Financial bubbles are real. A recent academic study proves people change their behavior when they witness their neighbors making money with little effort.

Everyone wants free money. A new academic paper provides strong evidence that the desire to obtain free money drives the insane behavior in financial manias.

It’s rather shocking that some academics believe there are no financial manias, instead concluding that rapid and unsustainable price increases are the rational action of an efficient market. The reality is that most investors are clueless herd followers that merely assume that everyone else around them must know more than they do, so when the herd piles in to one asset class or another, it must be for a good reason.

It’s not.

It’s even more obvious when amateur investors start speculating in residential real estate that few of them really know what they’re doing. The fact is that most homebuyers make irrational purchase decisions.

People buy houses as family homes for emotional reasons, and not always rational ones. Many analytical people conduct research, analyze financial returns, and so on, but this is generally only a rationalization for what is a deeply personal and emotional decision. Since the decision is more emotional than rational, and since most homebuyers are not professional investors, homebuyers are especially susceptible to participating in financial manias.

March 24, 2016, By Noah Smith

… But according to mainstream theory, bubbles are not driven by speculative mania, greed, stupidity, herd behavior or any other sort of psychological or irrational phenomenon. Inflating asset values are the normal, healthy functioning of an efficient market. Naturally, this view has convinced many people in finance that mainstream theorists are quite out of their minds.

Yes, common sense and observation of actual behavior of real people clearly demonstrates that financial manias are very real, and they are the direct result of people holding irrational beliefs about potential future gains or risk of loss. (See: Housing bubble’s defining delusion: real estate only goes up)

In a new paper, economists Patrick Bayer, Kyle Mangum and James Roberts make great use of these features to study the mid-2000s U.S. housing boom. Their landmark results ought to have a major effect on the debate over asset bubbles. Bayer et al. find that as the market overheated, the frenzy spread like a virus from block to block. They look at the greater Los Angeles area — a hotbed of bubble activity — from 1989 through 2012. … They found, unsurprisingly, that the peak years of 2004-2006 saw a huge spike in the number of new investors entering the market. So what was making all these newbie investors start buying houses? … if lots of people were buying investment properties nearby, it made other people in the area much more likely to buy an investment property. When properties were flipped — bought and then resold quickly — it had an even bigger effect in terms of drawing nearby people into the housing market.

People saw others making easy money, and they wanted some for themselves.

This is strong evidence that people were copying their neighbors’ behavior. When people saw other people buying and flipping houses, they started doing it themselves. … Even more startlingly, Bayer et al. found that housing investors who mimicked their neighbors ended up performing worse than other investors. …

This isn’t startling at all when you consider these were speculators and not investors. These people were attracted to the market because short-term price increases were large, so they extrapolated those price changes to infinity and believed they would make a fortune.

In housing it’s better to invest in cashflow than speculate on appreciation.

The lesson appears clear: Bubbles exist. Investors aren’t just rational, patient, well-informed, emotionless calculators of risk and return. Now the job is to figure out what really makes them tick.

Spotting a bubble isn’t really that hard. First, look for a short-term price increase that people can extrapolate to infinity. Second, find some plausible way for people to deny the too-good-to-be-true nature of their foolish extrapolation. Once those items are in place, it’s generally on a matter of how much the bubble inflates and when it pops.

A bubble here a bubble there

When I wrote The Great Housing Bubble, I scoured the academic journals for some insight as to why some markets bubbled and some did not. Some economists, like Paul Krugman, contend that growth restrictions that constrain supply are causal factors because the housing bubble was concentrated in coastal regions where development is more restricted than inland areas. There is some truth to the constrained supply argument; it can serve to precipitate the initial price movement that excites bubble thinking, but beyond that point, continuing price movement is purely a function of greed inducing people to buy because they want to capture the riches of appreciation.

The growth restriction argument does not explain the housing bubble in Florida. I have worked in the land development industry in both Florida and California, and I can tell you California’s process is much more restrictive of suburban sprawl. There was no shortage of supply in Florida as the glut of empty homes in South Florida attests to.

The growth restriction argument may explain why some some markets are more bubble prone because the restrictions are akin to lighting a match in a gas-filled cavern. The sparks may or may not cause a bigger explosion; it is merely a catalyst. Our current market conditions have potential to precipitate another bubble. Hopefully, the new mortgage regulations will prevent it, but with the government backing our entire mortgage market, and with plenty of fees to be made, the banks have incentive to try it again.

Show me the money

The real culprit in a housing bubble is expanding home mortgage balances — people take on more debt and bid up prices. The real question is, “why do people do it?” The short answer is to capture appreciation, but the truth is more nuanced.

In order for home price appreciation to motivate people to pay stupid prices and inflate housing bubbles, they need a way to access this appreciation. The more immediate and plentiful this access to money, the more motivated buyers are to borrow and cash out. Mortgage equity withdrawal is the doorway to appreciation; it makes houses very desirable and very valuable.

Paul Davidson, USA TODAY, March 28, 2016

Home equity loans are back! No, it’s not the roaring mid-2000s again, when Americans turned their houses into ATMs.

Have you noticed that whenever we read a report on how people are going back to their old bad habits reporters assure us it will be “different this time?” I don’t find their assurances very comforting. Do you?

But credit-reporting agency Equifax is expected to announce soon that lenders originated home equity lines of credit with limits of $146.1 billion in 2015, up about 20% from 2014 and the third straight year of growth at that level or higher. The total is up sharply from $73.2 billion in 2011 but still well below the more than $350 billion originated in 2005. “The home equity lending market is improving,” says Equifax Chief Economist Amy Crews Cutts. “Yet we are still seeing very tight underwriting.”

Let’s hope so.

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