Beware the amateurs

I once had a macro professor offhandedly suggest -in between demonstrating with Hamiltonians and representative agent models how rational bubbles could exist- that one way to identify a bubble would be the the number of complete amateurs lured into an industry. Similarly, my main data point in identifying the housing bubble was Flip That House and other shows like it.

What was happening on those shows defied everything micro theory says about how a market should behave. It wasn’t just that the behaviors couldn’t be explained by neoclassical, perfect information, Chicago School micro theory. There was no amount of information asymmetries, market power, or principal agent problems that could explain what happened on those shows.  Complete novices buy a house, spend four weeks doing a shoddy remodel, and sell it for 150% what they paid for it. This was clearly Animal Spirits.

“What is happening here cannot last”, I would tell people. If there are such insanely outsized profits to be had, surely professionals will put these amateurs out of business, owners of houses in need of rehabilitation will ask higher and higher prices,  and competition will drive prices down. Yet the shows went on for several seasons, with witless novices making profits that defied gravity.

The longer the show went on the more of a bubble I assumed was building. On the more professional home renovation shows they were leveraging up big time as well. And everyone knows hows it all ended.

I was reminded of all of this today by an excellent post from Mike Konczal pointing out this exact phenomenon across bubbles and industries:

In my personal opinion, in the same way middle-class people turned amateur stock analysts was the sign of a tech bubble, or middle-class people turned amateur realtors was the sign of a housing bubble, middle-class people turned amateur credit risk analysts and credit channel intermediaries was the surest sign of a credit bubble.

The amateur credit risk analysts he is talking about are the person-to-person lending websites that were once very overhyped in terms of their potential. This is an amateur market I had not considered, but it certainly makes sense.

The lesson here is beware the amateurs. Wherever they gather in huge profitable masses a bubble has surely formed, and the longer they are able to walk around blithely picking up $100 bills off the sidewalk, the bigger the bubble is.

Milton Friedman on Bubbles

Arpit Gupta writes:

Yet Milton Friedman’s arguments against bubbles remains powerful. Why would investors not respond to the addition of crazy money by betting against the bubble? Sure, most investors can’t technically bet against housing, but home owners could choose to rent, there are REITs out there, etc. Why couldn’t rational trading eliminate the mispricing induced by government spending, assuming that the government did intervene in unprecedented amounts before 2002?

I think Arpit is underestimating the difficulty of making negatives bets on housing here. First off, rental markets for single family homes are thin in many areas and the stock of housing there is systematically different than the stock of owner occupied housing. People also do not appear to be strictly indifferent between renting and owning, and transaction costs can be very large.

Even if some homeowners are able to bet against the market, investors not currently owning homes cannot. So you have a market where investors and owners can bid the price up but only owners can bid the price down. It’s not really surprising in this circumstance that when opinions differ about what the relationship between fundamentals and prices should be that a bubble occurs. Without the ability to bet against housing the market essentially becomes an auction where only the highest valuations are observed. When the variance of expected prices among potential market participants increases it’s not surprising that observed prices increase as well, since only those in the high-end of the distribution will be observed.

Another issue is that unlike the market for pork-belly futures, housing markets are dominated by naive investors, e.g. owner-occupied buyers. Given emotional attachments and lack of sophistication about markets is it unsurprising that too many homeowners did not sell but instead held when prices rose above believable levels? In a country with so much owner-occupied housing, investors have a limited ability to affect markets compared to financial markets.

If I had to play homeowner psychoanalyst I would guess that homeowners with a strong preference for homeownership saw cap rates were changing and believed house prices were heading towards a permanently higher plateau that would permanently price them out of homeownership. People who would want to buy houses in the future but were currently renting had this fear as well and rushed into the market. Risk aversion here thus did not lead to selling when prices rose as a simple model might predict. Believable models of how rational households should have behaved in the bubble need to be pretty complex and account for things like this. Not knowing what behavior it prescribes, appeals to rationality here don’t persuade me.

How to start a bubble

Paul Krugman has linked approvingly to Karl’s post on Fannie and Freddie, and I want to use this renewed attention to his piece as an opportunity to disagree with it. Well, maybe not disagree, but at the very least I want to present an alternative story of Fannie, Freddie, and the bubble that is inconsistent with his, and which I have yet to see a strong argument against.

