I started thinking about a memorable quote that one of my professors uttered to me. He told me (us, the class) that all of his years of experience and financial savvy did not help him to identify that he himself was in a bubble market (2005 which was the peak of the housing boom). He says that he only realized that the real estate market had peaked when even the most lowly [sic] of people, even those who are uneducated and those who normally would lose their pants in complicated financial investments were making unheard of amounts of money.
He says he knew that the US economy had arrived at the height of the real estate boom when a person whom he knew to be a janitor approached him at a party (the professor is a Harvard MBA graduate with 15 years of experience in finance and real estate) offering him advice and telling him how great the American economic system is. He (the janitor) had just purchased a 300,000 dollar home as an investment. The janitor told him that he was going to hold on for another year (this was at the end 2005) and then sell it to make what he says would have been a hundred thousand dollars profit. The janitor investment strategy was nothing more and nothing less than what the professor describes as the “greater fool theory.”
My professor says that he thought it’d be impossible for a person to realistically be able to afford a 300,000 mortgage payment on a janitors pay. Actually, in hindsight we all recognize how the janitor was able to purchase a home that normally would have been outside his financial grasp, and accordingly what may be the root cause to the rapid inflation of property values. That is, the complete and total lack of government regulation led to investment banks creating complicated financial derivatives that allowed mortgage lenders to offer programs such as the famous “NINA” program which refers to a Fannie Mae 1003 mortgage application in which a loan applicant does not have to state nor disclose any income or any assets in consideration for the loan. Hindsight is clearly 20/20, we all now know that the janitor had purchased the property using a Negatively Amortizing Loan ( a Neg-Am loan is a loan in which you have a 1% payment option which actually defers your interest and makes your payment incredibly low, at the expense of actually increasing your loan amount with the deferred interest.) Of course, the rationale of the janitor was that he didn’t care if he owed more on his loan by the end of the year because “obviously” even he could see that property values were accelerating so fast that the appreciation far outweighed any potential investment costs.
In fact, he was not basing this on pure speculation but on actual stories of people making about one hundred thousand dollars (if not more) in investment properties that they had just acquired not 6 months ago. Localized superheated micro-bubbles were created around pre-construction condo projects where talk and speculation lead potential investors to abandon any regard at all for common sense and supply/demand principles and snap up purchase contracts at a premium from buyers who had just purchased the pre-construction property. Typically developers would hold several rounds of offerings where blocks of units for the pre-construction condos would be sold at a specific discount to market and those contracts already held intrinsic value due to the expected future valuations of those properties. Accordingly it makes perfect sense for those at the back of the line, those who had the ability to purchase a condo but only at the lowest discount level to market to abandon their spot in line altogether and “skip the line” and purchase a contract for a premium from someone who had first pick at lower contract prices. Those who did sell their contracts to others walked off with handsome profits and no risk, which in my opinion were investors whom were also gambling and operating under the greater fool theory.
People who purchased the contracts themselves were blinded by a dizzying amount of talk and speculation. They arrived at these future property values entirely in their minds and on the basis of a loose interpretation of what other properties were selling for and what they themselves dreamt of possibly profiting. A dangerous combination of powerfully addictive psychological influences namely : Greed, and what I like to call “mental masturbation.”
People’s heads all over were filling with visions of riches and potential profits “just 6 months to a year down the line”, ironically fueled by actual stories of profits.
Moral of the story, if you like the professor find yourself at a dinner party, and all you hear about is “real estate this” and “real estate that”, and it just seems like no matter where you turn all you hear is “real estate” and you just can’t get away from some one that is talking about a particular segment or investment, then you know you’ve arrived at the top.
It’s impossible for everyone to make money at the same time, a perfect example is the stock market, there are two parties to any transaction and for you to make money on a particular stock transaction, the person at the other end of the transaction has to lose money. Your gain reflects anothers loss, even if its only opportunity cost.
For more on bubbles and the next coming bubble, you owe it to yourself to read and thoroughly understand this article
http://www.harpers.org/archive/2008/02/0081908
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