Scott Sumner asks whether those of us[1] who talked about a housing bubble are predicting another one now.
Sumner asks “Is it possible that the housing boom was not a bubble?”.
It’s certainly possible to define the word bubble so that it wasn’t. But I take the standard meaning of bubble in this context to mean something like a prediction that prices will be lower a few years after the time of the prediction.
Of course, most such claims aren’t worth the electrons they’re written on, for any market that’s moderately efficient. And we shouldn’t expect the news media to select for competent predictions.
Sumner’s use of the word “bubble” isn’t of much use to me as an investor. If prices look like a bubble for a decade after their peak, that’s a good reason to have sold at the peak, regardless of what happens a decade later.
If I understand Sumner’s definition correctly, he’d say that the 1929 stock market peak looked for 25 years like it might have been a bubble, then in the mid 1950s he would decide that it had been shown not to be a bubble. That seems a bit strange.
Even if I intended to hold an investment for decades, I’d care a fair amount about the option value of selling sooner.
2.
The U.S. is not currently experiencing a housing bubble. I can imagine a small housing bubble developing in a year or two, but I’m reasonably confident that housing prices will be higher 18 months from now than they are today.
Several signs from 2005/2006 that I haven’t seen recently:
- high leverage (i.e. unusually low down payments on mortgages)
- signs of amateurs engaging in speculation
- strange rationalizations for why we shouldn’t worry about a bubble
I mostly used to attribute the great recession to the foolish leverage of the banking system and homebuyers, who underestimated the risks of a significant decline in housing prices.
I’ve somewhat changed my mind after reading Sumner’s writings, and I now think the Fed had the power to prevent most of the decline in gdp, unless it was constrained by some unannounced limit on the size of its balance sheet. But I still think it’s worth asking why we needed unusual Fed actions. The fluctuations in leverage caused unusual changes in demand for money, and the Fed would have needed to cause unusual changes in the money supply to handle that well. So I think the housing bubble provides a good explanation for the timing of the recession, although that explanation is incomplete without some reference to the limits to either the Fed’s power or the Fed’s competence.
[1] – he’s mainly talking about pundits who blamed the great recession on the housing bubble. I don’t think I ever claimed there was a direct connection between them, but I did imply an indirect connection via banking system problems.
“it was constrained by some unannounced limit on the size of its balance sheet.”
“Since the 1930s, we have tried a fundamentally different approach to stopping runs and financial crises, emphasizing minimal equity and lots of debt. When depositors run, really the only way to stop it is for the government to guarantee debts9. But, once people expect debt guarantees, banks take on too much risk, and their creditors lend without regard to that risk. So, we tried to substitute regulatory supervision of asset risk for both ends of market information processing and discipline. It’s not enough, we have another crisis, guarantee more debt, and so on.”
There’s an unquantified, political friction on increases in the fed balance sheet. The current zeitgeist has ideas about distributing illegible risks between different entities. Externalities tend to get pushed into illegible dimensions over time which build up into systemic risks. And how effective a system is at moving these risks around would be nice to measure.
What can you do to profit from the bursting of a housing bubble? Did you do it in 2006? Did the timing work out well?
You linked to 3 posts: one from 2004-10, where you were not ready to declare a peak, another from 2005-09, in which you were about to position yourself for a peak, and the last from 2006-01, without comment. By the time of that post, had you followed through on your 2005-09 plan?
Romeo,
I don’t see a clear connection between the limits to bailouts and the limits to open market operations. See this Sumner post explaining why there’s no systemic risk from large Fed balance sheets, merely a risk of an awkward situation where the Fed loses money while the Treasury gains money.
Douglas,
I made some money shorting homebuilders such as Toll Brothers and Centex from late 2005 through early 2008. I also lost some money on AIG (not realizing how much it was exposed to housing prices), and lost some money by shorting financial institutions such as Countrywide Financial (not having enough confidence to maintain those short positions for long enough).
Thanks!
Sumner’s graph doesn’t have a labeled axis. Other copies suggest that the plateau was maybe 1/2006-3/2007. So you called the top pretty well. Why did the plateau last that long? When people say “bubble” there is an implication that when it bursts, it will be abrupt. But I guess the seasonal nature of home sales may make it hard to notice a plateau or fall. (This graph is seasonally-adjusted.)
I don’t know how to get historical stock data for companies that no longer exist, so I don’t know what the story was with Countrywide (or Centex). It looks to me that Toll Brothers’ bubble half burst before housing even plateaued. It ultimately only fell back to its 2003 price and I’m surprised it didn’t fall farther. Maybe the market priced the same declining market into both Toll Brothers and Countrywide, but took more years to recognize that defaults would destroy the bank.
Douglas,
Toll Brothers was more sensitive to the number of houses sold. Countrywide was more sensitive to the number of houses whose price dropped below some threshold.
I’d rather not have “bubble” imply much about the suddenness of decline. Housing prices decline more slowly than stocks because it’s hard to sell short houses, and because other constraints on liquidity slow down reactions to supply/demand changes.