The Irrational Exuberance Myth:
What Actually Causes House Price Bubbles
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What happens when an economist untrained in how the home trading infrastructure works becomes a go to expert on that infrastructure itself? What happens when you don't have the expertise to explain a market outcome and instead seek to find an explanation and gain fame regardless of how ignorant the explanation you offer actually is?
In the world of economics what happens is critical acclaim and universal belief amongst your fellow economists that your solution was valid. You are allowed to create a fraudulent House Price Index that is commonly cited as being correct. You are invited to speak to the Bank of Canada where you chastize others for how they approach economics by citing reasons of concern that expose your own mistakes, yet no one notices. This is what this issue of Debunked will address. The Irrational Exuberance Myth, how rational and prudent Home Buyers became labelled as financially irrational and the cause of why House Price Bubbles form. |
The Myth
In the most basic terms "Irrational Exuberance" describes a room filled with 1000 children where each child has $10 dollars to spend at the lunch counter that only sells vegetables and no sweets. Ten of the children brought a Chocolate Bar into that room which all the children now want to eat.
After one owner of a Chocolate Bar is offered first $1 then $2, one of the Chocolate Bars is traded and the buyer eats it in front of the other 999 now jealous kids.
Seeing someone get $2 for a $1 Chocolate Bar another of the remaining 9 children with Chocolate Bars offers their bar for sale for $3. Many hands now go up as only 9 bars are left in the room. That 2nd bar ended up costing $4 to eat as one child wanted it more than others.
The process continues and with each bar being eaten and fewer bars being seen as available to buy, a buying frenzy happens because we all know children lack the restraint to wait til school ends to visit the candy store. When the last remaining bar sells for $20 after two children teamed up to buy half each, all the children go back to class and 989 can't wait to hit the candy store after last bell to get a chocolate bar for $1.
Yes, the children acted irrationally and we all know the exuberance a child has when offered a Chocolate Bar. Adults spending hundreds of thousands of dollars and entering 25 year debt payment agreements are simply not children and it is insulting their intelligence to suggest they are.
After one owner of a Chocolate Bar is offered first $1 then $2, one of the Chocolate Bars is traded and the buyer eats it in front of the other 999 now jealous kids.
Seeing someone get $2 for a $1 Chocolate Bar another of the remaining 9 children with Chocolate Bars offers their bar for sale for $3. Many hands now go up as only 9 bars are left in the room. That 2nd bar ended up costing $4 to eat as one child wanted it more than others.
The process continues and with each bar being eaten and fewer bars being seen as available to buy, a buying frenzy happens because we all know children lack the restraint to wait til school ends to visit the candy store. When the last remaining bar sells for $20 after two children teamed up to buy half each, all the children go back to class and 989 can't wait to hit the candy store after last bell to get a chocolate bar for $1.
Yes, the children acted irrationally and we all know the exuberance a child has when offered a Chocolate Bar. Adults spending hundreds of thousands of dollars and entering 25 year debt payment agreements are simply not children and it is insulting their intelligence to suggest they are.
What is a House Price Bubble
A house price bubble begins the moment houses are selling for more than their replacement value. The greater the difference between selling price and replacement price the bigger the bubble grows.
How do House Price Bubbles Inflate
The Government establishes the legal minimum requirements under which Mortgage Debt can be assigned to any Home Buyer. One of those legal minimum requirements causes all House Price Bubbles to form and inflate. The maximum Loan to Value Ratio (LTV) is a legal minimum requirement established by the Government that causes all House Price Bubbles to form. It is the Valuation component of the Ratio that allows all House Price Bubbles to form and finally forces them to pop!
The Value component in LTV is established using a measure of value that is derived from an Appraisal which in turn is required by the Government to be completed following a set methodology. The set Appraisal methodology uses the Value of Similar Homes Sold and it applies a Time Adjustment to compensate for changes in house prices from when the similar home sold. It is that simple Time Adjustment that causes 100% of any House Price Bubble to exist. In other words, if enough Similar (Comparable/Comps) Homes were sold in the previous month or even two months, no Time Adjustment would be a needed in the Appraisal methodology. Unfortunately less than .0001% of Appraisals ever done did not have a Time Adjustment to at least one similar home and over the vast majority of history a Time Adjustment was applied to all similar homes used.
