The Human Bubble, pt. 1

Mr. Bishop: How's it going, rook?

The Rookie: Not so well, I'm afraid. I'm far underwater on my home mortgage and am thinking about walking away from it. Do you suppose that's an ethical thing to do?

Mr. Bishop: I'm just a bishop and therefore can't pretend to be an authority on matters of morality. What's your opinion?

The Rookie: I'm looking at it strictly from a business perspective, in which case it seems like the best course of action is to walk away. Then again, perhaps I don't have the best judgment in matters of business and money. I bought that house because, at the time, I thought that prices were going to continue increasing and that soon I would be unable to afford any house at all. Alas, who could have foreseen such a reversal of fortune from the good times of just a few years ago?

Mr. Bishop: Well, now that may be a question I can answer! I suppose the person who would have foreseen the reversal of fortune would have been someone who knew about the Palm IPO during the dot-com bubble.

The Rookie: What? You mean the company that makes PDAs?

Mr. Bishop: Yes, exactly. In the year 2000 Palm was owned by 3Com, who decided to spin off the company in a public offering. Soon after, Palm's stock price soared to dizzying heights. Then the tech bubble popped and Palm's stock price came crashing down.

The Rookie: Sure, I understand that bubbles exist and that markets sometimes behave irrationally. But sometimes markets behave rationally when prices increase. How can one tell the difference except after the fact? What's so special about Palm's IPO?

Mr. Bishop: What's special is that the IPO was obviously a bubble based on simple fundamentals knowable at the time. 3Com didn't spin off the whole company; rather, they spun off a small fraction of it while maintaining ownership of the remaining majority. But in the frenzied buying of the IPO, the market cap for the entirety of Palm became larger than 3Com's market cap.

The Rookie: I don't follow.

Mr. Bishop: Basically, the market was saying this: that something 3Com owned was worth more than all of 3Com put together. That's saying that 3Com had a negative net worth when excluding their Palm subsidiary.

The Rookie: Oh, I see. That does seem to be a contradiction, being as how 3Com was and is a successful company. But again, how does Palm's IPO relate to the housing bubble? There was nothing inherently contradictory about the rise in housing prices a few years ago. Based on what we knew at the time, it could have been a permanent trend, right?

Mr. Bishop: You said that when you bought your house you were afraid that prices could continue rising and you would soon be unable to afford a house, correct?

The Rookie: Yes, I did.

Mr. Bishop: And at the time you were stably employed and earning good money, correct?

The Rookie: Yes.

Mr. Bishop: So if you, due to rising prices, were to become unable to afford a house then who exactly would be able to afford one?

The Rookie: People who had even more money than I.

Mr. Bishop: Which is a smaller number of people than the number of people who have as much or more money than you, correct?

The Rookie: Yes, obviously.

Mr. Bishop: And all during this time the number of houses is not decreasing, correct?

The Rookie: Correct. Houses were being constructed everywhere they could squeeze them in, it seemed.

Mr. Bishop: So let me summarize. You were afraid that a resource of increasing availability was going to become affordable to a fewer number of people.

The Rookie: Well, when you put it that way...

Mr. Bishop: Did you imagine entire tracts of newly constructed houses lying vacant for want of an owner who could afford them? Did you imagine prices continuing to rise further despite high vacancy rates?

The Rookie: No, of course not. What if other people had become wealthier in comparison to me? They could have maintained the price increases. People who already owned houses were, in fact, gaining wealth quite rapidly. Maybe these vacant houses you describe would be bought as second homes by existing home owners using their primary homes as leverage.

Mr. Bishop: Sure, and some were. Equity in one house may be used to buy another house. But houses do not undergo mitosis; at some point the money borrowed to buy a house must be paid off, and eventually it must be paid off using money made outside of the house's appreciation itself.

The Rookie: So you're saying that a rise in housing prices by itself cannot sustainably drive housing prices upward? That makes sense.

Mr. Bishop: For you to have become priced out of the housing market—assuming a stable supply of houses—then either others would have had to come into more money or else you would have had to come into less. We already established that at the time you were stably employed. Did you expect others to begin making more money then you—on average?

The Rookie: No.

Mr. Bishop: So there was nothing to fear. It would have been impossible for prices to continue increasing.

The Rookie: Yes, I suppose you're right. I feel like such a pawn. But still one question remains.

Mr. Bishop: Which question is that?