This article discusses popular misconceptions about the causes of the 2008 economic crisis, and how ungrounded efficiency–theory economists and very senior policy makers failed to recognize the clear warning signs emanating from Wall Street’s mortgage banking industry.
Irrational exuberance again and again
Almost everybody reading this article will clearly remember the months in 2006 and 2007 when, almost overnight, a seemingly unstoppable increase of homeowner wealth turned into a panicked free-for-all of economic despair. This financial crisis and ensuing Great Recession were economic disasters unparalleled since the Great Depression.
The Great Recession’s magnitude, however, can lead us to forget just how surprising and swift it was for most of the population. One of the key lessons from the recession is just how little the majority of us are able to appreciate the fundamental economic forces that control our lives. More deeply, the nation as a whole failed to understand the fundamental lessons of economics, those basic principles of human behavior in commerce which we must learn and apply to succeed as real estate agents.
In recent years, a crop of terms like “irrational exuberance” and “bubble economics” have come into vogue among economists and financial analysts attempting to understand how so many seemingly intelligent people in high positions could have gotten the situation so wrong.
The unstable foundation of common beliefs
In the years leading up to the real estate market crash, boom economics reigned supreme. The popular opinion, accepted and repeated with lemming-like regularity, was that:
- the economy would never stop improving;
- control over the economy had been attained;
- the economic rises and falls of extraordinary business cycles were now a part of history;
- home prices would never drop; and
- adjustable rate mortgages (ARMs) and massive debt leveraging were acceptable steps in the course of acquiring ever greater wealth.
These erroneous beliefs, and the wrong-headed financial decisions that accompanied them, were reinforced by popular economists and influential public figures. More significantly, support seemed to come from the economy itself. As Federal Reserve (Fed) chairman Alan Greenspan expressed in a 2008 congressional hearing, even he was shocked by the seeming failure of free-market ideology “because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.”
To those experiencing the real estate bubble, the speed of their increasing wealth seemed like immediate justification for all variety of borrowings and expenditures.
When the bubble burst, bringing about the 2007 financial crisis, the 2008 Great Recession, and a period of economic stagnation that continues to this day (dubbed the Lesser Depression for its lack of jobs), the few major economists who had correctly foreseen the crisis seemed prescient. Although they had observed the same economic events as people in positions of power, they were able to detect fatal weaknesses in the system that the majority either failed to see or chose to ignore. Their understanding of the mortgage crisis is essential to our own appreciation of the current prospects for recovery, and for the prevention of future disasters. [For more on the causes and effects of economic disaster, see the July 2011 first tuesday article, The rocky roads: recession and financial crisis.]
One of the most well-known of those consistently successful prognosticators is economist Robert Shiller, the co-creator of the 30-year-old Case-Shiller home price index and a long-time commentator on the housing industry. In a recent article for the New York Times, Shiller steers clear from the blame games for past failures that dominated the media in the months following the financial crisis and recession.
Instead, he suggests that the ongoing mortgage crisis cannot be attributed to any single set of economic factors. Looking forward, it is our own naïve communal response to today’s market factors that now prevents the economy from recovering. When it comes to the economy, our decisions make us our own worst enemies. [For Shiller’s full commentary, see the June 2011 New York Times article, The sickness beneath the slump.]
In his 2000 book, Shiller spoke of the tendency of homebuyers and other investors to disregard clear warning signs as an example of irrational exuberance (also the book’s title), a phrase made popular in a 1996 speech by Greenspan. Such exuberance was on prominent display in the first decade of the new millennium: in the real estate pricing bubble, home prices increased by an average of approximately 10% annually nationwide. This pace of pricing was well above the 6.5% interest rate commonly charged for contemporaneous mortgage loans (and, more importantly, far above the 2% rate of consumer inflation), leading to the possibility of rapidly increasing dollar-denominated wealth for holders of leveraged real estate.
In 2005, after the height of the bubble had begun to show signs of waning (thanks in part to the Fed’s belated decision to begin increasing ultra-low short-term rates in June 2004), surveyed homeowners still expected real estate pricing to rise 7% yearly in the future; enough for prices to double over a ten-year period. Instead, they have dropped 34% since 2006. A newer survey, covering April and May of 2011, indicated homeowners now only anticipate 3% annual asset price inflation. [For more on historical home pricing trends, see the October 2011 first tuesday article, The equilibrium trendline: the mean price anchor.]
This lower rate is more reasonable based on historical norms; 3% is closer to the average rate of increase in mean pricing, which tends to correspond to consumer inflation rates. first tuesday forecasts a 1% price increase for California homes in 2012, insufficient to keep up with the rate of consumer inflation but a temporary end to price slippage. We do not anticipate a significant rise in pricing beyond the rate of consumer inflation until around 2016.
In economics, the efficient markets theory posits that markets respond to the rational beliefs of buyers and sellers. In this theoretical world, in which well-informed buyers always act in their own best interest, beliefs about constantly rising prices are indicative of the market’s strength.
Homebuying (the emotional experience)
Efficient markets theory is comforting looking forward, since an efficient market can be mathematically predicted and mechanically controlled in academic examples. Over the past 30 years, it has become one of the dominant theories in economics, and was used in behavioral models all too often in the years preceding the recession.
Shiller views the theory of efficient markets as unable to account for the variations in real estate pricing that have taken place in recent years, and claims the model is even partially responsible for the magnitude of the home pricing collapse.
People, it appears, do not always behave as rationally as theory requires. Worse, markets are not capable of self-regulation, since participants are destined to seek competitive advantage over their peers, to the unfair elevation of some, and the permanent detriment of others.
