Herd Behavior vs Casino Gambling

When I was a kid my parents had a pool with a 10 foot bottom. Sometimes I would play games in the water. One of my favorites was tying an anchor from my Dad's boat around my ankle and throwing it into the deep end of the pool. I would spend 2 minutes trying to untie the knot and then if I couldn't, I would grab the anchor, get in a crouch on the bottom of the pool and push myself up to grab the pool ladder. When my Mom found out about the anchor in the pool she kind of freaked out.

Contrast the pool anchor to the high wire acrobatics that some high end buyers are choosing to perform today. Let me recap.

There are thousands of examples in the areas that I follow of high end buyers that took on far to much risk and are presently underwater. There are many others that bought at fair prices before 2001 but have used their homes as ATM's and are presently underwater. As a behavioral economist I have noticed that this herd-like mentally has become very common in the last 15 years. With the collapsing of the interest rate mega bubble and the easy money policy by our Federal Reserve many people have become "financial geniuses". These "financial geniuses" through no ingenuity of their own have been able to make huge profits in speculation. Other people see this behavior and want to emulate it. This is herd behavior and is very human .

What is happening now seems very foreign to me. Now that the interest rate mega bubble, the housing bubble and the credit bubble are collapsing why are people still choosing to make huge gambles in the high end real estate market? There is no one to emulate. It's not herd behavior. It's just flat out speculation. Purchasing in any high end area of the Bay Area is taking on a huge risk with almost no chance of gain in the end. Unless the thrill of owning a house is worth the cost of overpaying a million dollars or more in rent for 30 years plus the immediate downside risk of over $300,000 when house prices correct to fair value in 5 years.

I go through the actual numbers in my last post called "Immediate Gratification?".

Let me explain one simple fact that is understood by absolutely no one today. Buying a home is renting. It is not like renting. It is in fact renting. You are renting money from the bank. The only difference in renting money from a bank compared to renting a home is that instead of a month to month lease you are tied to renting money for 30 years or until you sell your home.

Some might argue that you can refinance your loan. Let me explain another fact that no one understands. We are at the end of the interest rate mega bubble and are starting a new one. When you are in the upslope of an interest rate mega bubble you can't refinance because your equity is being wiped out as interest rates are increasing. Plus why would you want to refinance at a higher rate anyway. It doesn't make sense.

Some might argue that a house is "inflation protection". Let me explain again. We are in a contracting economy with no inflation on the horizon. It could be 7 years before we stop contracting. If you have any questions about this comment just google "Japanese lost decade". The Wall Street economists that are guiding our policy decisions are the same ones that were used by Japan to create twenty years of economic contraction. I also write about "inflation protection" in my "Immediate Gratification?" post.

Why would one bet on "inflation" when we are presently in "disinflation". Anyone that is buying an overpriced asset as "inflation protection" is betting that the people at our Federal Reserve that didn't notice the biggest housing bubble in history will be able to create Latin American style inflation without interest rates rising. If you are buying an overpriced house in a high end area now, it is a million to one bet, that if you win you are just given your money back. Good luck with that wager. I think that I will sit this one out and watch.

While I'm on a roll let me include one other fact that no one understands. Our housing market according to the latest Federal Reserve figures has a net worth of $6 trillion. We have outstanding mortgages on that $6 trillion dollar investment of $10 trillion. So as a country we have decided to create $10 in debt for every $6 in equity. We are debt slaves to our homes. Before it was a figurative expression that owners are renters through the banks. Looking at the present figures owners have literally become leaseholders that are overpaying the price of rent as they are locked into 30 year leases.

Back to the pool anchor. Would I vote to outlaw anchors in pools? Absolutely. There are just to many people that are willing to take risks far beyond what is prudent. The anchor that I spoke of above was an 8 pound plasticoated dingy anchor. At the time I could have given a pearl diver a run for their money. I could tread water while I held it. I could have repeated the game a million times without a problem. These were the variables then. But changing one variable would make it far to risky. People in general are very poor judges of risk. Plus there are always people that overextend a game and create more risk than is tolerable. An example would be anyone that is choosing to pay bubble prices to buy into a high end market.

