Accounting theory and contemporary issues

Why was there a housing bubble? Is the market not efficient enough to see through it?

Why was there a housing bubble? Is the market not efficient enough to see through it? The idea that market prices mirror estimates of value has always been uneasily associated with a view that represents market prices disengaged from economic reality. Recent events such as the housing or the past dot com bubble have fed scepticism as they have been completely unexpected events. A market is efficient when prices always fully reflect the available information to the investors and investors make rational decisions based on that information. The concept of market efficiency can also be understood as an implication about the speed with which prices respond to the change in information and that securities prices reflect the best possible estimates of future risks and returns. In the past few decades market efficiency theory had become the most important concept for most professionals related to the stock market including regulators. As Ronald Gilson and Reinier Kraakman observed in 1984, in their comprehensive law review article on the subject, "Of all developments recently in the financial economics, the efficient market theory has been able to achieve the widest acceptance by the legal culture, the efficient market theory is now the context in which serious discussion of the regulation of financial markets takes place" After the recent housing bubble, this notion has changed considerably, and has put serious doubt to the theory of market efficiency.

In our opinion the dotcom and the housing bubble took place because the market is not efficient and have not able to see through it. There is empirical evidence against market efficiency which includes evidence of pricing anomalies, delayed information response when new information is available, demand inelasticity, extreme price volatility of securities, and consistent superior trading by some investors. Market efficiency theory was at its peak in the 1980's but since the bubbles of 1987 and the recent housing bubble everyone has lost faith in it as it has failed.

We interviewed two different professionals in the related fields, a real estate broker and amortgage broker to obtain information about the housing bubble and efficient securities market in the real world. The real estate came to the conclusion that markets are only efficient if housing prices respond to available information not only quickly but accurately as well, and in the real world, not all information is accurate because of information asymmetry and various agency-principle problems. Furthermore, not all information is available to everyone because some companies refuse to share it with everyone to because they want to take advantage of it. Moreover, he explained that in the real world people do not share identical views of the intrinsic economic worth of particular houses which leads to the problem of how each house price may be set in a world where investors hold disagreeing opinions about the same security. If they did hold the same opinions about a particular house price, it is hard to explain why such many shares of the same company change hands, thus this also makes the market inefficient. The mortgage broker also believes that many but not all did realize that the increase in prices of homes is due to housing bubble. However, they were also trapped in this shackle as they wanted to reap some profits before the bubble bursts. The most imperative factor was the timing. Although, some recognized the housing bubble, but they invested in housing nonetheless because they expected the price to increase even further. . The expectation about prices increased with the passage of time as the bubble grew, and as the number of investors increased.

The mortgage broker also came to the conclusion that there was a housing bubble as the prices of the securities or the houses reflect the trading activities of the investors, if some investors are optimistic and invest heavily in the market, that creates a price pressure and drive the price up when accordingly to the market conditions and the information available the price should be lower than what it is. Moreover, he concluded that not all information is available to everyone because information is costly to acquire, process, and verify and there are always arbitrageurs in the market who sometimes get superior information and hope to profit if the rest of the market. Also, broker economic factors had very profound affects in the causation of housing bubble and its burst. In the pre-bubble period the Federal Reserve decrease the interest rates in order to stimulate the declining economy. Gradually, as the economy improved, Americans formed the tendency to take opportunities to borrow money at lower cost and invest to reap benefits over longer time span. This was also seen by home builders as an opportunity to capitalize on. There was a record home construction during this phase in the United States. From the broader perspective, it had looked as if the market was recuperating, as people were investing and builders and home owners generated profits. However, this same factor resulted in collapse of the economy. While banks were lending money at lower costs, they also adopted lenient lending policies. The credit checks were not conducted and income investigation was also neglected, this led even the non eligible people to obtain loans. These factors escalated the economic activities, as the banks were active in lending money, and people were active in purchasing houses and builders with their construction.

