The Self-Fulfilling Housing Bubble Prophecy

There has been a lot of talk about a housing bubble lately. Business Week even made it their cover story. The funny thing about market bubbles is that they often become self-fulfilling prophecies.

The mere mention of a bubble is enough to spook some buyers from entering a market. In fact, a client and I had this exact conversation Saturday which then prompted this weblog entry.

Mention "bubble" to a nervous buyer and inertia sets in. It is much easier to do nothing than to face the risk of buying into a bubble market.

This natural reaction creates a reduction in demand, which causes sellers to lower prices. As sellers lower prices, buyer recognize that the market is softening and begin to wait for further drops in price. Waiting for the "floor" reduces demand further which, again, causes sellers to reduce prices.

The spiral continues downward and the Bubble Prophecy is fulfilled.

A cornerstone argument of the Bubble Prophecy is that rising interest rates makes homes less affordable for prospective homebuyers. In other words, the demand for homes will decrease because fewer people can qualify for mortgages. This will start the downward spiral, they say.

With each passing year, though, lenders develop new mortgage products that make homeownership possible for credit types that were previously excluded. This creates a sustained demand by continually introducing new buyers into the marketplace.

Evidence that supports my theory can be found at the U.S. Census Bureau's Web site.

Until the 1950s, banks required all homebuyers to make a 20% downpayment in order to qualify for a mortgage. If a person did not have the 20% downpayment, the bank would deny the mortgage application. Private Mortgage Insurance (PMI) was created at this time to assist homebuyers who did not have a 20% deposit.

Banks would lend more than 80% against a property's value in exchange for the homebuyer taking out an insurance policy against their own default.

PMI spurred demand for homes as more buyers entered the market. The program was not widespread until 1971, however, when regulatory authorities expanded the program's reach to cover 95% LTV on purchases. This move spurred homeownership rates to 64.5% in Q4 1971, a record for the U.S. population since the Census started tracking this information.

Later, banks devised a system in which they would lend on the first 80% of a home, and then create another loan for the difference between downpayment and home value. A 90% loan, for example, was split into one loan at 80% LTV and another loan at 10% LTV. The 10% loan was called a second mortgage.

Again, homeownership rates increased because homeownership became affordable to more Americans. By Q4 2004, the rate of homeownership was 69.2% nationally.

To give a real-life example, I can currently lend up to 100% of a home's value if the borrower has a 575 FICO score or better. 93% of all Americans meet this criterion and many of them are still renting. There is an enormous pool of potential homeowners that are unaware that they can purchase a home.

The Bubble may not burst, but the Real Estate market may soften in specific markets, meaning that Real Estate prices and values must be evaluated on a neighborhood-by-neighborhood basis, not as a blanket statement for the entire country. That is the dangerous effect of stories like the one featured in Business Week.

Ironically, the self-fulfilling nature of the Bubble Prophecy should be a homebuyer and a homeseller's greatest concern.