More on Spotting Bubbles

In comments on my previous post on bubbles, John McGowan and others point out that you can use the price-to-rent ratio (or price-to-income) as an indicator of a housing bubble. I think this is a partial but not a perfect solution.

The value of a thing should be the net present value of the future cash flows from the thing. In experimental economics, they use securities with absolutely certain cash flow profiles, so when a bubble in prices appears, you have an objective measure of value to compare it to. With individual stocks, on the other hand, the P/E ratio could go up to 100, and you can back an implied growth rate of earnings out of that, but who’s to say the company won’t hit that growth rate? At that point it’s just your opinion against the market’s.

The question is whether housing is like an economics experiment or like stocks. I think it’s pretty clear that one house is more like an individual stock. You could look around at other houses you might rent, but houses tend to be somewhat unique. (This is also one reason why bubbles perpetuate themselves; as Bond Girl pointed out, people are perfectly able to believe that one part of the market is in a housing bubble, but the part they are buying in is not in a bubble.)

Now, as Leigh Caldwell pointed out, it should be easier to spot a bubble when looking at all stocks in aggregate. If the implied growth rate of earnings of the entire market is 20%, then that looks implausible. Similarly, if the price of houses in aggregate is twice the value implied by the rental income they could geenrate, that looks implausible.

I say this approach is partial but not perfect because current potential rental income is a poor proxy for the long-term value of a house. The fact is that most people buying houses aren’t going to be renting them out, and what they care about is the price at which they will be able to sell that house in 10 years, which depends in part on the price at which that buyer will be able to sell the house 10 years after that, and so on. And it’s entirely possible that the relationship between house prices and rents could change over that timeframe due to any number of economic factors – the homeownership ratio; shifts between the exurbs, suburbs, and cities; the aging of the population; and so on. There’s no axiom that says that these ratios – price-to-rent or price-to-income or price-to-earnings for that matter – have to remain constant over the long term. At the least, it’s generally possible to come up with a reasonable argument that things have changed this time. In part, that’s why we have bubbles, but it’s also why it’s hard to be objectively sure you’re in one.

By James Kwak

56 thoughts on “More on Spotting Bubbles

  1. As I posted before, the long term term price to income ratio used by economists must change because the cost of construction and the cost of development has gone way up relative to income.

    Cost of materials, cost of code upgrades, cost of carrying property for much longer development periods, cost of land restricted by “smart growth” policies, the significantly longer time to reach market and a huge increase in the risk premium for development have all added to a huge increase in development cost and risk. All these cost increases are a result of government meddling. New housing is no longer affordable in most urban areas solely because of government intervention.

    If demand for housing is strong and it is still, particularly in those areas where ‘smart growth’ policies have restricted housing supply, the cost of replacement for housing will have a huge impact on housing market price long term.

    Therefore, the idea that one can determine housing bubble solely because price to income ratios have deviated from long term trends is just plain wrong. Government intervention in many parts of the country has altered the cost of development relative to income and therefore the income to housing price ratios.

  2. I believe bubbles can only be spotted in hindsight. One can find many a justification for one’s position(s). Just look at the inflation /deflation debate going on or the debate on fiscal stimuli.

  3. Really? People looked at the astronomical rise in housing prices and never questioned it?

    The little house I once lived in more than doubled in value in a short amount of time. It seemed so artificial to me – but since I’m not an economist, I’m not equipped with equations and math facts that prove or disprove anything…

  4. Whether one can analytically determine in real time if a price increase is a ‘bubble’ or an appreciation in ‘real value’ (itself a dubious concept in a market economy), it is emphatically possible to develop a legal framework, regulatory regime and tax code which inhibit and penalize financial speculation in all its forms. Such an enviroment would tend to moderate asset price bubbles as a matter of course.

    Such an environment is not merely consistent with, it is also conducive to, rapid economic development and sustained, widely shared growth. Consider the United States, 1950-70.

    Unfortunately, I don’t believe the political will is present to do this. Perhaps it will develop over the next several years.

  5. James,
    The difficulty with identifying a bubble is that few participants want to recognize the fact and end the party. Most people suffer from recency bias and work very hard to justify why it is a new era.

    A second difficulty is that finance is an art not a science. You might identify an asset class entering an extreme only to watch that extreme extend further making you look very wrong in the short or medium term. Timing is always nearly impossible when it comes to such excesses.

    For this reason the identification process cannot be exact like identifying the boiling point of water. It only needs to adequately illuminate the situation.
    For this reason ratios work quite well. In the stock market extremes can be viewed by studying price to earnings ratios or price to replacement value or any of the other popular value ratios. In the same way for housing you could compare median prices to median household income. When Jeremy Grantham did this earlier in the decade he found that housing was more than 3 sd above historic levels. Of course, one still needs to believe that this time is not somehow different and possess the fortitude to hold to your convictions.