Unwittingly, we may ourselves be the element of instability that mathematical economic models seek to discount. Instead of efficient markets models, Shiller suggests economists need to develop expectations theory models. This approach attempts to account for the causes and effects of homebuyers’ often-times irrational (unfounded) beliefs and aberrant financial behaviors. Humans, he claims in a book co-written with George Akerlof of Cal-State Berkeley, are not computer-like models of efficiency; they are controlled by their animal spirits (the same latent desires that advertisers, artists, and psychologists have sought to understand and manipulate since the Freudian revolution). [For more on consumer expectations, see the first tuesday Market Chart, Homebuyers feel ready and willing to buy, but not financially able.]
The money illusion
The Case-Shiller home price index is the most respected and widely-used measure of home pricing both in California and nationwide. [For the current Case-Shiller indexed prices in California’s largest cities, see the first tuesday Market Chart, California tiered home pricing.]
The multi-tiered home price index is useful for many reasons, not least because it presents prices as an index figure rather than an inherently misleading set of dollar numbers. After all, actual dollar home prices are related to current interest rates and inflation which can make it difficult for those without a finance degree to compare different locations or different time periods. Shiller’s index accounts for these factors, and creates a simple way to display home price movement over time. Agents need to pay attention.
To help explain why home prices so often seem to rise without regard to objective stimuli one need only look to Irving Fisher’s classic 1928 book, The Money Illusion. Fisher’s enduring insight was that homebuyers and sellers pay attention to the dollar price of homes, rather than the purchasing power of the dollars that underlie those prices. The majority of homeowners have neither the education nor the time for such analysis when selling or purchasing a home.
A home priced $100,000 ten years ago would need a very different price today for it to be of the same worth to the buyer. Nonetheless, sellers refuse to sell their homes until the dollar value has risen beyond their purchase price (or the neighbor’s sales price), regardless of the economy’s behavior in the meantime – the sticky price syndrome.
Homebuyers, on the other hand, see every drop in pricing as a chance for a bargain, even when increased interest rates and capitalization rates make those lower property prices objectively less appealing. Just such a shift is likely to take place in upcoming years. [For more on the factors that go into setting the price of real estate, see the first tuesday Market Chart, Buyer purchasing power.]
While the efficient markets theory suggests that homeowners will always buy the home based on real prices (inflation-adjusted), the fact is that homebuyers respond to nominal prices, such as a property’s listed price. Put in other terms, the flaw in the efficient markets theory, and in the possibility of a self-regulating free-market economy, is that real estate sales and the health of the economy as a whole are less a result of current rates and pricing than of the public’s perception of those rates and prices.
If the majority of potential homebuyers are optimistic about their future ability to make mortgage payments, homes will be sold even at inflated prices, temporarily untethered from the long-term mean price. If, on the other hand, homebuyers are uncertain about their jobs or otherwise lack confidence in the economy, prices will need to drop to unusual lows to entice reluctant buyers back into the multiple listing service (MLS) market. [For more on the irrational movement of prices, see the December 2009 first tuesday article, The flat line recovery, a side-effect of sticky housing prices.]
Price distortion beyond the Great Recession
Shiller’s understanding of consumer mentality is as revealing for contemporary real estate agents as it is for students of history. Home prices at today’s low figures are still too high, as evinced by low sales volume which persists in spite of historically low interest rates. Without lower pricing, and with all rates at their minimum, real estate prices are boxed in by a liquidity trap. Thus, sales volume is going nowhere until some other factor is at work (for instance, stimulus spending or job growth).
Current sales volume and pricing are in part a response to a lack of income from jobs among the general population, but unemployment alone is not sufficient to account for the public’s reluctance to buy. 90% of Californians employed in 2007 remain employed today. However, these workers are now trying to reduce their debt and save more.
To encourage buying, agents must remain aware that most workers have retained their high credit scores and thus their ability to finance a home purchase. Although lenders have become less willing to originate mortgages since 2007, 30-year fixed-rate mortgages (FRMs) are still readily available on demand for homebuyers with good credit and sufficient funds for a down payment. [For more on current and historic home sales, see the first tuesday Market Chart, Home sales volume and price peaks.]
Instead, homebuyers remain unwilling to buy for the moment, in spite of increased savings, relatively low prices and historically low interest rates. They are simply very afraid about their futures — uncertain about the economy and their own finances. That lack of consumer confidence, together with the knowledge home prices are slipping, keeps them from purchasing the homes they desire. Until consumer confidence improves, all the loan modification programs and troubled asset purchases in the world will not be enough to re-start the flagging real estate market.
So what will move the real estate market?
While the efficient markets theory has a unifying simplistic appeal that explains its dominance over the past fifty years, recent history is evidence that no behavioral theory for sellers and buyers can be considered comprehensive unless it takes into account the possibility of human irrationality. Those tricky-to-analyze animal spirits require agents to delve into deeper and more thoughtful conversations with clients in counseling sessions.
As a matter of fact, most people do not always make financial choices in their own best interest, even when they have sufficient knowledge to do so, and agents know this. Thus, salesmen often pander to emotion rather than reason, to the detriment of the client.
Robert Shiller’s predictions of market collapse in the mid-2000s were accompanied by clear warning signs for those considering homeownership, but the market at large had gone wild, and participants refused to heed the message.
Not surprisingly, the excitement of dramatically rising prices was too strong, and nearly all the nation was swept away by it. This is the nature of a bubble economy, and unless the Fedcan learn from its mistakes made managing monetary policy during the period between 2001 and 2005, and enact future financial policy to restrain (lean against) such bubbles in consumer confidence, it is a story of speculation that is likely to repeat itself again and again.
first tuesday anticipates a new boom(let) to take place from 2018-2020: this will be the first test of the Fed’s evolving monetary policy (job and price stabilization), and their next chance to get it right. Real estate brokers and agents will have the same opportunity, provided they remember the painful lessons of the recent past.