'[No One] could have foreseen a loss like that.' -- Reader Comment
I think we need to take time out for a history lesson. Why? Because many readers and folks today are under the age of 30, and thus were mere children during the real estate crises of 1989. Even people in their 40's were still in college then, and their parent's grumblings about housing prices tanking were probably blips on the radar.
And it seems that many people conveniently chose to forget about the 1989 crises. As I noted before, economic "memory" in humans seems to span about 18 months, tops. After that, they start afresh as an infant.
During the housing bubble peak, I would mention the 1989 bubble to people and they would give me a blank stare. "What are you talking about? Bubble? There have never been bubbles!"
No, really. People said this to me.
What happened in 1989 and why did it blow up? Why were the effects not as severe as they are today? And why did the 1989 bubble lead to the 2009 bubble? The answers are complex and go back decades.
30-year mortgages are a somewhat modern invention. Prior to World War II, they were unheard of. In the 1930's, to stimulate home sales, banks were offering 10 and even 15 year mortgages, which most folks thought was a scandalous length of time. Prior to that time, you pretty much had to pay cash, or take out a short-term loan.
And not surprisingly, houses back then were cheaper. Cheaper because the monthly cost was higher, so people could not afford to pay more. Cheaper because houses were smaller - rooms were smaller - and less lavishly appointed. One bathroom was the norm for most middle-class homes.
In the postwar era, new houses sprang up in new suburbs like Levittown, and new 30-year mortgages were invented to get people into them. These Levittown "cracker boxes" were small homes - 2-3 bedrooms at most, maybe 1 bath. Again, our standards for homes were a lot lower back then.
Mortgage interest was deductible - as was all interest and thus the effective mortgage payment was made lower, thus encouraging more people to buy rather than rent. The "American Dream of Home Ownership" probably can be traced to this post-war era. It was a false dream.
In the 1960's, houses got a little larger, and luxurious things like multiple baths and eat-in kitchens started to appear. Most of the country lived in the Northeast, and even air conditioning was considered an unheard-of luxury, reserved for the very rich. A microwave oven cost more than a good used car.
Housing prices went up, over time, but not at any fantastic rate.
Enter the 1970s, the era of stag-flation. The 1973 Arab Oil embargo shocked the economy and jacked the price of gas through the roof (from 25 cents a gallon to 50 cents, how quaint). Suddenly, the price of everything went up. And wages went up, as more and more people went out on strike (1/3 the workforce was unionized). As wages went up, prices went up, in a spiral of inflation and stagnation - stag-flation. Usually inflation accompanies a growing economy. Economists were stumped.
Here is where it gets weird. President Nixon went on television to announce a series of wage and price controls . No, really, a Republican President telling Americans what their wages and prices should be. Today, it would be considered Communism, Socialism, or Heresy. Being GOP back then was a lot different than today. Ask the ghost of Governor Rockefeller - back then the Republican party had a "liberal" wing. No shit. I am not making this up!
By the late 1970's, we were in bad shape. We lost the Vietnam War. Nixon resigned in disgrace. Inflation was running in the double-digits. You could only buy gasoline on alternate days (again, many people claim not to remember this!). The shit had hit the fan, and it made today's "troubles" look like patty-cake. Iran fell to the Ayatollah and we had a hostage crises.
And yet, housing remained relatively stable. Why? Because mortgage interest rates were so high, no one could afford to pay much for a home. So prices remained relatively modest. A 14% mortgage doesn't buy much. I recall, at the time, my boss telling me about a friend buying a home with a "$1000 a month mortgage payment! Can you believe that! How could they afford to live there?"
But they could. The new generation of dual-income Yuppies were making money, and suddenly, "Don't trust anyone over 30!" was replaced with "Don't trust anyone under $30,000 a year."
The stage was set for the Real Estate bubble of the 1980s.
Interest rates started to fall in the mid-1980's. The rates are still laughable by today's standards - 10% or more. But this represented a huge drop from the sky-high rates of the early 1980's. Suddenly, people could afford to pay more for a home, and in the "Reagan Recovery" it was Morning in America, and buying a home and fixing it up (as the new TeeVee Show "This Old House" promoted) seemed like a swell idea.
