The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble (43 page)

The average American lived in a suburban house thought to be worth $188,800. Since stocks began to decline in January 2000, his net worth had not necessarily declined, but it had become less abstract; he now had to live in it. Even in Philadelphia.

A housing bubble in Philadelphia? It seemed almost impossible. Who would want to buy a house in Philadelphia, much less at a premium? But house prices rose in Philadelphia, and even in Baltimore. Parents and grandparents had been loath to spend more than 25 percent of their incomes on rent or a mortgage. Now, people were spending more than 50 percent. By mid-2005, it was reported that one in five new home buyers spent half their disposable income on housing.

There was disappointment built into this delightful show. It is all very well that the world financial system matches up borrowers with lenders, but the matchmaking only works if it produces satisfying results. If you match a princess with a frog, when the poor girl bends down to give the amphibian a kiss, something remarkable better happen or there will be regrets. Reproaches. Maybe lawsuits.

Just as a traveler is never really sure he’s had a good trip until he gets home, you never know if a loan is a good one or a bad one until the money makes its way back to the lender. That is where the disappointment is likely to come. Are lenders too lenient? We will know when the money gets ready for the return portion of the trip. Our guess was that not as much would make it home as people expected.

The amount owed in home equity lines of credit soared 42 percent in 2004 alone. And the median down payment slipped from 6 percent in 2003 to only 3 percent in 2004.

“The boom in interest-only loans—nearly half the state’s home buyers used them last year, up from virtually none in 2001—is the engine behind California’s surging home prices,” said the
LA Times.
¹

California house sales hit a new record in February 2005. And again in March. And again in April. Housing starts nationwide were at a 21-year high. All over the 50 states, people were buying, flipping, refinancing.

“It is as if you were paid to live in California,” said a skeptic to the
LA Times.
²
Prices rose 22 percent in 2004. It meant that an average homeowner, with an average $400,000 house, added $88,000 to his net worth. He did this without lifting a finger.

In the Bay Area, houses were selling for half again as much as people asked for them. The
LA Times
mentioned a house offered for $980,000 that sold almost immediately for $1.5 million. The
Times
told of a young woman who bought her first house with no money down and “interest only” payments. In 2001, fewer than 5 percent of new houses were purchased with “interest only” mortgages. By mid-2005, the total was nearly 50 percent. From the newspaper report, the woman appeared to be headed toward a financial crisis. Homeownership, she believed, would bail her out. She told the paper that she intended to use her equity to pay down her credit card debt! More of the
Times
article: “I have $40,000 in student loans from my master’s degree,” she said. “I have high credit card debt. I’m a typical American. And yet they wanted to give me more debt to buy a house.”

“If you’re like me, you’re so incredulous that anyone would give you any money whatsoever, you just close your eyes and sign the papers . . . . I would have signed anything.”
³

On the East Coast, the situation was not much different:

An expert was interviewed by the
New York Times.
He remarked that in the past real estate investors expected annual rental returns of 8 percent to 10 percent of the purchase price. But such a “historical perspective” was wrong, he said. It caused investors to pass up good opportunities.What they needed was a “fresh prospective”: “They’re not being foolish; they’re looking at it differently than people who have been in the market for a long time.”
⁴

Forget the wisdom of the dead, in other words.This was a new era.

People bought property as they had bought tech stocks five years before—without any regard for earnings. It was all a greater fool’s game—betting that someone would come along who was an even bigger numskull than you were. The game continued such a long time that people came to see it as eternal. And the more confidence people had in it, the more reasons they invented for it to go on. Most experts cited “demographic factors” as guaranteeing higher residential property prices. There were supposed to be many more people who would need a roof over their heads in the years ahead. According to the theory, there were so many new immigrants and baby boomer children that the homebuilders couldn’t keep up with them. Prices would rise. Why the homebuilders would build enough houses to keep up with the demand was a matter of debate. How the new buyers would be able to pay higher prices—when incomes were falling—was not clear either.

A major reason given for why stock prices had to continue rising in 1999 was that so many people were putting so much money into stocks for their retirements. The logic was supposedly irrefutable: The baby boomers must save money. They had no choice but to put it into stocks. Stocks had to go up.

The reasoning was perfect—as long as stocks went up. But then something happened: Stocks went down. Baby boomers felt little desire to buy stocks. But the “demographic factors” argument was still perfectly serviceable for the housing market. It would work fine too—until houses went down in price. Then, miraculously, the multitudes in need of housing just vanished.

On April 10, 2005, an article entitled “The Hunt, Becoming a Mogul Slowly” appeared in the
New York Times.
It told the story of a 25-year-old New Yorker who had been making real estate deals ever since 2002. Drawing on this deep well of experience, the young Trump offered advice. “An apartment is more attractive to me when other people want it. While the price might seem expensive now, it might not be expensive six months to a year from now.We overbid to capture the opportunity.” By some instinct, he had captured the gist of the efficient market hypothesis—and applied it to real estate (discussed in Chapter 15).Whatever price he paid was okay—because it was the price others were willing to pay.

The
Times
article told us that “his success has inspired six of his young, former-renter friends, to follow in his experienced footsteps,” because “I made it seem like a very cool thing to do.” Meanwhile the real Donald Trump said he was getting a million dollars a pop just to tell young mogul-hopefuls his secrets.
⁵

In mid-2005, you only had to get in a cab to realize that the real estate boom had become a bubble. Cabdrivers would point out how much houses had gone up. While once they gave tips on tech stocks, now they told you which neighborhoods were likely to experience the greatest price inflation. Listen carefully, and you were likely to overhear drivers on their cell phones talking to real estate agents about their new condos.