The housing bubble was one of the economic phenomena and an abnormal trend which the financial market with its complexities and sophistications failed to predict, anticipated and forecasted. It was an "economic mishap" that results in trading higher equity or securities associated with housing and real estate at prices that was considerably at variance with their intrinsic and fundamental values. It was a time where trade in stocks or assets were very much inflated values There are many explanations that have been suggested, it has been recently shown that bubbles appear without uncertainty, speculation, or bounded rationality. Often time however, this economic mishap becomes identifiable only in retrospect, when or after prices begin to drop precipitouly with the influx of market participants. The resultant drop in prices characterized as a crash or a burst indicates an end of a market run seen as though a positive feedback went beyond the normal market mechanism which figures out the equilibrium price under normal market circumstances.

The concerns for this housing bubbles is the significant negatively impact on the economy because it causes misallocation of economic resources into non-optimal uses, destroys large amount of wealth causing continuous economic malaise to investors and creating dumping public confidence in the financial and capital market system. The protracted period contributed to prolonged economic downturn for the US economy and induced price deflation close to the case of the Great Depression in the late 1930s. The aftermath of the housing bubble weighed adversely on the US economy going forward, and its effects is seen reverberate through the corridors of many other financial markets around the world. Entrepreneurs and other investors who hold on to the overvalued assets feel sense of lost and have tend to cut discretionary spending which hinders economic growth or, worse, exacerbates the economic slowdown leading to greater unemployment.

When prices in global financial markets plummeted precipitately, the housing bubble burst in United States became the epic center of discussion and analysis for many of market analysts, politicians, economists and investors. Many concluded that the housing bubble was the major cause. However, the question that was quickly over looked was how can homebuyers' activities in North America lead to derailment of the financial system so complex within such a short period of time and across the spectrum of the financial market. The answer is not far fetch when one takes a critical look at the housing sector in consequential of US government financial interventions by way of fiscal and monetary policies, the activity of Federal Reserves, market speculators (noise traders) and blatant risk takings of investors and corporate greedy by the business community, just to mention a few in a system which is considered to run efficiently.

One of the other main reasons was information asymmetry. The aura of the market was such that investors expected high returns and persistence in the increase of prices. However, the enshroud factor was availability of reliable information. The banks and mortgage companies had alleviate their lending policies and they were aware that the market is weak, as they allowed even the non-eligible to borrow loans. Interest rates are critical factor in determining the house prices. The investor expected the interest rates to stay constant. Since banks have the information about projected interest rates and an average investor does not. Had the future interest rates divulged to the investors, there would have been less uncertainty, thus less damage. In addition, real estate brokers are integral part of housing sector. They have the responsibility to project reliable information to the people about demand and market. Instead they try to mislead people by giving over optimistic view about future, to entice them to invest. Thus reliable information does not get to the investors for them to take useful decisions.

A housing bubble causes immense demand and supply of money which is generally temporary. When bubble start to unravel, a contraction take place to reduce the excess, which decrease the prices and investors suffer losses. The recent housing bubble also showed such signs, where investors heavily invested in houses causing the prices to increase, followed by depreciation in prices. A number of investors filed for bankruptcy, causing the market to collapse. People expected persistent increase in the future value of real property and due to low interest rate and lenient borrowing conditions, a number of people invested in real property. However, the outcomes were against investor's expectation and they lost their investment.

Housing bubbles may occur in local or global real estate markets. The recent housing bubble also incepted mortgage crisis. The major reason of housing bubble being low interest rates and lenient borrowing conditions, the financial institutions are now suffering deficits and collections problems. During the economic bubble, when prices were increasing financial institutions dispensed excessive money without examining credit history, which allowed even the non-eligible to borrow money and invest in the market. However, when the bubble started to contract, investors could not get the expected return to pay back their lenders, thus the market collapsed.

As the bubble matures appreciation in prices continue because of increase in the number of investors and also the demand. Housing bubble followed by decrease in home prices deeply affected the investors as they paid more than original value of the asset and their debt is more than equity. Investors don't have any subjective probability of what will happen in the future if it will be a good state or a bad state, that's the reason why they can't calculate their expected utility to base their decision on; which might result in an irrational behaviour of investors. If investors know the probability of certain outcome for sure then there is still a risk that the outcome will be undesirable and that is what happened in the housing bubble.

