It's Pure Speculation

Lenders would have benefited from a lesson on the Florida land boom of the 1920s.

April 1, 2010

There’s a lot you can learn about today’s real estate market by looking closely at our past.

If you go back to the late 19th century when reliable housing records were first kept, you’ll find that for 100 years starting in 1896, housing prices generally tracked the inflation rate.

Then, between 1996 and 2006, housing prices suddenly doubled. The problem, of course, is that average incomes did not rise anywhere near that quickly.

History tells us that it’s impossible for housing prices to exceed income gains for any sustained period—unless there’s an enabler, a speculator’s tool that allows this to happen. What was the enabler? It was, in my view, the adjustable-rate mortgage.

In 1980 Congress passed the Depository Institutions Deregulation and Monetary Control Act, which, among other things, made it legal for banks to charge a higher mortgage interest rate to less creditworthy customers. Two years later, Congress passed another law that for the first time allowed ARMs. Prior to this act, they were illegal.

Once these acts were passed, a real estate crisis became inevitable. It was only a question of when the stars would align for such a disaster to occur. As we know now, the mania didn’t arrive until the early 1990s, when real estate prices rose relentlessly until 2007.

The good times seemed like they’d never end. Buyers rushed to get in on the action, even if they really couldn’t afford to. They thought they couldn’t lose because no matter how much they overpaid, rising prices were going to bail them out. The greater the risks, the greater the reward. Or so it seemed.

A Familiar Story

In all of American history there has only been one prior real estate bubble that resembles the boom and bust we’ve just experienced. It was the great Florida land boom of the 1920s. And just as with the modern real estate bubble, prices rose fast largely because a spectator’s tool was in play.

The device used in Florida was the so-called "binder." This real estate term has gone out of use today, but the binder was an option payment that served essentially as a down payment. Investors would buy the binder for a fraction of the property price and try to flip it for a fast profit. Buyers thought they were speculating on real estate but they were really speculating on real estate options. When prices grew out of control and investors backed out, the market came to a halt.

Options Always Expire

The stock market has long been the ultimate proving ground for speculative investors.  Stock options offer tremendous leverage—you can make a killing on a chump-change investment. But all options become worthless if they’re not exercised by their expiration date.

Like the binders of the 1920s, the modern ARMs are, in essence, options. Sure, in the right hands, under the right circumstances, an ARM can save borrowers money, but that unfortunately was not the case with most ARMs made during the housing boom.

Most were written to expire in two or three years after the fixed-interest-rate period. At that moment, the option had to be exercised or rolled over because it would otherwise become worth-less. Just as in Florida, people believed they were buying real estate, but in reality they were speculating in real estate options.

Once prices stopped rising so dramatically, many ARM borrowers realized they were in way over their head. With buyers unable to afford their mortgage anymore, foreclosures exploded. Things became incredibly ugly for the banks—massive expenses landed on their heads like a falling safe. The banks never knew what hit them.

Too bad more lenders were not better students of history.