In most high end markets people have gone beyond good natured herd behavior. There are less and less suckers to pass the overpriced asset to. There is absolutely no driver to warrant the behavior. No herd behavior, why would you emulate people that are losing money. No profit motive as I have shown in many times in my previous posts. It's just an individual madness to own a home no matter how overpriced it is. It is casino gambling and the "house" almost always wins in the long run.

It was a little painful to watch during the housing bubble as people were overpaying for homes. But it was so human, this herd behavior. The present high end real estate market is driving me nuts. That's one of the reasons that I started this blog, as kind of an outlet for my angst as I watch people make very bad decisions. It is not herd behavior anymore, it is flat out speculation in a negative economic environment. Casino gambling by a nation of "financial geniuses" who don't understand that the last 25 years of easy money was a once in a century aberration and not a birthright. It is mathematically impossible to recreate this madness in the same way that it is impossible for someone that is underwater in their home to borrow another $250,000 from the bank. We are tapped out and Uncle Sam the loan shark is soon to run out of easy money. The game is over. When you buy an asset it has to make financial sense. It has to be affordable and the worse the economic environment the more affordable the asset must be.

It was impossible to document all of the bad decisions of the past 8 years because there were so many. But of course it was a mania so it is better to document the event in the aggregate. But now is different. The group is not driving prices anymore in high end areas as herdmembers are leaving the market. The market is being driven more and more by individuals. Unfortunately some of these individuals are tying a boat anchor very tightly around their necks. It will have a bad effect on the whole high end market as we trend toward affordable prices.

I would like to document some individual sales that are creating some of the Lafayette Lotto(see my Lafayette Lotto post) winners. These casino gamblers that are risking everything for no chance of gain.

Looking at the sales from 1/1/2010 it is comforting to see that prices in Lafayette are trending downward toward fair value. But there are still uninformed individuals that are grossly overpaying for individual homes and slowing the fall in prices to affordability for everyone while they are taking on huge risk to themselves. I would like to use examples gleaned from Property Shark to track the markets trend back to the fair value prices of 2001.

My first example will be a sale in Burton Valley in January. It sold for $1.1 million. It is an average home built in 1962 on a quarter acre lot. The purchase price works to over $503 a square foot. Close to peak bubble price. This home sold for $397,000 in 2001. This will be property "A" from January 2010. In 5 years it could trend to $300 a square foot while each month the owner is overpaying rent by 100%.

I would like to interject that 99% of the people that read this blog will not understand what I am talking about. They are not able to comprehend the idea of fair value because it is a foreign concept. We have lived in a period like none other with money falling from the trees. That is what you are used to just as someone that lived through the Great Depression saved 25% of their income and kept it under the mattress. We are a product of our environment. So if what I just said did not make sense don't worry about it. I will have another chance in two years to explain once the data is in. You will be able to see the trend downward. Of course you can deny it then also. In psychology I guess that is called a self defense mechanism. But be aware that there will be some point in the future where everyone will realize that money does not fall from trees. Where saving and productivity gains are the way to increase our standard of living. Not easy money bubbles, government pork and horrendous amounts of debt. The sooner that you realize this the better off you will be. The sooner that our society realizes this the better for everyone, especially our children.

Speculation with debt is so ingrained in our society it is almost impossible for investors to step back and look at value. Believe me I know. I have spent the last 15 years getting blank stares from people when I explain the principle of fair value.

Would I purchase a home in a lower end area like Anitoch? Absolutely, prices there are affordable compared to rents, household income and historical trends. Would I buy a home in a higher end area? I would much rather tie an anchor to myself and throw it in the pool.

My next post will explain why there is no such thing as a value investor.