  6. yes, houses are like stocks. The problem is how to determine the future cash flows. We just make assumptions, hopefully, our cash flow prediction will be true.

  7. “I say this approach is partial but not perfect because current potential rental income is a poor proxy for the long-term value of a house. The fact is that most people buying houses aren’t going to be renting them out, and what they care about is the price at which they will be able to sell that house in 10 years, which depends in part on the price at which that buyer will be able to sell the house 10 years after that, and so on. And it’s entirely possible that the relationship between house prices and rents could change over that timeframe due to any number of economic factors – the homeownership ratio; shifts between the exurbs, suburbs, and cities; the aging of the population; and so on.”

    i am not at all sure that most homeowners think of the value of their houses in that way. The primary value (utility) of their house is as a home. It is where they and their family live. It is part of a neighborhood. It is not simply, or primarily an investment. People put down roots. Most do not buy houses with the expectation of living on the street 10 years from now. The U. S. has a highly mobile society, so that people move relatively frequently. Even so, they do not particularly worry about the price of their house. If they move in 5 or 10 years, they expect that the value of their new house will be comparable to their old one. If the price of their new house has risen in those years, then the price of their old one probably has, too. It is only local changes that worry them, but the things that would bring down local property values are things that they would worry about, anyway, even if they had no intention of selling.

    People talk about the rationality of walking away from homes that are underwater. But if you bought a house and its value as a home has remained the same and you can afford your mortgage payments, what does it matter if it is underwater? That is not an irrational viewpoint. As J. P. Morgan (the person) said, prices fluctuate. It is rational not to pay too much attention to them.

    In an earlier post I quoted the song, “You can’t count your winning while you are sitting at the table.” That poker adage is quite rational. While you are playing the game, chips are just things you make bets with. If you think of them as money in hand, you are likely to make poor decisions in the game. The song continues, “There’ll be time enough for counting when the dealing’s done.” When the game is over, you cash in your chips and go home. Then you can count your winnings.

    Note that there is a distinction between being at the table and being at home. When you are at the table you are in the game, when you go home, you are not, and you can enjoy your winnings or bemoan your losses. When you are at home you are not in the game. Economists make the mistake of thinking that everybody is always in the game. Or of thinking that always being in the game is rational. Well, that is one viewpoint, but one that most people do not share. Moi, I am with the poker players. You can go home. :)

  8. “There’s no axiom that says that these ratios – price-to-rent or price-to-income or price-to-earnings for that matter – have to remain constant over the long term. At the least, it’s generally possible to come up with a reasonable argument that things have changed this time. In part, that’s why we have bubbles, but it’s also why it’s hard to be objectively sure you’re in one.”

    IMX, an infallible sign of a bubble is the phrase, “This time it’s different.” ;)

  9. “Spotting Bubbles” is just another way to say “outguess the market”. There are very very few, if any people who can do this, and hundreds of indicators or tools to try. Do you know how many people in the Federal Reserve (not to mention the private companies) are currently employed to do this? Nouriel Roubini has basically been proclaimed a Nostradamus because he got it right ONE time. Yeah, ONE time. So now he says something about a “W” recession—does Roubini really know?—or is it a good way to sell newsletters???

    People have talked about “spotting bubbles” ad infinitum, and (no disrespect to James) I have no doubt they will continue to do so.

  10. James,

    If you look at the total financial commitment of a house, vs. that of say a stock, the only thing I think you can sensibly compare it with is real after-tax income, with some assumptions around percent of income dedicated to housing. In the long run, housing values have to be supported by income of some kind. When those two disconnect, there is a bubble. The financial amounts involved are too large, in both the micro and macro sense, for anything else to make sense.

    Since housing is the most highly leveraged asset available to the wider public (especially in the last few years, with no-down, no-doc loans) we can expect to have to be vigilant in preventing excess credit-granting, particularly since housing is fundamentally a depreciating asset. So we should be overly conservative when determining if housing is in a bubble, rather than permissive. The numbers and risks of overcommitment are too large, and the temptations for the banks to create “money” are too high. The solution is strict, simple leverage limits on banks and all credit-granting institutions.

    Ted K, I disagree: it was easy to spot the housing bubble, and it has been pretty easy to spot some previous bubbles as well: the dot com boom, silver in the 80’s, the recent oil run up, etc. What is hard to do is to time them. Roubini was excoriated from 2005 to 2007 for being a perma-bear who was always wrong. Hedge funds who were short an obviously overvalued market in the mid 2000’s got crushed. Etc.

    I still can’t get my head around how the Fed didn’t see the housing bubble. The only explanations are gross incompetence or active malevolence.

    JMO, and I am not an economist.


