Rational Actors: What We Knew

I have blogged in the past on our decision to rent our house out (rather than sell it) and just a little bit on the ideological food fight over human decision making going into the crisis. Before the crash, did lenders and home buyers act rationally (according to perverse incentives) or did they simply lose their minds? I can only provide insight into one tiny transaction within the housing boom, the one I was involved in.

Why did we buy the house? What were we thinking? In hindsight it is clear that the correct decision would have been to defer buying the house to avoid the 25% decline in asset valuation. But when we bought in 2006* (near the top of the market), what did we know?

• We knew we wanted a house. We were old enough, and had rented for long enough that we wanted to try it the other way.
• We knew that we would have to live in the house for at least 4 or 5 years just to break even on high transaction costs related to housing purchases. We had no intention to sell the house on a shorter time frame. (In hindsight we ended up leaving after 4 years - a bit earlier than expected.)
  
• We knew the house was unlikely to appreciate in value. We were aware that the rent-to-mortgage ratio was pretty far out of whack, and we believed that house prices couldn't really go up any more. In other words, we had no speculative interest.
• We "knew" that high housing prices were sustainable. Before Washington DC, we had lived in Boston, and I had worked in San Francisco, two markets with sustained unusually high housing costs. So it didn't seem implausible to us that in the suburbs of Washington DC, housing prices could simply remain high.
• We knew that we could get decent financing with a manageable fixed long term interest rate, and that this was desirable. We put down a very large down-payment. We had no expectation of strategic default at all.
• We knew that there had been rapid turn-over and price appreciation (a "boom") in the housing market over the last few years, with crazy things going on (bidding wars, no inspections, etc).
• We knew that there were tax incentives to pay a mortgage rather than rent, and we could do a monthly-cost analysis to show that we'd get a reasonably good deal (in terms of monthly payment) despite rent-to-mortgage ratios.
  

We did not know that underwriting criteria had so totally fallen apart; stories of NINJA loans and liar loans were not mainstream and the Giant Pool of Money was two years away. And we had no idea why Wall Street would make loans that would not be repaid (nor did we realize that this they were doing such a thing).

We also did not think that Washington DC was likely to suffer a real-estate bust they way Texas did in the 80s; it seemed that the government was hiring lots of people and would keep on doing so and that the housing build up was reasonably permanent, similar to other high-priced east coast cities. The notion of a nation-wide, rapid, steep housing crash wasn't on our radar; we didn't recognize that the volatility in housing prices we were seeing was, in fact, real volatility.

So putting it all together: our purchase of the house was not speculative. We expected flat home values and tolerable expenses, and we were willing to accept that to not rent. We had no sense of the price volatility that a house might display.

Better Late Than Never

I started reading finance books after we bought the house; before the house purchase, my strategy was "save money for the house." It was only after the house down-payment was paid for that I started to ask "what else to save for."

So one of the questions I have to ask is: had I read all of the books first, would we have avoided buying the house? Upon writing up our assumptions, I think the answer is "no". In particular, simply making a case that houses are tied to interest rates and interest rates can be volatile would not have scared us off. Houses are illiquid and expensive to sell, so we would have expected a rate spike (even a serious one) to only slow the market down, not murder it. The missing piece of information was the huge exposure to ARMs and deteriorating lending quality. It's not that this information wasn't know-able back then, it's that we didn't know about it.

If you want to categorize this transaction, the best label is probably "information asymmetry".

* This is not meant to be a "cry-me-a-river" post regarding the house; we are very, very lucky that we were able to absorb the loss without having to put our career and life plans on hold. Many others are not so lucky.