The trick was to find a “fixer-upper,” do a little cosmetic work on it, and put it right back on the market. So many people were looking for fixer-uppers that canny sellers were considering deliberately making a wreck of their houses—so prospective buyers could hallucinate about how much money they would make after fixing them up.

In the spring of 2005, the Federal Deposit Insurance Corporation (FDIC) identified 55 areas in the nation that it said were undergoing a boom in residential real estate. These were areas where prices rose 30 percent or more over the preceding three years. Not in 30 years had so many parts of the country experienced such a boom, said FDIC. Even in the last boom of the 1980s, only half as many areas met the test.

“A lot of the psychological well-being of the American public comes from how well they’ve done with their house over the years . . . ,” said the Sage of the Plains, Warren Buffett, in April 2005. “Certainly at the high end of the real estate market in some areas, you’ve seen extraordinary movement . . . . People go crazy in economics periodically, in all kinds of ways. Residential housing has different behavioral characteristics, simply because people live there. But when you get prices increasing faster than the underlying costs, sometimes there can be pretty serious consequences.”

“You have a real asset-price bubble in places like parts of California and the suburbs of Washington, DC,” added Charlie Munger.

Buffett: “I recently sold a house in Laguna for $3.5 million. It was on about 2,000 square feet of land, maybe a twentieth of an acre, and the house might cost about $500,000 if you wanted to replace it. So the land sold for something like $60 million an acre.”

Munger: “I know someone who lives next door to what you would actually call a fairly modest house that just sold for $17 million. There are some very extreme housing price bubbles going on.”
⁶

“Flipping real estate . . . without getting burned,” is a headline from the weekend
Seattle Times.
⁷

There’s something about a bull market that weakens brains and permits senseless metaphors. The
Times
could have said, “Flipping houses without having them fall on your head” or “How not to get burned in a red-hot real estate market.” But the hacks in Seattle didn’t bother to think about it; who did? Everybody knew property was hot, and everyone knew you could get rich—fast. By April 2005, the press was beginning to report on people who had quit their jobs to get in on the house bubble before it went sour, we mean, before it popped.

The
Times
article referred to “30-something investors” who had left gainful employment to invest in real estate. What they were doing had little in common with real investment, but neither they nor the reporter seemed to realize it. The houses they bought rarely yielded any real, net income. What they were really doing was gambling on rising property prices.

It was much like the end of the 1990s when young investors were quitting their jobs to day-trade stocks. As long as stocks were rising, these traders were geniuses.When the stocks went down, they were idiots.

“I lost a ton of my portfolio in 2001,” the
Times
quoted a rising property mogul.The man fired his financial planner and put his money in a self-directed IRA that he could use for speculating in houses, practically day-trading them. “By the end of the year we’ll be doing two or three a month,” said he.
⁸

Another similarity between the bubble in tech stocks at the end of the 1990s and the housing bubble in 2005 was the rise of “clubs” designed to help members speculate in the company of others.At the end of the 1990s, people joined investment clubs so they could yak about stocks with other people who didn’t know anything either. In 2005, they joined real estate clubs. There were at least 177 of them by mid-year. Members got together to talk about “techniques” and “strategies.” Four of these “strategies” were recorded for the benefit of future Donald Trumps, and perhaps history, in the
Times
article: (1) Buy a house, hold it, and sell it later, (2) buy a house, fix it up, and sell it, (3) flip the damn house before you actually have to pay for it, and (4) rent the house for more than it is worth, giving the tenant the right to buy it in the future.

We were tempted to add exclamation marks after each strategy. But the items scream such imbecility that amplification seems unnecessary. They reminded us of our own dictum about stock market speculators of the late 1990s: There is smart money; there is dumb money; and there is money so moronic it practically cries out for court-ordered sterilization.

They say on Wall Street that no one rings a bell at the top of the market, but so many bells were ringing in the spring of 2005 we thought we would go deaf—or mad. Playmate of the Month, Jamie Westenhiser, was abandoning a promising career as a model to take up real estate investing.

What would make a nice girl like her end up in place like that? Maybe it was the 12.5 percent gain in real estate nationwide in the previous 12 months? Or maybe it was the 50 percent increase in housing prices in five years? In hot markets—such as California, Florida, and Washington, DC—prices had gone up 60 percent in two years.

It was a “real estate gold rush,” said the cover of
Fortune
magazine. But Americans were suffering from delusions of mediocrity.They took for normal what was actually extraordinary.

Prices of American residential real estate, in real terms, rose 66 percent between 1890 and 2004. But all the increase happened in just two brief periods: right after World War II, and after 1998. Other than those two periods, the real price of housing was either flat or falling.The big difference between the period following World War II and the ’98-’06 era was that after the war the U.S. economy was growing and healthy. America not only had a positive trade balance, but had the most positive one in the world.Wages were going up, so people could afford more expensive houses. Families were expanding faster than the economy—so they needed more houses.

But by the end of the century, incomes were stable or shrinking. The nation spent more than it earned; it desperately counted on rising house prices—and the savings of poor people in foreign countries—just so it could continue living beyond its means. And Playmates of the Month were giving up strutting their stuff to invest in real estate.This was not a normal situation.

Other news stories told of friends who were teaming up to buy houses—they had become too expensive for a single couple to afford on its own.The main cause of foreclosure was divorce, because neither spouse could afford to keep the marital home. Imagine two couples. You might think the risk would double. In fact, it probably quadrupled—or more. Either couple might break up. Even more likely, the two couples might decide they can’t stand each other. A lender would have to be brain-dead to agree to such a deal. But in 2005, many did.