Long before the last Los Angeles real estate bubble when real, inflation-adjusted house prices nearly tripled from 1997 to 2006 but then fell nearly in half by 2011…
… And long before the S&L bubble when real Los Angeles house prices fell over 40% from the peak in 1989 to 1997…
… There was the Los Angeles real estate bubble of the 1880s when real land prices increased 10-fold from 1882 to 1888 and then fell by one-third in one year, the next year, 1889.
Even though the population of Los Angeles was skyrocketing at the time, real estate prices still got way ahead of themselves and then busted hard.
From land speculation in New York state after the Revolutionary War, to a huge bubble in Chicago in the 1830s, to our 21st century bubble, the United States has always been a nation of real estate speculators, according to Edward Glaeser of Harvard University in his brief and paper called, “A Nation of Gamblers: Real Estate Speculation and American History,” from 2013.
In addition to the bubbles mentioned above, the paper also covers bubbles in cotton farm land in Alabama in the early 1800s, and wheat farm land in Iowa and New York City housing in the early 1900s.
One of the conclusions of the paper is that some busts trigger financial crises but others don’t.
Los Angeles Bubble – 1880s
For example, in the Los Angeles 1880s bubble, sellers were often the “banks” for their buyers. Many sellers would take down payments and then let the buyers pay the rest of the money to them over time in seller “carryback” mortgages. When that bubble burst, Los Angeles didn’t have a banking crisis because sellers absorbed a lot of the losses instead of banks.
Chicago Bubble – 1830s
On the other hand, the Chicago bubble of 1830-1841 contributed to a large financial crisis. Real land prices in the Chicago loop increased 400-fold from 1830 to 1836 but then fell by almost 90% by 1841. The Illinois legislature had sponsored the Bank of Illinois to finance infrastructure projects like the Illinois and Michigan Canal but the legislature also pushed the bank to support real estate. That Bank of Illinois money chasing real estate played a role in the boom.
The year after the bubble peaked and prices stopped increasing, Illinois had a banking crisis and banks suspended payments. The Bank of Illinois couldn’t continue to finance the infrastructure projects due to its real estate losses and eventually, in 1842, the bank declared bankruptcy.
Fortunately, in both the Chicago and Los Angeles examples, their long-term underlying economies were skyrocketing so just a couple of decades after those bubbles, the crazy high peak real estate bubble prices didn’t look so crazy.
To me, both of those bubbles have a bit of the flavor of the Dotcom bubble. Everyone knew the internet was opening up huge new economic frontiers. The long-term fundamentals looked great but prices became completely unhinged like the Amsterdam bubble 300 years ago, “The higher prices triggered additional purchases justified by those past house price increases, which in turn caused additional price increases and additional purchases, and so on until house prices were completely out of whack.”
New York State – 1790s
Going a little bit further back and although not a bubble story, Professor Glaeser mentions the fascinating case of a signer of the Declaration of Independence who at one point may have been the wealthiest man in the country. A frequent real estate investor, in 1790, Robert Morris bought 1.3 million acres of New York state land (with some degree of financing) and sold it the next year for almost double what he paid. He plowed his incredible profits into more land deals but slowly over time, he ran into “increasingly difficult credit conditions” and eventually he went bankrupt.
Here are some of my favorite conclusions from the paper.
Revert to the Mean. The paper emphasizes that larger real estate booms tend to be followed by larger real estate busts. At the end of the bust, prices are often near where they were at the beginning of the boom, or where they would have been if pre-boom price trends had continued. That is, prices in real estate bubbles tend to revert to the mean.
Underpricing of Risky Mortgages. He also focuses on a bit of market failure – lenders in real estate booms often underprice risky mortgages. He calls it the “underpriced default option.” The buyer gets to keep all the gains when prices increase but when prices fall, the buyer may default on the mortgage and walk away from the property which then leaves the lender with all the rest of the losses.
Large Social Costs. Real estate boom-bust cycles cause significant social costs, especially when they trigger financial crises. Therefore, “there may be advantages if bank regulators recognize the regular tendency of real estate values to mean revert after booms.” And presumably, that bank regulators encourage or force overly optimistic lenders to charge the full cost of risky mortgages in order to reduce the size of real estate bubbles and the economic and social damage that follow.
If buyers are particularly prone to engage in wishful thinking about future price appreciation, the policies that encourage homeowners borrowing can lead to larger social losses.
It sounds like he may be suggesting that when real estate prices are increasing unsustainably fast that mortgages need to become more expensive to reflect the real risks of real estate boom mortgages.
Added. And maybe this would be an accurate paraphrase of Edward Glaeser, ‘If
buyers mortgage lenders are particularly prone to engage in wishful thinking about future price appreciation, the policies that encourage homeowners borrowing mortgage lending can lead to larger social losses.
An earlier version of this piece was published on Forbes.com.
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