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On Tulips and Bubbles, and why a housing crash isn’t likely this time around

Bay Area housing is now in the midst of another period of rapid appreciation. I have heard some worry that another “bubble” may be in our future. But that’s too strong a word. “Correction” would be a more likely scenario.

What’s the difference? A “bubble” is characterized by trade in an asset at a price that strongly deviates from the asset’s intrinsic value, followed by a rapid contraction when no more investors are willing to buy at the inflated price.

Our last housing bubble, about 10 years ago, was fueled by loose credit. When everybody can qualify for a loan, everybody competes for housing. That drives up the prices and speculators jump in. They’re not interested in inhabiting or renting the home, just in selling at a higher price. The price exceeds the intrinsic value when it can no longer be justified based on the value as a residence or the amount of rent income it can generate. That’s unsustainable, and crashes are inevitable.

The classic “bubble” case study is the “tulip mania” craze which swept Holland in 1637, when wild speculation in tulip bulbs reached such a fevered pitch that, at one point, 12 acres of land were offered in exchange for a single Semper Augustus bulb, according to British author Charles Mackey in his classic 1841 book Extraordinary Popular Delusions and the Madness of Crowds.

As tulip popularity grew in Holland, professional growers paid higher and higher prices for the bulbs. Then the Dutch created a type of formal futures market where contracts to buy bulbs at the end of the season were bought and sold. The Dutch described tulip contract trading as windhandel (literally “wind trade”) because no bulbs were actually changing hands. The price of tulips skyrocketed because of speculation in tulip futures among people who never saw the bulbs. Men made and lost fortunes overnight.

By February of 1637, tulip bulb contract prices collapsed abruptly and trade ground to a halt. (Perhaps not coincidentally, this occurred during an outbreak of the plague, as many buyers were afraid to show up at the auction).

But residential real estate isn’t in a speculative bubble this time, according to some economists. “The havoc during the last cycle was the result of too many homes and loose credit,” said Jonathan Smoke, chief economist at Realtor.com. “That’s the exact opposite of what we have today.”

To illustrate his point, Smoke compiled an index based on six factors he deemed crucial to the housing boom and bust of the mid-2000s, including price appreciation, the prevalence of “flipping”, the share of buyers who used mortgage financing, and other factors. Then he benchmarked the index to 2001, a year when the housing market was fairly valued.

Last year, only six metro areas exceeded the benchmark by 10 per cent (led by San Jose, at 19 per cent!). In 2005, there were 29 cities that were at least that overpriced.

It’s not surprising that the areas that look most like a bubble are those where population is growing faster than the housing supply. Meanwhile the percentage of households that rent is near 50-year highs, driving up rents and giving incentive to investors.

Figuring out how to create enough new housing to meet demand is a tricky question, one which we’ve covered at length in previous newsletters. Most of the barriers that have historically constrained Bay Area housing growth, particularly the geographic limits, are still in place. And we’re still attracting the world’s best and brightest, and paying them enormous salaries.

Easy credit? That’s a relic of the past. Today, we’re experiencing some of the toughest loan underwriting guidelines in history. No more “easy qualifying”. If you can get a loan these days, it’s because you’ve proven beyond a shadow of a doubt that you can make the payments.

So, what I foresee is not a “bubble” but a “correction”:  The rate of appreciation will slow, or prices will level off when interest rates rise and fewer buyers can qualify. But until Santa Clara County ceases being the Valley of Heart’s Delight, and until Apple, Google, and the rest of Silicon Valley relocates to Peoria, Bay area real estate will continue to be a valuable commodity.

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