The Time Adjustment most commonly used is MLS Average Price or MLS Median Price. At times an MLS Sub-District or MLS Housing Type Average or Median could be applied. Alternatively so-called repeat sales indices or benchmarks can be used but since both of these simply mirror the identical change of the Average or Median over time, you still are back to MLS Average and Median.
If a Similar Home sold 12 months ago at $100,000 and the MLS Average Price increased 6% over those 12 months a Time Adjusted Increase of 6% would be applied to that Similar Home's selling price which inflates that price by $6000 now totalling $106,000.
If another Similar Home sold 6 months ago for $102,950 a 6 month Time Adjusted Increase of 2.96% would be
applied to that Similar Home's selling price which inflates that price by $3045 now totalling $105,995.
Understanding that this exact same methodology was used to establish the LTV at the time each of the Similar Homes were sold gives some insight into how repetitious the Time Adjustment really is, as it is a self perpetuating inflationary part of the methodology.
The simple truth is that if no Time Adjustment was applied and instead at most an Inflation Adjustment was allowed, House Prices would not increase above their current replacement cost because LTVs for Mortgaging purposes would stop any bubble forming.
The Value component in LTV is established using a measure of value that is derived from an Appraisal which in turn is required by the Government to be completed following a set methodology. The set Appraisal methodology uses the Value of Similar Homes Sold and it applies a Time Adjustment to compensate for changes in house prices from when the similar home sold. It is that simple Time Adjustment that causes 100% of any House Price Bubble to exist. In other words, if enough Similar (Comparable/Comps) Homes were sold in the previous month or even two months, no Time Adjustment would be a needed in the Appraisal methodology. Unfortunately less than .0001% of Appraisals ever done did not have a Time Adjustment to at least one similar home and over the vast majority of history a Time Adjustment was applied to all similar homes used.
The Time Adjustment most commonly used is MLS Average Price or MLS Median Price. At times an MLS Sub-District or MLS Housing Type Average or Median could be applied. Alternatively so-called repeat sales indices or benchmarks can be used but since both of these simply mirror the identical change of the Average or Median over time, you still are back to MLS Average and Median.
If a Similar Home sold 12 months ago at $100,000 and the MLS Average Price increased 6% over those 12 months a Time Adjusted Increase of 6% would be applied to that Similar Home's selling price which inflates that price by $6000 now totalling $106,000.
If another Similar Home sold 6 months ago for $102,950 a 6 month Time Adjusted Increase of 2.96% would be
applied to that Similar Home's selling price which inflates that price by $3045 now totalling $105,995.
Understanding that this exact same methodology was used to establish the LTV at the time each of the Similar Homes were sold gives some insight into how repetitious the Time Adjustment really is, as it is a self perpetuating inflationary part of the methodology.
The simple truth is that if no Time Adjustment was applied and instead at most an Inflation Adjustment was allowed, House Prices would not increase above their current replacement cost because LTVs for Mortgaging purposes would stop any bubble forming.
Price Confirmation Repetition
House Prices are confirmed to Home Buyers by two primary sources. The first source is a real estate sales person who councils the Home Buyer in giving guidance on what a home is worth. The secound source is the Government which by accepting an LTV created from the current Appraisal methodology not only confirms to the Home Buyer that the purchase price of the home is priced accurately enough to secure the integrity of the nation's financial systems (ie Banks) but it also provides support to the guidance provided by the real estate sales person, once again perpetuating the inflationary part of the methodology in the form of an authoritative confirmation.
It would be irrational for a Home Buyer to believe the Price they are paying is exuberant when the two sources they primarily rely upon for house price guidance, are stating the price is rational and supported by those same two sources. It is the Repetition of Price Confirmation and the authoritative nature of that confirmation that leads to rational decisions being made in what a Home Buyer believes is a prudent price determinant manner.
