Irrational Exuberance Moves Home

Darren C. Pollock is a portfolio manager at Cheviot Value Management, Inc. (, a money management firm in Santa Monica, California.

Buying a home, if the price is right, is often the best investment most people could make. However, the recent spectacular rise in home prices may turn today’s home purchase into a speculation that will engender eventual losses.

In April 1999 we warned our clients about the dangers inherent in what was then a tremendously overvalued stock market.i At the time popular books were predicting 36,000, 40,000 or even 100,000 on the Dow Jones Industrial Average. As we write, six years later, the Dow is trading around 10,000 and the overall stock market, as represented by the S&P 500, is down 10% since March 31, 1999 and may well go down more. This letter is intended to caution our clients about a similar risk in today’s market for residential real estate.

National home prices, adjusted for inflation, have appreciated about 40% since 1995 and many areas are up more than 160% in that same time. “If you go back to the 1980s, during that cycle, adjusted for inflation, total price appreciation was 18%. In the prior boom in the 1970s, it was 15%,” cites David Stiff, an analyst with esteemed real estate research firm Fiserv CSW. He continues, “It’s alarming… I am surprised that it’s that high.”ii

There are several reasons for the recent rapid rise in home prices including but not limited to the stock market decline, low interest rates, lax mortgage lending standards and speculation in homes by both American and foreign buyers hoping to re-sell soon for a quick profit.

Once the stock market started to decline five years ago many stock market participants began looking elsewhere to put their money. Low interest rates provided a double impetus for home prices. Declining interest rates on bonds and bank accounts made these investments less attractive while low interest rates reduced borrowing costs for home loans.

Once home prices began to show a consistent upswing, mortgage lenders began offering increasingly relaxed terms for borrowers. Years ago, getting a home loan was a more difficult endeavor for would-be homebuyers. Loan officers would scrutinize the potential homebuyer’s income, credit history, and net worth, probing for any weaknesses or holes and rightfully so: the bank that lent the money would need to collect the payments on the loan for the ensuing 30 years. In these old days, the mortgage lender wanted to be as sure as possible that the borrower would make good on the loan.

In 1989, due to Congress classifying the debt of Fannie Mae and Freddie Mac as “low risk,” the two Government Sponsored Enterprises (GSEs) started receiving larger pools of money which would then be provided to private mortgage institutions such as banks and mortgage lenders. Over time, and once housing prices began to rise again in the late 1990s, lending institutions were originating more mortgages–yet holding fewer of them–than they had in the past. These banks and lenders could simply originate the mortgage, take their fee, and immediately pass off the risk of the loan by selling it to Fannie Mae and Freddie Mac. When the lenders realized this, the standards by which prospective homebuyers were judged began a descent that continues to reach new lows.

All the while, Fannie and Freddie happily obliged the lenders and gobbled up as many loans as possible. In just one decade, the share of the nation’s mortgage debt funneled through the GSEs ballooned to $3.7 trillion and 70% of the entire market, the latter of which more than doubled since 1990. Now, with Fannie and Freddie facilitating the erosion of lending standards, many banks strive to generate mortgage originations at as fast a pace as possible so that they can pocket the fees and then originate the next loan.

And today’s mortgages are not the safe loans of yesteryear. Creative means to finance the purchase of a home have blossomed and today’s homebuyer can get piggyback loans (one loan for the 80% mortgage and another on top of it for the 20% down payment), interest only loans (which allow the buyer to make smaller monthly mortgage payments because the buyer is paying off only the interest–not the principal–of the loan), and negative amortization loans (whereby the buyer pays less than just the interest and the unpaid principal and interest is continually added back to the loan, thus increasing the size of the loan).

These easy loan programs are available to individuals with inferior levels of income, credit history, and net worth. As William Fleckenstein, investment manager with Fleckenstein Capital, states, “Anyone with a pulse can get 100%-plus financing for housing.”iii And the market for these loan products thrives because climbing home prices reduces the risk of these aggressive loans. Yet it is unproven if these creative mortgage loans can weather an economic storm. “A lot of this innovation [in mortgage financing] is not recession-tested,” comments Jack Phelps, an analyst with the FDIC. In a recent FDIC report Mr. Phelps states, “A favorable economy and rising home prices cover a lot of mistakes.”iv

As we witnessed with the stock market boom of the last 1990s, rising prices temporarily obscured countless problems that were lurking beneath the euphoric surface. Today’s manic real estate market resembles the stock market of a few years ago when individuals purchased stocks simply because their prices were rising. With home prices spiraling higher, the classic bubble characteristics of euphoric greed (the intense desire to participate in a rising market) and the fear of being left out of the market cast a spell over investors.

