on? Am I crazy?
Don't understand why the price is still going up. Who is buying $800,000 + homes?

One realtor told me there are lots of people with equity who are trading up or down. I also heard of company giving people forgivable loans. I guess lots of people are making $200,000+ in Glendale.

I feel priced out. I can't justify the cost of owning a home to staying where I am. I'll wait because that's the only thing I can do.


Anonymous said...

What do you think about this one?


NorCal Real Estate Market Heating Up. LOL.

Dr Housing Bubble said...


I appreciate the link. We've talked about this many times in numerous articles but I think we all realize that to a large extent, this market is being driven by psychology as opposed to fundamentals. This coupled with a social epidemic of easy credit and nonchalance toward savings and we have our current environment.


I think your three points are important. However I think that this train wreck may take longer than most of us expect. Imagine the analogy of slowly boiling water with a frog in it. The tightening of credit will have a major impact on this market.


This is a worldwide credit bubble from Canada, UK, Europe, and even Australia. Once the domain of local authorities and businesses CDos have given the world easy access to speculation anywhere you may live.


Especially when many baby boomers will want to downsize. But the demographics are changing drastically. We aren't seeing the typical generational cycles because the large number of immigrants in our country. Not only that, families are opting for one child so we actually aren't funneling a new batch of new home buyers to replace the boomers. Somehow I doubt all these immigrants will be buying the $500,000 mansions with no-doc mortgages.


I can understand your frustration. Just look at how many housing bubble blogs are out there. You are not alone. If anything, the trend is heading down. There is no rush for you to purchase right now. If you feel the need, open a MM account and consider that your downpayment fund. If you can reach 10% of the purchase price of the home, you may be ready to buy. Wait until winter of 2008. Prices won't go up, that is a certainty. Too much pressure is sending this market down. If you buy now I hate to say it but you'll lose a lot of equity in the next two years.


Good link. Let us all jump into N.Cal real estate because of a minor jump in some whacked out numbers. Please.

sed said...

NorCal market heating up?

The proper analogy would be the heating process in a nuclear power plant once the cooling water has leaked out.

Crazed said...

Thanks Dr HB.

I'll wait for awhile. There isn't a need to buy something that just isn't worth it. The value of owning isn't there.

I don't want to be house poor, nor do I want to be a slave to a lender.

Thanks again,

PO'ed said...

Somehow I doubt all these immigrants will be buying the $500,000 mansions with no-doc mortgages.


You may be surprised to find who the desparate realtors are suckering into buying $500-$800k homes:


That's right: we have Spanish-speaking real estate agents preying on their own, apparently only worrying about their FAT commissions while pitching the American Dream of Home Debtorship.... I love the section where the Spanish-speaking agents and loan officers troll the San Jose Swap Meet from a rented booth, looking for fresh victims, at least until they're kicked out for being too annoying!

It would be nice to think these types of practices ended after the sub-prime meltdown, but this article from today (4/11/07) suggests otherwise:


I'm starting to think that the ONLY way to get these corrupt and greedy loan originators and reasl estate agents to cease and desist from such outrageous behavior is to have the authorities kick down the door and place them in handcuffs....

Jackson Wallace said...

I agree with Wayne and his comments on the baby-boomers. I would add to his portrayal of doom the wars we are involved in. The boomer generation is going to face a lot of resentment from people under 40, as the generation that got the good life, at the expnse of younger people,
who are going to be expected to pony up lots of tax money to cover the boomers lack of savings.

This will lead to enormous friction, and political manipulation. Others have mentioned it but its still true,
boomers were counting on their houses for retirement! My mom turns 67 this year and she is right ahead of the boomers. In five years, the exodus begins. This housing bubble is exploding BEFORE the time when the boomers were counting on retiring and the next generation is, I believe, far poorer, in both assets and wages, though they will be paid mightily to keep the machinery running. At some point, the boomers are going to get kicked into the street, and left behind just like after the USSR collapsed. Sorry, grandpa, we cant afford you, now go die somewhere.