  11. Houses developed speculative value by virtue of the instruments used to finance them.

    Consider the people who took out unaffordable mortgages believing that they would be able to refinance the loan before it became a problem. They are betting that the house will appreciate and the house has speculative value to them. HELOCs, same idea. That’s the kind of behavior that contributed to housing becoming a bubble.

  12. I think that trying to identify bubbles just by looking at changes in asset prices–or even ratios between price and some other variable–is kind of pointless. I’m pretty convinced by the argument Charles Kindleberger makes in his book Manias , Panics, and Crashes that the really ugly bubbles are always associated with “financial innovation” and large increases in leverage. This suggests that identifying and controlling leverage is the key to identifying and reining in bubbles. And I think that monitoring overall leverage is probably easier than trying to figure out how much the price of any given thing is deviating from its “fair value”. I don’t think you’ll ever convince people not to speculate on asset prices. The key, as Carson says above, is to restrict their means to do so.

  13. There was a fundamental demand component as well, largely driven by issues that others have described (e.g. Paul above).

    But also, many people who had wisely stayed out of the early part of the bubble approached points in their lives where they needed to settle. Moreover, after 4+ years of being told that housing was overpriced and seeing it go further up, they began to fear they would never have a chance to “get back into the market”. It wasn’t just greed (speculation), but also fear… Fear of being left out.

    And the expectation of interest rates rising then front-loaded demand (as buyers rushed in to beat rate rises), leaving an empty wake. This peaked the bubble, which then promptly popped.

    As a side effect, one could argue this helped feed into the interest rate inversion that many people (correctly) identified as preceding the recession.

    Remember this old debate?

    Oh, here’s a pretty quote:

    “Some economists think it signals a coming recession. Others, notably Fed Chairman Alan Greenspan, claim it is no longer a reliable indicator.”

    In terms of identifying what portion of the bubble was real vs. speculative, it varies dramatically by region of the country. Note the relative peak-to-trough differences by region…

    Phoenix, Las Vegas, Miami… these were the most speculative.

    Then, on the other side… Um, exactly how is Cleveland “speculative”? And yet it still dropped 20%…

  14. Even with fixed future cash flows, you can’t value an asset without knowing the discount/interest rate. If the interest rate goes from 1% to 2%, the value of assets with large future cash flows changes drastically. The value of consumer goods doesn’t change much. That is why Austrians argue that artificially low (government induced) interest rates make people spend too much money on assets with large expected future cash flows. The thing I don’t understand is why speculators should expect the interest rate to be low indefinitely.

  15. Bubbles aren’t really that hard to spot.

    Follow the greed. And the hype.

    That old axiom…anything that’s too good to be true…blah, blah, blah.

    My current bubble detector screams…Petrobras.

    It’s recent price is… indefensible.

    But Wall Street loves the reported oceans of crude in Petrobras’ pre-salt fields.

    Who says there are massive oil finds there?

    The Brasilian government…that just happens to own HALF of Petrobras.

    A few dry wells so far. No problem. Yet.

    Maybe I’m a perma-bear like Roubini…but when you take a big whiff of the air…and something that doesn’t smell right… that, my friends, is probably a bubble.

    Of course, I may end up eating this Petrobras observation.

    Part of the risk of trying to be a bubble detector…is missing the ride…and the return!

    The large number of speculative purchases is a clue. The worst part is that many of these speculative buys was that they were nearly 100% debt financed, on loans that did not completely disclose the >= 2nd home status. People are much more likely to walk away from a home they don’t live in, and banks used to require higher dp’s and interest rates on 2nd+ homes.

    This would be further reflected in where home prices rose the most and where there was the most 2nd home buying. The bubble & bursting is still very geographically dependent, as was the exuberant speculative buying.

  17. …The fact is that most people buying houses aren’t going to be renting them out, and what they care about is the price at which they will be able to sell that house in 10 years, which depends in part on the price at which that buyer will be able to sell the house 10 years after that, and so on…

    The Hot Potato theory of Finance.

    If we look at what happened in the housing market..

    1)Only 5-6% of housing stock gets traded every year. Volumes are too low.

    2)Home ownership increased only 5% in the bubble.

    3)Housing is marked to market.

    Thus a tiny group of speculators with reckless borrowing, speculating on a tiny float, created high prices.

    These high prices made the other 95% home-owners think they are rich. Because, marked to market, it seemed the houses were worth more.

    Now, I am no economist. But how does mark to market create wealth? If one idiot buys the home next to me for double what it will actually fetch from a sensible buyer, I become wealthy? Maybe – if I can find another idiot to do the same with my house. But on a scale of the whole economy, this is not possible.