This emotionality should remind you of the recent stock market bubble. Yet more similarities between the stock and housing markets exist. The share prices of the major homebuilders have risen meteorically during the past few years. Insider sales in this industry escalate as share prices climb. Notably, the CEO of Toll Brothers, Robert Toll, sold 20% of his stock in the last few months. This would not have caught our attention–and scorn–had he not gone on CNBC to tout his company’s stock while he was selling it. “The shorts are gonna get crushed,” he boasted. “You ain’t seen nothing yet.” This “pump and dump” technique is a page ripped out of the playbook of the tech executives from the great tech bubble.

In addition to the shares of homebuilders, investors are attracted to homes in record numbers now, too. In 2004, 23% of all homes sold in the U.S. were purchased by speculators (who fancy themselves investors). Furthermore, another 13% of all homes sold were bought by second-home buyers. Consequently, 36% of all homes purchased were bought by individuals who do not plan on living in the home. The annual average is 5%.

“Real estate speculators are buying at a pace that far exceeds previous estimates of their influence on the housing market,” states a March, 2005 report from the National Association of Realtors (NAR). David Lereah, chief economist for the NAR and well-known cheerleader for home buying, summarized this data succinctly: “I am astonished.”v He shouldn’t be. “It’s at the end of the cycle that you start to see people investing irrationally. If anything is a sign of a price bubble, that is it,” notes Mr. Stiff of Fiserv

Currently, the acquisition of U.S. real estate seems to also make sense to foreign buyers. The declining dollar combined with an explosive domestic real estate market is generating additional demand from across the globe. Liz Agnello, a real estate broker in Orlando, Florida, refers to the influx of foreign buyers thusly, “It’s not an uptick–it’s a surge.”vii This increased demand pushes prices higher and heightens the speculative frenzy as many Americans consider these foreign purchases to be justification for their own interest in real estate. But this interest on the part of international speculators is not unprecedented. The last time the real estate market attracted this level of attention was during the late 1980s–just as prices were peaking. Years later, when the fervor wore off, the prices of most properties had declined dramatically and most that were sold were done so at a loss.

Today’s bubble market, just like those in the past, is fraught with peril. As housing prices increase the equity in one’s home, homeowners have cashed out this equity at a record pace. During the years 2001 through 2003, homeowners with conventional loans took out a total of $341 billion. The next highest level over a three year period was $103 billion from 1998 through 2000.viii The use of one’s home as an ATM spurred economic growth but at the cost of increasing household debt to potentially unstable levels. “We have an economy that’s rolling along on the basis of a false sense of wealth,” states Christopher Thornberg, a senior economist with the UCLA Anderson Forecast team.ix Nonetheless, investors continue to borrow against their home to facilitate their spending needs, make home improvements or, worse yet, to purchase additional real estate.

Taking additional debt against one’s home can be alluring while prices are rising but having too much debt can be devastating when prices are falling. For example, a Denver home owner who paid $150,000 for a home in 2002 refinanced about every six months and eventually had a mortgage balance of $210,000. Recently the owner tried to sell the home but rejected the best offer received of $155,000. The agent involved in the offer stated, “With a $210,000 mortgage, it is clearly upside down [there is more debt owed on the mortgage than the current market value of the home]. My guess is the bank is going to end up selling it in the low $160,000s.” It is worth noting that the agent believes the home will be taken over by the bank in a foreclosure.

Having too much household debt is not just the burden of those that have cashed equity out of their homes. An increasing number of new homeowners are finding themselves overleveraged because their incomes are not rising as quickly as home prices. This decrease in a home’s affordability has continued to fall to unsustainably low levels. As seen in the accompanying graph, only 17% of homebuyers in Los Angeles County can afford to purchase the median priced home. In Orange County, the percentage is a miniscule 11%. An increasing lack of affordability can help bring a bubble to its ultimate end as the pool of potential homebuyers decreases in the face of escalating costs. The bubble eventually collapses under its own weight.