Whether or not you agree that a bubble had actually started by 2002, it’s clear that fundamentals had become divorced enough from historical levels to begin convincing some people, notably Dean Baker, that a bubble was present. To me this divergence and the subsequent uncertainty around it was a key driver of the huge and indisputable bubble that followed the debatable 2002 and 2003 semi-bubble.

Once fundamentals were potentially outside historical levels, it became unclear to market participants and economists what the fundamentals were anymore. Thus, a signal which traditionally could be used to hold prices in check was gone, and the only signal market participants were left with was prices themselves. It’s as if someone turned out street lights and the only way drivers could navigate is by looking at each others headlights and tail lights. It’s easy to see how this could lead everyone collectively far from the roads despite behaving rationally individually given the information available to them. This uncertainty and unanchoring of fundamentals set off the herd behavior that drove prices even higher, this lured private companies in who eventually crowd Fannie and Freddie out of the market.

Now herd behavior of market participants is also causal here, but that doesn’t mean that the initial divergence of fundamentals that set the herd off was not causal as well. However, this story does make Fannie, Freddie, and their enablers less negligent than typical stories that assign causality to them. This is because few could have foreseen that causing fundamentals to somewhat diverge from historical levels would set off such extreme herding behavior. This unforseeableness of the consequences means you can’t exactly call their policies reckless. In contrast, had they been the primary force continually driving the prices higher and higher to manic levels, as some narratives of the bubble hold, then one might call them reckless.

So that’s one story of Fannie, Freddie, and the bubble. Maybe it’s not the right one, and maybe Karl’s is, but I’ve yet to hear a convincing case for why it’s wrong.

Think of a house as an investment

Some time ago there was a blogospheric debate about whether a house should be considered an investment. I contended that almost necessarily it has a large investment component, and should be thought of as such. In addition, for many people -although I don’t know how many- housing can be a good investment. Felix Salmon and Ryan Avent disagreed, with Ryan arguing housing was an investment, but rarely a good one, and Felix arguing that it was not an investment at all. Today, esteemed economist Karl E. Case of Case/Shiller fame weighs in on the housing as an investment debate:

But for people with a more realistic version of the American dream, buying a house now can make a lot of sense. Think of it as an investment. The return or yield on that investment comes in two forms. First, it provides what is called “net imputed rent from owner-occupied housing.” You live in the house and so it provides you with a real flow of valuable services. This part of the yield is counted as part of national income by the Commerce Department. It is the equivalent of about a 6 percent return on your investment after maintenance and repair, and it is constant over time in real terms. Consider it this way: when Enron went belly up, shareholders ended up with nothing, but when the housing market drops, homeowners still have a house. And this benefit is tax-free…

…This financial crisis has made us all too aware that we live in a Catch-22 world: the performance of the housing market drives the economy, and the performance of the economy drives the housing market. But housing has perhaps never been a better bargain, and sooner or later buyers will regain faith, inventories will shrink to reasonable levels, prices will rise and we’ll even start building again. The American dream is not dead — it’s just taking a well-deserved rest.

Karl wants you to think of housing as an investment, and he wants you to invest. I’ll agree with him on the first point, and remain agnostic on the second.

He also makes an important point about how housing lacks any true fundamentals like financial investments do:

Real estate sales are unlike other financial transactions. You can place a rough inherent value on a stock or bond by looking at fundamentals: a company’s profits, price-to-earnings ratios, quality of its products and management, and so forth. But a house is worth what someone is willing to pay for it. That’s a very personal, emotional decision….

This lack of solid fundamentals is an important problem with identifying housing bubbles. It is entirely possible for there to be an exogenous increase in the preference for home ownership that will drive up the prices of housing, as well as the price to rent ratio. Capitalization rates, which determine how an individual translates a flow of housing services into a house price, differ among individuals. Demographics can shift in ways that will affect cap rates, for instance average income or age can increase, but so too can the raw preference for home ownership. So house prices went up 15% while rental rates remained constant; what just happened? Is this irrational speculation, or did preferences for home ownership increase?

UPDATE: Felix does some real reporting and gets Case on the phone. I am apparently interpreting his use of “investment” too literally.