    Because it’s not enough that we have a whole slew of idiots to buy every house at exorbitant prices from the sellers. We need these mass of idiot buyers to produce more – food, clothing, entertainment, health care, whatever – which affords them to set apart more of their income to housing. Higher housing prices do not make a country richer.

    Even I can grasp this. But not the Fed, apparently.

    Martin Wolf had an article about this 3 years back.

    “Do higher house prices make a country richer? The answer is simply “no”. If the market value of the stock is raised, those who own it are made better off by as much as those who will buy their houses from them are made worse off. Higher prices merely redistribute income among residents, principally from the young to the old.

    …Where prices have risen far faster than underlying incomes, only two possibilities exist.

    Either prices have moved to a higher equilibrium level, in which case future purchasers will have to save more and consume less. That would itself have significant economic implications. Or they have reached an unsustainable level, in which case they will fall in real terms. That would have far more significant economic implications.”

    It is not that bubbles cannot be spotted. But they work to the advantage of the richest and powerful, and hence are never restrained.

    In fact we should not call them bubbles, we should call them what they really are.. “pump and dump”.

    My take is that even people who are screwed by these bubbles do not really grasp that they are screwed, and so end up supporting the “see no bubble” thugs.
    The majority are people who do not understand the bust side of the bubble. Because the boom happens in a micro fashion [the normal guy who bought pre-bubble and whose house is now double its price even after the bust] and the bust happens in a macro fashion [inflation, tax hikes, crumbling society, services]. They think that bubbles are good – the gains are tangible and immediate [my house is worth twice] – while the effects of the bust are prolonged and remotely caused.[ damn the govt, immigrants, unions, …] This is behavioral.

  18. Spotting asset inflation is one thing. Correctly concluding that such inflation constitutes (or will constitute) a speculative bubble is another. And the likelihood of a safe landing from employing macroeconomic braking action to slow or reverse inflation approaches nil the longer a truly speculative bubble persists

    For these reasons, I don’t think an NPV approach is all that informative. First, such an approach is based on utility theory, which does not reflect how humans really think, nor everything that they actually value (hint: utility is slave to location, location, location when it comes to home prices). Second, such an approach cannot account for changes that naturally lead to asset inflation such as the rise of a new industry and the influx of jobs and wealth that it brings to the region. I’m specifically thinking about how the rise of the internet significantly increased home prices here in the SF Bay Area in the mid-1990s. Finally, an NPV approach is static in nature and cannot successfully model a dynamic system.

    Soros basically has it right: we need to view the market in terms of both magnitude and direction, not just magnitude. If you spot undue acceleration in the market away from the fundamentals, you dig in to see if speculation is involved.

  19. In the spirit of helping prevent bubbles…


    The argument basically goes that no one believes ratings agencies have to be perfect, or even close. But giving AAA ratings to subprime mortage backed securities was SOOOO incompetent and corrupt, that this is essentially negligence/fraud, with civil damages.

    They deserve this.

  20. Ted K: ““Spotting Bubbles” is just another way to say “outguess the market”. There are very very few, if any people who can do this”

    Actually, there are a lot of people who can spot bubbles. But outguessing the market requires more than that. It means that you can time the market, as well. Roger Babson got his clients out the U. S. stock market in 1928. He spotted the bubble just fine. But he did not time it correctly. Alan Greenspan spotted the bubble, but 1) was afraid to burst it, and 2) thought that bursting bubbles was not his job.

  21. And con men can spot bubbles. That’s one reason why fraud goes along with bubbles so often.

  22. To find bubbles, look for large increases in debt, particularly debt that is short-term compared to the asset in question. Almost all bubbles occur from too much debt financing, and misfinancing long term assets with short-term debt.

    That is a more reliable test than looking at asset prices. NPV calculations don’t help much, because discount rates can be in bubble territory as well. Recent example — junk bonds and CDOs had really low yields before this whole thing blew.

  23. At first I thought it said scalpers, not Calpers. ;)

    According to the report, this goes far beyond incompetent assessment and conflict of interest:

    “Information about the securities in these packages was considered proprietary and not provided to the investors who bought them.”

    Can you say caveat emptor, boys and girls?

    “Calpers also criticized what contends are conflicts of interest by the rating agencies, which are paid by the companies issuing the securities — an arrangement that has come under fire as a disincentive for the agencies to be vigilant on behalf of investors.”

    Probably not actionable, in itself, since Calpers had known this for a long time.

    “In the case of these structured investment vehicles, the agencies went one step further: All three received lucrative fees for helping to structure the deals and then issued ratings on the deals they helped create.”

    Please allow me to introduce myself. . . .

  24. Anyone schooled in statistics realized the housing market was way out of line 2004-2006. It was an obvious bubble; although not any more than the recent internet and oil market bubbles. These 2 standard deviation events always revert back to the mean. Jeremy Grantham has been very successful at identifying bubbles through this simple means.

