Tiptoe Through the Tulips

There once was a time when a flower cost the equivalent of seven years’ salary. 

In this case the flower was a tulip, which was introduced to Europe in the 16th century. Now, tulips are lovely, and if you had never seen them, I’m sure you would have been excited. You’d probably even overpay slightly to get the latest one for your garden — it would be a nice conversation piece, after all.

In the Netherlands, though, things got a bit out of hand. The price of tulips rose quickly, especially for rare and unusual types. In 1635, 40 tulip bulbs sold for 100,000 florins — a sum that would’ve purchased 1,000 tons of butter or 3,300 pigs. Tulip bulbs were listed on local stock exchanges. Tulips were valuable simply because they were valuable.

It couldn’t last, of course. By 1637, prices flat-lined, then declined. After all, tulips were just flowers, and when that realization struck the Dutch, many fortunes were destroyed. 

Tulip mania, as it has come to be known, is a classic example of a bubble economy. Something starts out rising in value for legitimate reasons — in the tulip’s case, its novelty and rarity.  But soon, the rise in price becomes self-reinforcing  and detached from logic.

A more recent example that many of us lived through was the dot-com bust.  Yes, the internet was a marvel of technological innovation and a transforming invention in human history, but even then, it didn’t justify the sort of ludicrous valuations that dot-com stocks reached. Ultimately, people wised up, the bubble burst, a recession hit — and slowly, values of tech companies reached sane levels.

Now, if you’ve read this far, you might suspect that I have a point, and I do. During the past 10 years, home mortgage lenders have become quite creative. They’ve invented fun programs like the:

• Interest-only loan. You pay only the interest for the first 10 years and then the loan converts to a 15-year adjustable rate mortgage.
• No-docs loan. You need to make $75,000 for this loan. What? You only make $12,500?  Well, just write on this piece of paper, “I make $75,000.” Voila!
• The 2-28. This old standby is fixed at a crazy-low rate for two years then adjustable thereafter. 

Now, all this creativity did three things.  First, it drove the demand for home ownership, by allowing people to finance homes they would not otherwise have been able to afford.  Second, it drove home values through the old Econ 101 supply-and-demand logic. Third, it drove consumer spending, as homeowners used home equity lines of credit and refinancing to take increased value out of their homes and convert it to cash.

Of course, all that creativity was great, but the downside was obvious: by financing people who couldn’t otherwise qualify for loans, people ended up taking out much bigger loans than they could afford. The family who might have been able to swing a $160,000 townhome instead bought a $300,000 house because their lender sold them on a 2-28 without fully disclosing what that meant.

And now, unsurprisingly, as these loans end their fixed period, they’re adjusting — radically. People who could just barely swing the $1,400 monthly mortgage find themselves trying to make a payment that has jumped to $2,200, a trend that shows no sign of falling anytime soon. Delinquencies in the subprime market and foreclosures have spiked. At least one lender, New Century, appears to be in danger of going under. The result is that lenders have suddenly tightened their lending practices, but that only exacerbates the problem at this point. 

With foreclosures on the rise, more houses are available at the precise time that fewer buyers are available.  What happens when supply outstrips demand?  Right, home values fall.  Not only do subprime borrowers find themselves in trouble, but even those with good credit find that they can’t get that home equity loan anymore because they don’t have equity in their home. This keeps people from refinancing mortgages to pay off credit cards. The credit card companies tighten their lending practices because of all the outstanding debt and declining cashflow. And the economy becomes further depressed.  Meanwhile, what happens to all those jobs in construction, real estate, and banking that depend on home sales?  They’re flat-lining.

It won’t last forever, of course. Houses aren’t tulips. They have intrinsic value. At some point, prices of homes will fall enough to reignite the market. When the $350,000 homes fall to $250,000, people will buy them. In many ways, the correction will be good — it will make housing cheaper in the long run.

But the collapse of the housing market won’t be fun for anyone involved. And it will pile pain on top of what most Americans are already facing.  At this point, it’s hard to see anything stopping it; all we can do is pay attention to what happens when we lose sight of the true value of things, and what happens when government eases regulation to the point of laissez-faire.  Sometimes, it’s helpful to have someone whose job is to question whether a tulip is really worth $350,000.