Over the past few years, the housing sector has seen a major shift in government interventional policy as an economic tool to boost the economy because of its quick multiplier effects. Ever since then the sector has become liable to continuous government policy as a tool to control the economy. This knowledge has become a universal concept to all and for most government in the world. The irony however is that, the world's economies have significantly become much integrated over the years, such that any economic policy or action by one economy creates consequential effect for other economies in the world within short possible time. The aggressive economic intervention by US Federal government in trying to stimulate the economy and making homes affordable for ordinary citizens amidst the already heated housing sector can be cited as one significant factor that led to the housing bubble. While the government pumped more money into the housing sector, the Federal Reserve restricting market to set exchange rates through the usual arbitrage system posed to cut interest rates to record-low levels. U.S. politicians by means of legislation, further propped up risky housing and construction ventures, boasted tax credits and incentives for housing savings accounts, offered subsidies and sponsorship programs, which ended backing lower accessibility criteria for loans & mortgages for awful lot of people that the market normally considered not creditworthy. Also many organizations with the federal government backing created further securitization of mortgages for sale which turn out to be hot investment items for many financial institutions. They insidiously repackaged, replenished and sold mortgage loans with little or no fundamental values. The Federal safety net and the provision of federal sponsored deposit insurance made most financial institutions and investment companies took greater risks than they normally do knowing very well they had the backing of the federal government to bailout under the pretext of "too big to fail". They therefore ended up in a lucrative position to privatize any gains but socialize any losses.

Another big reason for a U.S housing bubble was that U.S banks lent too much to homebuyers. The loose lending practices in U.S including approving mortgages for those who didn't even qualify for mortgages with no credit check and no downpayment,dropping the mortgage rates and reducing the subprime mortgage rates for high risk investors all supported the housing bubble2. According to the Financial Crimes Enforcement Network "Suspicious activity reports relating to mortgage fraud increased by 1411% between 1997 and 2005"Eventually what happened was that more than 120 mortgage lenders declared bankruptcy in U.S just because they approved mortgages to high risk applicants and at low interest rates who defaulted on their payments. Due to increased availability of homes and decreasing demand because people couldn't afford houses, prices dropped significantly in 2005. The household net borrowing amount of U.S was 7% of disposable income just before the bubble burst. According to 2007 statistics, the household net borrowing amount of Canada was 6.3% of disposable income which is very close to U.S. The reason why many home owners defaulted on their mortgage payments (lost their homes) was that they were driven to own homes in 2001 when government decreased the interest rates to soften the effect of recession, which eventually reduced the mortgage rates and demand for houses increased and when eventually in 2005 interest rates started to rise and those homeowners couldn't afford to own houses.

In 2005 builders built too many houses in U.S, which increased the supply of the amount of houses available in the market. As the supply was rising, demand was decreasing at the same time as people couldn't afford the houses anymore, which led to increased supply and decreased demand, which eventually burst the bubble.

Another reason was the dot com bubble that made investors to shift towards investing in real estate in 2001 which was considered to be a reliable investment at that time and hence demand was boosted which created an abnormal increase in price till 2005.

Investors consider themselves as a part of self-attribution game in a sense that as long as the prices of houses are increasing they will admire their decision making skills and the decision making skills of realtors, but in 2005 in U.S when home prices started decreasing they blamed other factors for it. And eventually this strengthens their confidence more and what will happen is that home buyers will keep on investing after they get some early signs that recession is about to end (or interest rates are about to decrease- evident in Canada, even though we are not talking about Canada, but homebuyers in Canada should take a lesson from U.S housing bubble).

In case of housing market, it was good news for investors which persisted from 2001 to late 2005 in U.S, so investors assumed it as an ideal state (prices will keep on increasing) and made assumptions to have some utility in terms of their future returns. But the reality is that we are under a non-ideal conditions and the future is more likely to be independent of the current situation as evident from 2005 housing bubble.

One other reason for the housing bubble was that homebuyers are tend to be more of risk takers because they are borrowing funds from bank even if they are personally risk averse investors if they have to use their own personal funds. This risk taking behaviour encouraged home buyers to invest in real estate property during loose lending practice period (as discussed above) in U.S.