    Of course, you always have naive interpretations such as this one:

    Click to access athens_bubble_paper.pdf

  25. Something about this discussion has been bothering me for the last few hours, and I think I have figured out what it is.

    Does it seem to anybody else that the developing narrative of the current economic crisis is rapidly converging to the conclusion that the housing bubble was the cause?

    While nobody can deny that the collapse of the housing bubble was the catalyst for the current crisis, it was not the cause. No, the cause was the financial system itself. If the financial system had not been rotted from the inside out, it would have been able to withstand the collapse of the housing bubble much better than it did.

    So, what is the point of spotting bubbles, particularly when not all bubbles are created equal? For example, the collapse of the internet bubble did not have the same impact on the braod economy as the collapse of the housing bubble. The macroeconomic tools that the Fed has its disposal to control money supply are a bit ham-handed and will, more likely than not, punish the whole class (i.e., the whole economy) for the behavior of one unruly student (i.e., the housing sector).

    Could it be that the Fed saw the housing bubble but had neither the mandate to target asset inflation (I thought it was supposed to control money supply, not asset prices), nor the stomach to potentially throw the entire economy into a tailspin to quiet one part of the economy? Could it be that the Fed had no understanding, and no reason to understand, the potentially destabilizing influence of RMBSs, CMBSs, CDOs, CDOs and increased leverage (all of which, I believe, are regulated by the SEC)?

    The fact is that even if you spot a bubble, and many of us spotted the housing bubble, you don’t necessarily know what will happen when the bubble collapses. Yes, you know that the economy will head downwards, but you don’t know the magnitude of the downturn.

    We would all be better served if the powers that be would focus on how to create a more robust financial system that can better withstand the collapse of bubbles. I’d argue that if Glass-Steagall were still extant, the collapse of the housing bubble would not have wreaked even a fraction of the havoc it did, assuming it could ever have arisen in the first place.

  26. The housing bubble was strikingly visible in Northern California (the San Francisco Bay Area) in 2003 and the first quarter of 2004 in the form of a gross discrepancy between housing prices and rents/rental rates and conditions. Apartment rents were either flat or dropping sharply in 2003. Apartments frequently had large vacancy/rooms available banners and offered a wide range of special move in deals. In contrast, home prices were soaring at something like 20% per year. This was against the backdrop of a severely depressed local economy, due to the end of the Internet Bubble, with substantial unemployment and many people moving out of the area. Nor had there been any significant change in land use or zoning. Indeed, many builders were building new housing developments to meet the mysterious demand for homes. The discrepancy between home prices and rents simply had no “fundamental” explanation.

    The local economy improved noticably in the second quarter of 2004, but rental rates remained flat into 2005 and then began to rise slowly (about inflation). In contrast, home prices soared, accompanied by extensive home building in a number of areas.

    I would say the discrepancy between home prices and rental rates was true in many housing markets throughout the country. The housing bubble was visible in the form of a sharp discrepancy between home prices and rental rates, coupled in most markets with a lack of any fundamental cause. Of course, further examination of conditions in each market would have shown loosened lending standards for home loans and, in the background, mortgage backed securities and other so-called financial innovations.

    The experience of the housing bubble would indicate that bubbles often manifest in price discrepancies between the speculative bubble asset and substitute goods or assets. Closer examination of the price rise will typically reveal that the fundamental causes that might explain the price rise and discrepancy are lacking and, on the other hand, loose lending or other speculative causes are evident.

    In the case of the housing bubble, one could go through each geographical market and document the price rise, the discrepancy with local rents, and the lack of fundamentals that could explain the price rise. Dean Baker and his colleagues at the liberal Center for Economic and Policy Research (CEPR) put out several reports breaking the housing bubble down market by market, in part to rebut arguments that the bubble was only in a few markets.

    As the housing bubble became increasingly obvious, the bubble peddlers began to promote the idea that the bubble applied only to certain homes in a market, for example “low quality” homes were being bid up but your home’s high price was still based on sound fundamentals. Even this can be countered by looking at sales of comparable homes in the same market. One needs to look at homes not only of the same size but also actually examine the individual home to determine the “quality” of the home.

    Several people who identified the housing bubble while it was on-going presented detailed arguments why it was a speculative bubble that have largely been born out as the bubble deflates. They weren’t simply screaming “The sky is falling! The sky is falling!” Nouriel Roubini, Robert Shiller, and Dean Baker all seem to qualify.