As with any other asset, when the price rises to a point that is too high, buyers will search for alternatives and could exit the market. In the case of housing, they can rent or move to a less expensive location, enough of either of which could put an upper limit on home prices. In fact, “The real estate boom is showing signs of fizzling out in some cities,” states Mr. Shiller. “We have learned from experience that a slowdown often precedes a price collapse.”xi

Moreover, due to the high level of household debt seen in this country, the number of foreclosures is reaching new heights. “This is the worst time for foreclosures basically since the Great Depression,” says John Dodds, director of the Philadelphia Unemployment Project.xii Economist Tucker Hart Adams comments on this growing problem: “I don’t think this is a surprise. People were encouraged by extremely low mortgage rates and extremely innovative mortgage products to buy homes, buy bigger homes and get out of apartments and into homes for the first time. Many of these people, if they miss only one or two paychecks, are not able to make their mortgage payment.”xiii And these foreclosures, which will have the effect of lowering real estate prices, are occurring in the absence of higher interest rates and lower home prices–generally two factors that will increase the rate of foreclosures.

These are signs that the bubble is beginning to burst. Whether or not this is true at this precise time can only be judged in retrospect. However, it is clear that due to a variety of reasons, home prices will need to come down. And, because there are now so many possible causes to force prices lower, rising interest rates–which have been known to force home prices lower–are not even needed to pop this bubble.xiv

The eventual decline in home prices will follow an all too familiar pattern. As prices fall, the confidence of homeowners and potential buyers will erode and the most recent buyers–especially those that are overleveraged–will be the first to feel the pinch. As prices begin to fall, many would-be sellers who held out for higher prices will list their homes, increasing the inventory of available homes for sale. Prices will slump further as this inventory increases along with the time it takes to sell a home. Banks and lending institutions will then take on more foreclosed homes and try to quickly sell them. Lending policies will tighten, effectively closing the barn door after the horse has left the stable, thus gradually returning the mortgage market to its more old fashioned roots. Larger down payments and less creative financing will be required, which will decrease the size of the potential pool of home buyers. At this point it will be evident that the same reinforcing mechanism which propelled prices higher is now working in reverse to orchestrate their decline. (This is a common downward spiral with a recent example occurring in the manufactured housing industry after its implosion.)

The U.S. economy, increasingly dependent during the last few years on cash-out re-financings, will be adversely impacted by plunging home prices and the concomitant reduction in available home equity. The possibility of this type of unraveling is so great that John Templeton currently believes that the risk of a 50% decline in U.S. home prices is “quite possible.”xv He notes that the Japanese real estate market, which peaked in 1990, has fallen by roughly 75% over the ensuing 14 years. Mr. Shiller shares Templeton’s pessimism but won’t predict how far prices could fall. What he does say will certainly come as a surprise to many home buyers today: “I don’t think housing prices will be higher five to ten years from now.”xvi

It is important to note that individuals will avoid adverse effects of a sizable downturn in home prices if they have no need or desire to sell, can afford their mortgage payments in any event and do not increase their debt by using their home equity to borrow for consumption purposes. We are not as optimistic for homeowners who are overleveraged or for the many speculators in the housing market.


  1. See “S&P 500 Index Funds: A Trap for the Unwary?” in Investment Values, April 1999 issue, reproduced at our website, (literature library, articles).
  2. “Investors Buy More of Housing Market,” by Mary Umberger, The Chicago Tribune, March 4, 2005
  3. “Leverage: The Secret Sauce of Real Estate Gains,” by William Fleckenstein,, March 1, 2005
  4. “Market Hasn’t Adjusted for ARMs: New Loans Are Untested in Economic Downturn,” by Jonathan Lansner, The Orange County Register, February 22, 2005
  5. “Investors Buy More of Housing Market,” by Mary Umberger, The Chicago Tribune, March 4, 2005
  6. Ibid.
  7. “Real Estate’s Foreign Affair,” by Ray Smith and Ryan Chittum, The Wall Street Journal, March 8, 2005
  8. According to Freddie Mac
  9. “Real Estate Reliance May Hurt California,” by Nicholas Riccardi and Annette Haddad, The Los Angeles Times, March 15, 2005
  10. California Association of Realtors Affordability Index, August 2004
  11. “The Next Bubble (Or Bust),” by Robert Shiller, Global Agenda Magazine, January, 2005
  12. “Record Number of Foreclosures Spurns Drive to Suspend Auctions in Philadelphia,” by Jason Strazuiso, Associated Press, February 6, 2004
  13. “Foreclosure Rate Scary,” by John Rebchook, Rocky Mountain News, November 10, 2004
  14. It is a widely held belief that rising interest rates will be the cause the falling home prices but, as stated earlier, rising rates are just one of numerous possible causes. Furthermore, home prices can fall when rates are actually falling as was the case after the late 1980s real estate boom.
  15. Financial Intelligence Report, February, 2005
  16. “Booms and Bubbles: Economist Robert Shiller Discusses the Enigma of Market Highs and Lows,” by Karen Lowry Miller,, January 27, 2005
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