In an essence, housing bubbles occurred because of too much money chasing after too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamental values to an unsustainable level. Once the bubble unravelled investors and homebuyers are left with less than appreciable values for the investment. Federal Reserves and the banks who shouldered most of the mortgages are left to soak up the liquidity in the financial system or risk a collapse of its currency.

No government intervention or regulations have been able to stop bubbles like the housing bubble, they are inevitable and represent that the market is inefficient and we cannot do anything about it. The government regulations after the technology bubble did not stop another housing bubble from happening and this represents that markets also depend on the moral and ethical behaviour of the principle and agency affecting it. It depends on the companies and investors who are making decisions to prevent from making the same mistakes that they made before, regulations also do not work because some of them can stop investors from making the best decisions in a crisis because they encourage safety. Regulations often tell investors to do what is best practice which is what the government found to be best at a certain period in time but it does not work for investors and companies in different times. The efficient market theory tells us that no government regulation is needed in the market as bubbles or crisis would not have take place because there are ideal conditions in the market.

In an efficient securities market there is no uncertainty about the future state of companies as all information is known, whereas in an inefficient market there is always uncertainty about which companies will be profitable and which will not be. Increase in business uncertainty activity changes the opinion of investors and potential investors, and leads to decreased investment in those sectors, compared to increased investment in a sector which offers certainty. The increased uncertainty is one of the reasons why bubbles take place in the market, as investors decrease to invest in a particular sector which leads to its downfall. In an efficient market there would be no bubbles created because investors would be certain about their investments.

The efficient securities market tells us that everyone in the market has equal information and decisions by investors and companies are based on that equal information. In the real world, this is not the case, as there are agency-principle problems where the agency has more information than the principle and leads the principle into making overinvestments in certain sectors and companies and leads the market into being inefficient. This is also known as corporate fraud, as it increases the share price of that particular company when according to the real market conditions it should be lower and eventually leads to a loss for the investor. Moreover, when the investor finds out about the fraudulent activities of the company, the investor becomes overly cautious and restrains from making decisions which leads to underinvestment in certain sectors and companies. This leads to those companies having lower stock prices when they should have had a higher price and leads to the market being inefficient.

In efficient securities market, investors cannot make a profit on trading information that is publicly available and as new information becomes available in the market, no investor can make a profit by trading on it as it adjusts itself in the market when it becomes available. In the real world arbitrage opportunities and trading strategies are created based on new information and information known only by few investors. Few investors in the market obtain more information about a company than the other investors and make arbitrage profits by selling short if they know that the information they have will drive the price of the security down or sell long if they know the information will make the price go up. This is why arbitrage investors can have an effect on the price of a particular security and make the market inefficient as rest of the investors do not know about it. Moreover, some new information by companies is so sophisticated and technical that it takes time for a market response which is why only a few investors can understand it and who then make arbitrage profits on it. Arbitrage profits and investors make the efficient market theory fail because the theory says that equal information is available to everyone and no one if better off than the other.

Investors in the market have limited funds to make investments, this makes them risk averse. Investors always want to make investment that gives them the most return with the least risk. The efficient market theory tells us that in ideal conditions there would be no risk involved as investors would know which security is going to perform well and which is not and will only invest in the one in which it makes a profit. In the real conditions, Investors who are risk averse will be indecisive before placing all their wealth into a single security even if the price of that security is underpriced, because investors can diversify that risk by investing in different securities. Thus, aversion to risk will lead an investor to stop buying a particular security even if she still believes that it will be underpriced, which is why this phenomena makes the efficient market inefficient as investors will always be risk averse and invest in various securities because the future prices of all securities are unknown and cannot be predicted. In an efficient market as information is available to everyone, investors do not have to worry about risk as investors know the future state of all the securities.

        In the efficient market theory prices are stable and there are no big volatilities in the prices of securities, if there are changes the investors are informed about it beforehand. Whereas, in the real world there is a great deal of price volatilities because of information or events unknown to the investor, this leads to making the market being inefficient as the sudden price changes result in huge losses for some investors.