  27. CEPR put out a briefing paper

    The Run-up in Home Prices:
    Is It Real or Is It Another Bubble?
    By Dean Baker

    Click to access housing_2002_08.pdf

    in August 2002. Here is a quote:

    Two thirds of the run-up in home prices is attributable to a rise in the price of buying a home relative to the cost of renting a home, as shown in Figure 1. This is what would be
    expected if there is a housing bubble, since it suggests that families are buying homes in large part as an investment rather than primarily as a place to live. A sharp slowdown in the rate of inflation in rental cost index in the last six months, and a record high rental vacancy rate, suggests that demand for rental housing is lagging, which could precipitate the collapse of the bubble.

    Note that if the housing bubble had popped in 2003 (!), there would probably not have been massive systemic effects, although many people would have been hurt. This of course is the issue. If the bubbles can be spotted early enough, they can be reigned in before they do massive damage.



  28. Scot Griffin: “Does it seem to anybody else that the developing narrative of the current economic crisis is rapidly converging to the conclusion that the housing bubble was the cause?”

    No. That is just the current topic du jour. The role of derivatives has been discussed before, as has the role of deregulation. A numebr of causes has been discussed. However, there is a reluctance by the powers that be to face up to the Too Big to Fail doctrine. They might like the narrative to focus on housing.

    “Could it be that the Fed saw the housing bubble but had neither the mandate to target asset inflation (I thought it was supposed to control money supply, not asset prices), nor the stomach to potentially throw the entire economy into a tailspin to quiet one part of the economy?”

    I believe that Greenspan has said as much.

    “We would all be better served if the powers that be would focus on how to create a more robust financial system that can better withstand the collapse of bubbles. I’d argue that if Glass-Steagall were still extant, the collapse of the housing bubble would not have wreaked even a fraction of the havoc it did, assuming it could ever have arisen in the first place.”

    Regulators have focused on mitigating the effects of crashes for over 100 years, at least by bailing out banks, but have not focused much on prevention. That is one reason that the question of preventing bubbles or pricking them early has come up. The segregation of different types of financial firms was a preventive measure in Glass-Steagall. Nothing is perfect, and Glass-Steagall should perhaps have been amended, but repealing it was ideological stupidity.

  29. Dean Baker convinced me in 2002 or 2003 with a simple argument, accessible to the layman, and verifyable through personal experience: Housing prices were going up, wages were not. My salary kept pace with rent, it had no chance to keep up with housing. A casual study of housing prices in the Silicon Valley area against the backdrop of fake money minted in IPO’s added to my understanding.

    This is not a case of Hoocoodanoode. There are simple, common sense observations to determine that the housing price increases were not sustainable. If you felt the need to predict when exactly that unsustainable trend ended, then you are a market timer.

  30. I believe that that the household coverage ratio (the mortgage payment as a portion of disposable income). This can’t be extended beyond a certain level, on aggregate. Once you get to the point where households have coverage levels that eliminate meaningful saving and are cutting heavily into consumption, that may indicate that a bubble is present.

    Leverage ratios for households may be useful, too- something like the average debt-to-equity ratio in new mortgages. I believe that we will have seen an enormous expansion of this over the last 10 years or so. Some work, of course, would need to be done to find the appropriate, sustainable debt-to-equity ratio. And that might not necessarily be the long-term historical average.

  31. John,

    The economy was in the tank in 2002 and 2003. It’s pretty hard to say there was a Housing bubble then.

    Despite what I said in my first post, the historical ratios of income to price and price vs rent are useful tools in assessing the market. I just said they are not the sole indicator of a bubble; other factors need to be considered.

    The housing market of 2005 was frothy; just like the stock market of 2000. There were insane prices on certain houses and stocks respectively in each. In those situations, I think it is safe there was a bubble.

    However, I agree with Scott that the housing bubble of 2005 was not the sole cause of the massive systemic collapse we have seen. The Fed did restrict credit in late 2005, and housing prices in the upper end of the market, at least in LA, cooled.
    Interest rates rose slightly and conventional bank credit was constrained. However, lending by Fannie and Freddie in subprime accelerated. Some of the most ludicrous appraisals and loans were made in the lower end of the market after 2005 as a result.

    One big question I have is that why didn’t the Fed and Bernacke see the explosion in credit in subprime, while everything else was slowing down. A significant portion of the subprime loans and CDs were written after 2005. It should have been obvious and should have been addressed.

  32. Yeah.

    Wether or not Calpers gets the money, the court scene will be satisfying. I hope they can unearth a good sensible history of the ratings. The quotes from agencies that say their models break down if there is a decline in housing prices are pure gold.

    That has to be criminally negligent. These agencies need to have political pressure. Especially since their approval is important in other contracts and collateral calls.

  33. It may be that price to rent ratio is not sufficient to predict all bubbles, but it certainly would have worked for this one.

    The problem wasn’t that people didn’t recognize the bubble, it is that they didn’t consider it to be a serious threat to the economy. If the Fed treats all bubbles as a potentially serious danger, we’ll be in a much better position to avoid future crises.