Housing started to increase in value, in many markets, sometimes dramatically. In the Washington DC area, housing prices soared, as under Reagan, the government grew to enormous proportions (again, being a Republican meant different things back then!). In Fairfax County, Virginia, for example, in the years 1985-1989, housing prices went up by 20-30% per year. People were "buying and flipping" houses in less than a year, and taking out tens of thousands of dollars, which back then was a lot of money.
And a new kind of bank called a "Savings and Loan" appeared on the scene. Savings and Loans were being bought up by entrepreneurs and used to finance all sorts of deals. One developer in DC actually owned their own Savings and Loan, and used it to finance a series of downtown office buildings - the boom in Real Estate not being limited to homes, but to commercial as well. And on Wall Street, something called the "Junk Bond" was being touted, and a guy named Michael Miliken was making a lot of dough.
In 1989, it all came apart - suddenly. To fans of chaos theory, this would not be a surprise. Things build up and up and up, and then, BAM, like an over-inflated balloon, they burst. And everyone says they didn't see it coming.
My boss at the time told me, "Property values will always go up in Fairfax County!" - no doubt something his Real Estate Agent told him. Wrong.
A friend of mine quit his law career as he was making so much money buying and flipping mini-mansions in Fairfax County. Stop me if this sounds familiar, and bear in mind, this was 1989, not 2009. He finally cashed it all in and bought an apartment complex, hoping to take it condo. That was right before bubble burst. He lost it all and went back to being a lawyer.
People big and small were hurt, and there were calls for government reform and such - much of which occurred. But others were less convinced that everyone was a victim here. People buying houses and hoping to flip them in six months for a 20% profit? Just greedy.
And buying something that they actually call a Junk Bond and then wondering why it goes bad? What were they thinking? What do we need to do, call them "Piece of crapola guaranteed to lose money bonds"?
"Oh," they say, "But everyone else was making money in the Reagan Recovery, why not me?"
And a young Governor from Arkansas ran against an incumbent President on the platform of "It's the Economy, Stupid!" and won - two terms.
Back then, I had lots of friends who lost money on their houses. I had just bought a house in Fairfax County for the whopping sum of $189,000, the most ever paid in the development (my neighbors gleefully informed me). For the next few years, it was touch and go. If we had to sell that house, we would have lost money. But since we had to put 20% down, we were never "upside down" on the house.
Others were not so lucky . A friend of mine foolishly bought a condo out on a cornfield, two hours from work. One weekend afternoon he drove out there and the sales lady "sold" him on the place, and he bought, thinking he was "getting in on this housing deal". To sell the condo, he had to bring $10,000 to the closing table.
Again, this is 1989, not 2009. Remember that. 1989. OK?
And on and on. Others simply "walked away" from houses, or did deeds in lieu of foreclosure, or short sales. Sounds familiar? And yet people today think our situation is unique and never happened before - or was unforeseeable!
Throughout the early 1990's, housing remained down. Housing prices were pretty flat, and the number of foreclosures were taking years to work their way through the system. I met a nice fellow selling foreclosure properties for Ford Motor Finance. Yes, back then Ford and GM were in the loan business. He sold us a foreclosure duplex that we could rent at a positive cash-flow, and sponsored Mark at the agency, where he got his license.
In 1995, housing prices were flat, but interest rates were dropping further. Since a lot of amateur investors got out of the market, the demand was slack. You could buy a nice duplex for $99,000, within walking distance to the metro, and rent it out for $1200 a month. You do the math on that - it is a money-making from the get-go, and you throw in the depreciation deduction, well, it knocks down the taxes for a young lawyer by a lot.
And by the late 1990's a lot of people were starting to figure this out - that income-producing properties were a great tax haven, and since they were attractively priced, were a good investment as well.
And as interest rates continued to drop, more and more people got into the market. And most of these new people were like the amateur investors in stocks - looking only at prices, and not the underlying fundamentals. "Stock in XYZ company is going up, up, up! I'd better buy some!" they shout. But they fail to see that XYZ company is one step from bankruptcy.
So the folks like me, who spend days agonizing over a house buying decision - doing the hard math to see if the rents would cover costs - were replaced by the "buy it on a whim" people who bought "investment" properties and never even bothered to rent them out. They were convinced that they would make money on the sales price when they sold.
And for a while, they were right. Once the market got overheated, they could buy one day and resell the next. On some days, you could buy a house and re-sell the contract for a $50,000 profit - in a week.