The efficient market says that all stocks should be correctly priced and no stock should be a bargain relative to any other, this would then mean that all stocks in a market are perfect substitutes for each other. Thus, demand for a particular stock will be perfectly elastic; also the demand curve for that stock will be matching flat. Thus if a stock's price is raised above the level set by an efficient market, that would cause investors to refuse to purchase at all, and if the price was lowered that would cause infinite demand for that security. In the real world, no security is a perfect substitute for another security as the market is inefficient and characteristics such as risk, future profits, information and state of the company do not allow it to be perfectly elastic to each other. Inefficient markets is the reason why some investors make huge profits in one trade and some incur huge losses, if the market was efficient, this would not be possible as no chance to create that huge loss or profit would be created.

The market efficient theory tells us that all information about securities is known by investors and that all investors have equal access and ability to use all information about the expected returns of securities. In the real world this is not the case because investors cannot predict with assurity the price of the securities in the future because the market is inefficient and it is not possible to do so. Therefore, investors have different forecasts about the future state of the security, which is why they invest different amounts in different securities based on their expectations. As the future become's present some investors lose and some profit on their different expectations, making the market inefficient. In an efficient securities market investors would have been able to better predict the future state of the price of the security as all information had been available to them and there would be no risk.

Due to corporate fraud that exists to deceive the investors, shareholders and potential investors/ shareholders results in market inefficiency. Most of the time corporate fraud exists because of insider information not being disclosed to investors/ potential investors which makes the market inefficient. This clearly creates an inefficient investment for investors mainly because of conflict of interests between investors and management (agency theory) and information asymmetry. Information disclosed might be inaccurate to mislead investors and investors based on that inaccurate information will invest to maximize his/her expected return in the future. Even if the accurate information is disclosed by management on which investors rely; still some investors might not be have all the information of what will or might happen (probability) in the future with certainty, so how can the market be efficient? The prices might go up or down not based on the current information available or historical data which follows a random walk theory. Even though certain rules and regulations like Sarbanes Oxley Act exists to deter any kind of fraud and information asymmetry, but still there are certain loopholes that exists in these regulations with the most important one that Sarbanes Oxley Act doesn't applies to only public companies. It should be applicable to private companies and banks aswell, which can increase market efficiency.

Information is not always rational because interpretation is required to make a rational decision and most of the time information is not interpreted due to time constraint and also due to the assumption that market is efficient and information need not be interpreted. The truth is that it needs to be interpreted to act rationally, to reduce the risk (also because of "lack of trust" on businesses). Investors just follow other irrational investors which creates a "noise factor". Hence to avoid that and to make better decision investors need to wait and analyze and check the reliability of the information which costs the investors. The time constraint factor plays a vital role because it changes the relevance of the information. So by the time investor's act upon the available information after analyzing; share prices or prices of an asset will change. Hence, it makes the market inefficient because some of those investors who already had all the relevant information (insider information) on or before it being released are the ones to benefit the most and also according to a condition of efficient market that information need not be analyzed is violated, just to make a rational decision.

Sometimes information to be acquired is costly to make a more appropriate decision and it varies with investors how much information they need to acquire to make a decision to invest how much or just not to invest. Even the information acquired needs to be analyzed and this analysis also varies with cost. Also the information analyzed needs to be verified if it's reliable or not which also costs the investor. All these factors vary with the amount the investor spends and hence investors might have different perception of the investee to make a decision.

          We conclude that market is a weak form efficient or almost inefficient because clearly in the case of housing bubble available information or current prices of the houses didn't reflect any future value. Useful information is hidden from the investors, which lead them to make poor decisions. The Federal Reserve did lower the interest rates to stimulate the economy; however the duration of those policies was excessive, which had very deleterious affects on the economy. It is imperative that institution divulge reliable and relevant information to investors to increase their original returns rather virtual. The recent bubbles made the market inefficient and unreliable because the probability of the future events due to which investors invested to maximize their returns was completely erroneous and uncertain. That is why we need accountants; auditors and financial analysts to atleast try to help investors not to act irrationally by reducing their behavioural biases to some extent. Our researched showed that increase of prices of houses should be constant however when erratic changes are observed it can be harmful for the economy as a whole clearly, in this case we observed various institution and businesses were affected due to the housing bubble.


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