  34. I believe many who look at the housing bubble look at it wrong. One can look at it in terms of rent to housing or income, but depending on where you live investment in housing by outsiders can change the housing market of those who work in the area. Thus, a retirement area may have a housing bubble that cannot be looked at in terms of local wages or rent.

    Outsiders can often cause housing bubbles just as second homes do when they come into an area. Depending on where these new homeowners are from, they are often use to higher prices and are often willing to pay more then the local populace can creating a bubble. Thus, Joe got X for his house; now I will not sell mine for less then starts the bubble. Here again looking at local wages and rents vs. housing does not work when outsiders are willing to commute. Even if only upper management moves in for a local business — the majority of wages are still at Y while a few have higher wages, but the perceived value of housing goes up as the new people are willing to pay more for housing, raising the overall value of housing while the majority of wages stays stagnant.

    The Vale area is a good example of second homes, the county of St. Croix, WI for an area were outsiders come into an area forcing all to commute to make the wages need to own a home. There are many other examples where the locals often cannot afford homes on local wages, but because of outsiders will not sell below the new perceived price to locals. States with the least amount of population influx from either second homeowners or business managers like Kansas, the Dakotas, etc., did not see the housing bubble in general.

    Many of the hardest hit bubble areas were started with second homes and outsiders and not local buyers. Those that were hurt the hardest economically though were the locals who did not have the income to afford housing in their own area and those investors/builders who did not understand their market they became prey for the sub prime markets. As for the formulas to look at this, too often formals show us what we want to see and not what really is taking place. As someone who was trained in a science field first, I feel one needs to get their boots on the ground to see if the math is really telling what is going on.

  35. Why not put the purchase price of housing back not the CPI where it used to be? As a component it can be tracked and the inflation can be measured. A bubble is fundamentally hyperinflation.

  36. This is a direct quote from the CPI web site and will answer your question. The Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.

    Key word urban consumers. Most housing bubbles started in rural areas that became urban. Example: a farmer/rancher sells his land for development. It isn’t until the population reaches a certain level that it even gets noticed.

  37. good point. if enough people believe they are being paid to borrow money, well, you’ll get a bubble sure as not.

  38. You say that what people “care about is the price at which they will be able to sell that house in 10 years”. I don’t see that as an argument against valuation based on rents: if the purchase price of a house is low relative to rents, this indicates that you are getting a deal and are more likely to sell the house at a profit.

    If you overpay for a house hoping to sell it to a greater fool at an even more inflated price, is that not the very definition of a bubble?

  39. Anyone could spot the housing bubble if they applied common sense and lived in the right area. Walking around Florida in 2005, everyone knew there would be a burst if they had any logic.

    The problem is information. People who looked at the construction boom did not know what the banks were doing, what assets they were buying, how much financial crap was being created. As Rumsfeld said: there are things that you don’t know that you don’t know. The dots weren’t connected.

  40. I think the idea that the underlying driver of home prices is the price someone else will pay 10 years hence is just wrong, or at least is unhelpful. If we thought that the underlying driver of the value of a stock was the price we could sell it for in the future, and not the earnings we’d receive, then there would be no firm basis for pricing stocks well. It’s exactly this idea that the price you can pay for a home is based on what you can sell it for 10 years from now that has gotten us into this mess of overinvestment in the housing stock and overpricing of that stock.

    If you were never able to monetize the value of your next home, what would you be comfortable paying? That’s a better measure of affordability and maximum prices than asking how much you’d be prepared to pay now if you expected to sell it for 50% more 10 years from now. With that kind of gain, and the typical leveraging allowed now, buying a home is like being given free housing.

    How can you assess what prices would be if people didn’t rely on getting all their own money back with significant gains? I suggest a simple way is to require minimum downpayments of 30% of the price, going down to 20% for buyers that can prove all the money is theirs, and the price is true market value, and it’s owner-occupied etc. It’s not perfect, but if people had to put up a lot of their own money up front, then they would be less cavalier about paying well beyond the underlying “fundamental value”. And if you can’t fund 30% of your home’s price in your 30’s and later, or maybe 20% in your late 20’s, then you probably cannot afford the home.

    In fact, why do we subsidize, through the home mortgage interest deduction, loans of more than 2 x (65 – Age of owner)% of the value of the home? If we made interest on the excess over that non-deductible, that would really help make home prices less bubble-prone, and encourage people to save for retirement.

  41. I don’t think the suit is going anywhere for the simple reason that if it did, then all three rating agencies would be out of business – and we can’t have that, can we?

    But as Dave correctly points out, this will make great courtroom theatre. The discovery process alone will be worthwhile.

  42. Because finance is not a science, no need to over-complicate the analysis. Here are my 3 key factors:

    An asset price which has gone up for more than a year and far more than anyone expected, is a candidate for a bubble.