We walked away from some deals like that. I had a chance to buy a town home in Del Ray from the builder (a friend of ours) for $189,000 - nothing down deal. I could have sold it a year later for $400,000. I didn't do it. Why? The risk scared me shitless. If it worked out, I would make a mint. If it didn't, I would be stuck with another mortgage - and I already had several properties at that point in time. Pigs get fat, hogs get slaughtered, as my tax professor told me.
So by the mid-2000's, I was getting very, very nervous. This was not a sustainable model, that much was clear. And many economists were sounding the alarm - they wanted to shout "sell!" but like with so much else, they say platitudes like "[There are] signs of froth in some local markets where home prices seem to have risen to unsustainable levels" - as Alan Greenspan testified to in 2005. There was your warning, right there. Few heeded it.
What disturbed me, at the time, was the happy-talk, like my boss said in 1989 - "Housing prices will always go up" - and yet the basic math made no sense. Your average working Joe could not afford a simple two-bedroom house, without paying through the nose. Often, in many areas, the rents were less than HALF the cost of owning. Now recall that in 1995, I was making a positive cash-flow on rents.
Nothing - repeat NOTHING - can go up in price at 10 times the rate of inflation, indefinitely. Whether it is oil, gold, houses, or a college education. Eventually, the bubble bursts - when the commodity becomes so expensive that no one can afford to buy it, other than the speculators. There has to be an underlying market of real consumers for the product.
So, it was readily apparent to me - and a whole host of others - that the bubble would burst and burst hard. And in some areas, it would burst harder than others. Huge condos were going up in South Florida, and Las Vegas, with no real idea of who would want to buy them or why. When I saw a one-bedroom "designer ready" condo for sale in Pompano for $850,000 - with a $3000 a month condo fee plus another $1500 a month in property taxes - I realized that the silliness had gone on long enough. Unless busboys stated making $100,000 a year, no one could afford this.
I sold out. Sold it all. Because I foresaw that what happened in 1989 was going to happen all over again, only this time on a far larger scale, as low-interest loans and funny money were throwing gasoline on the fire.
So, here we are. 1989 all over again. We have new Michael Milikens to blame for our mess. New, weird financial instruments that have "Crapola" written all over them, that we bought anyway. New subdivisions of foreclosed upon homes, and another Presidential election coming up, where the primary issue is, "It's the Economy, Stupid!"
To be sure, there were a lot of other issues at work as well. Since mortgage interest was now the only deducible interest, many folks took out home equity loans or lines-of-credit to pay off high-interest credit card bills, or to buy luxury cars. Why not? For $100 a month more, you could afford a Mercedes-Benz, even if you were amortizing it over 30 years.
And the steep rise in property taxes helped burst the bubble. Rather than lower millage rates, local jurisdictions (I'm talking to YOU, South Florida) raked in the dough and spent it, on lavish government buildings and appointments, new equipment, and the like.
But for the most part, the cause of the bubble was a LOT of people making BAD FINANCIAL DECISIONS - buying houses that no one could afford, and not thinking to themselves, "Gee, maybe I shouldn't do this - after all, if I lose my job, how could I afford this?" or "Who will I sell this house to - it is so expensive that even a wealthy person could not make the payments!"
This was not rocket science. But most Americans, it seems, get their normative cues from the television and media - both of which hyped the "buy now before you are priced out of the market" bullshit.
Today, we see the same thing in gold, which will burst and burst hard, and take out a lot of "true believers" who thought they were entitled to riches, and now will blame the government - or even me, for saying the price is too high.
Or take cars - people are in a buying frenzy right now, driving UP the price of used cars and allowing manufacturers to drop incentives. The book value on my roadster actually went UP $300 this year. That's just insane - it is a used car.
What happens next year when Toyota and Honda recover from the tsunami damage and the car market is flooded with cars? You will feel like a fool for paying close to list price in 2012 for a car, that's for sure.
Going with the lemmings is never a good idea. We all do it, to some extent, as we are like a school of fish, moving as a flock. But when the lemmings march off a cliff, for God's sake, don't follow them.
Learn from history. Those who do not, are doomed to repeat it. As we have, from 1989 to 2009.
(Revised and edited, June,11 2012, from original posting of January 31, 2012, edited February 2015 to correct typos and formatting)