It would be irrational for a Home Buyer to believe the Price they are paying is exuberant when the two sources they primarily rely upon for house price guidance, are stating the price is rational and supported by those same two sources. It is the Repetition of Price Confirmation and the authoritative nature of that confirmation that leads to rational decisions being made in what a Home Buyer believes is a prudent price determinant manner.
Solutions can only begin when we accept and then admit that house prices do not in fact change in any 62 day period. It is the fact of the extreme rarity of finding two or more Similar Homes, (required to determine value as comparable sales), selling within any 62 day period that allows the myth, that prices do change and a Time Adjustment is required, to make up for this market reality. Accepting and admitting that Time Adjustments are themselves determined by changes in MLS Price metrics which in turn only change themselves because of compositional change to what is being included in those metrics, during the month, would be challenging for any Government body to admit. It would certainly bring down organized real estate as we know it to an end.
The only solution is a new methodology to measure whether house price change is taking place or not and any Time Adjustment made to establish an LTV for the lending of mortgage principle uses that new measure. Such a methodology is simple and is able to withstand a peer review assessment unlike all current measures of change cannot.
Such a methodology has been created and awaits implementation.
Such a methodology has been created and awaits implementation.
Conclusion
House Price Bubbles do not form because of the irrational and exuberant decisions of Families seeking to secure their lives through homeownership. On the contrary, the prudence of Canadian families who purchase and then own homes is recorded in monthly arrears data the last 40 years and this is a testament to just how rational and prudent they always have been.
Canadians historically have relied upon two authorities for guidance on what they should be willing to pay for a home. First, they rely upon real estate sales people, a group where the majority doesn't average the sale of a single home a year, yet the organization that represents them cites their expertise. Secound, is the Government through its mandating of a maximum Loan to Value that is established from an authoritative Appraisal approving the mortgage loaned. These authorities provide repetitive confirmation to the Home Buyer that they are making a rational determination on price. It is demeaning and insulting to suggest it is the Home Buyer who is to blame as outlined in the myth we are debunking.
House Price Bubbles will continue to form then pop and in turn cause massive financial damage to the average family and to the national economy until we revise how LTV is determined. Canada's Gross Domestic Product which is dominated by household consumption will continue to falter unless we address this issue and end the cyclical damage House Price Bubbles create.
Finally, changes can be made to all other legal requirements tied to mortgage lending like GDS, TDS or Down Payment but those changes will not solve the problem but rather only extend the time required before a Pop happens. Canada only needs to look back to 2017 and 2018 when the Government's financial authority reduced the Maximum GDS and TDS to a historical low yet obtained just the opposite intended outcome because of the Time Adjustment methodology used for LTVs, worked in tandem with that change in GDS and TDS to drive the time adjustment itself even higher.
We have a solution. We will provide it FREE of charge to any Government body.
Canadians historically have relied upon two authorities for guidance on what they should be willing to pay for a home. First, they rely upon real estate sales people, a group where the majority doesn't average the sale of a single home a year, yet the organization that represents them cites their expertise. Secound, is the Government through its mandating of a maximum Loan to Value that is established from an authoritative Appraisal approving the mortgage loaned. These authorities provide repetitive confirmation to the Home Buyer that they are making a rational determination on price. It is demeaning and insulting to suggest it is the Home Buyer who is to blame as outlined in the myth we are debunking.
House Price Bubbles will continue to form then pop and in turn cause massive financial damage to the average family and to the national economy until we revise how LTV is determined. Canada's Gross Domestic Product which is dominated by household consumption will continue to falter unless we address this issue and end the cyclical damage House Price Bubbles create.
Finally, changes can be made to all other legal requirements tied to mortgage lending like GDS, TDS or Down Payment but those changes will not solve the problem but rather only extend the time required before a Pop happens. Canada only needs to look back to 2017 and 2018 when the Government's financial authority reduced the Maximum GDS and TDS to a historical low yet obtained just the opposite intended outcome because of the Time Adjustment methodology used for LTVs, worked in tandem with that change in GDS and TDS to drive the time adjustment itself even higher.
We have a solution. We will provide it FREE of charge to any Government body.