    If “reflexive” factors upwardly reinforce each other contribute to the higher asset prices are discernable, the probablity that the asset is in a bubble rises.

    Finally, if OTM put options (10 delta or lower) trade at far higher implied volatilities than ATM options on the underlying (potential bubble) asset, then some market practioners have spotted it, and the probability of a bubble is, thus, higher.

    Expectations, surveys, trading volumes, long term historical similarites, media coverage, and related manias, could also be deployed to estimate liklihood of a bubble.

    But the nature of major bubbles almost necessitates that all of society gets caught up with believing it.

    Negative bubbles need to be considered as well.

    Nick in Kyoto

  43. Great courtroom theater, yes. But courtroom theater isn’t often a good way to bring about change. We need a decent honest Congress to legislate decent honest regulation–a big trial is unlikely to bring any positive change about.

    Also, while I’m no friend of the ratings agencies, I have little sympathy for Calpers here. They supposedly had sophisticated finance people managing their investments, and paid Wall Street size compensation by the taxpayers to do so. Their complaint essentially says that they bought a pig in a poke because the seller’s friend, whom they well knew was paid by the seller, said it was a good deal. Give me a break! I can see grandma getting suckered into that deal, but these are supposedly professionals. The pensioners should be suing Calpers.

  44. I hope you’re wrong on that predicition, StatsGuy. Until the financial/legal system is allowed to work, this financial mess will never be resolved.

    When the securities firms and rating agencies originally issued the fraudulent derivatives, they had to know they could be sued. And now they are and I hope they pay through the nose. That is how the system is supposed to work. Fraud is to be punished. When it is not, fraud flourishes.

    Until those firms, who believe they have special privileges are forced to play by the same rules as everyone else, the market will not return to normal functioning.

  45. Paul,

    That may be true in individual markets, but in aggregate there is only so much money to go around. Society as a whole, and even individual households, cannot commit more of a percentage of their after tax income to housing unless either:

    * Other goods become cheaper
    * People forego other consumption in favor of housing (which must always be viewed with skepticism, given the predillection of humans to manias.)
    * People use debt to forward shift future income

    Those are your options. Have other goods become cheaper? Perhaps, but it doesn’t seem so in aggregate. Are people willing to forego consumption in order to pay more for housing? Not in the last decade they haven’t. So what changed? Easy debt.

    Long run, income must support the total debt load and, worse, when the debt load is based on fundamentally non-productive assets, such as housing, you have to pay the interest out of other productivity improvements.

    There can be some small, concentrated markets that show no relationship to income, of course. But entire MSAs must largely have income in line with housing over the long run, unless they become entirely dependent on income from other areas.

    James, I disagree with your premise that housing should be analyzed on a per-house basis. At the end of the day, it is income that must support housing prices, not “what someone is willing to pay.” We’ve just seen a decade of people willing to pay about double what was an actually supportable price level, built entirely on debt. And now we are seeing the, to me anyway, obvious ramifications.

    In short, I continue to believe that housing bubbles are both obvious and preventable.


  46. Essentially this is correct if you try to spot bubbles by looking strictly at prices. This methodology will fail. One can always argue about prices. In some cultures it is a requirement of doing business regardless of how mundane the purchase.

    If you instead look at peoples behaviors, you have a much better chance. When people start discarding rules normally used as yardsticks to assess risk, something has failed. The bloggers at calculatedrisk did this, and clearly were out in front on the issue of the housing bubble.


  47. It was not that Greenspan did not spot bubbles. In fact, other central bankers did, too. See,1518,635051,00.html .

    William White, chief economist for the Bank for International Settlements, warned about the problems in 2003, but his call for action went unheeded.

    “For years, the regulators of the global money supply ignored the advice of their top experts, probably because it would require them to do something unheard of, namely embark on a fundamental change in direction.

    “The prevailing model was banal: no inflation, no problem. But White wanted central bankers to take things a step further by preventing the development of bubbles and taking corrective action. He believed that interest rates ought to be raised in good times, even when there is no risk of inflation. This, he argued, counteracts bubbles and makes it possible to lower interest rates in bad times. He also advised the banks to beef up their reserves during a recovery so that they would be in a position to lend money in a downturn.”

    In a 2003 paper, presented at a symposium at Jackson Hole, “White and Borio described the dramatic changes that had taken place since deregulation of the financial markets in the 1980s. Price stability was no longer the problem, they argued, but rather the development of imbalances in the financial markets, which were increasingly causing earthquake-like tremors. . . .

    “All it takes to predict such imbalances, White argued, is to monitor “excessive credit expansion and asset price increases,” and to take corrective action early on, even without a pending threat of inflation.”

    As others here have opined, White says that the keys are credit expansion and price increases. :)

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