House prices always go up. Buy stocks on the dips. Your 401(k) is going to pay for a comfortable retirement.
For most Americans, these core beliefs — heavily marketed by the financial services industry — have been widely held for decades. But the collapse of the housing bubble, Financial Panic of 2008 and Great Recession have upended much of the conventional wisdom most individuals took on faith.
The frightening events of the past year have left important lessons for those who lived through them.
Here are seven (once) widely held principles that turned out to be seriously flawed.
Home prices don’t go down.
It hadn’t happened in living memory. And because almost nobody remembered the last big slide in home prices during the Great Depression, it became easier to cling to the myth that it couldn’t happen again. That view was also bolstered by the housing downturn of the early 1990s, in which home prices slipped but saw nothing like the plunge they’ve taken in the past two years.
As the housing market soared toward a peak in 2005, analysts hotly debated whether home prices were headed for a fall, as we reported at the time. The theory being advanced by the real estate and mortgage industries was that as long as incomes kept going up, people could afford ever-bigger mortgages and pricier homes.
But that theory turned out to be wrong for several reasons. First, incomes didn’t keep pace with home prices following the recession of 2001. Second, to feed the bubble, loans were offered to home buyers based on ever-sloppier underwriting. In many cases, borrowers were approved without any proof they could pay the money back. And appraisers were pressured to keep the house price bubble expanding; the evidence of appraisal fraud during the tail end of the bubble is now unassailable.
Despite recent signs of life in the housing market — home sales have bounced off extremely depressed levels — prices are still falling in many parts of the country. It’s still far from clear when those prices will begin to level off.
Wall Street rocket scientists have tamed risk.
One reason lenders were lulled into giving mortgages to homeowners who couldn’t pay them back was that Wall Street convinced investors that the “science” of risk management had advanced to the point that default risk could essentially be eliminated. The mechanism was a series of complex “structured” products that mixed loans together, chopped them up into new investments, added insurance in the form of a credit default swap and — POOF!! — the risk of a homeowner defaulting on a mortgage went away. The pitch was so effective, purveyors of these mortgage-backed securities convinced bond rating agencies to give them their highest, Triple-A blessing.
It wasn’t until the house of cards began to fall and investors went scrambling to cover losses with those credit default swaps that the flaw in the “science” became painfully clear. No one had bothered to check whether the firms writing all that insurance had the money to cover the defaults. And no had bothered to check the theory to see if it stood up when housing prices were falling. Because these derivatives were completely unregulated, no one even knew which banks or investment firms were on the hook, or for how much.
More than any single factor, the unwinding of this CDS market was the spark for the inferno that consumed Bear Stearns, Lehman Bros., and many other firms, threatening the stability of the world financial system.
A 401(k) account is going to pay for your retirement.
American savers got an early warning about this one when the dot-com bubble collapsed in 2000. But following the dot-com crash, the market rebounded smartly enough to keep the hope alive that savings in a 401(k) account — or IRA for people whose employers didn’t offer matching contributions — would create enough wealth to retire on.
Today, despite the stock market’s recent rally from panic-driven lows, Americans facing retirement are likely to feel woefully unprepared to finance decades of leisure or philanthropic pursuit. Most of us will simply have to work longer.
Ironically, the shortcomings of the retirement system contributed to the housing bubble as many investors tried to supplement their savings by "flipping" homes or otherwise attempting to profit from the boom. Tales of easy money from early flippers helped spark the later-stage stampede that helped push prices to unsustainable levels.
A house is a great way to save money for the long term.
The real estate industry, through its front-line agents selling houses, was quick to sell new buyers on the idea that a home wasn’t just a place to live. When you put a small amount of money down, and the home's value grew by double-digit leaps year after year, you were onto one of the best investments available, especially for families with little investment money to play with. Since home prices never go down, what could go wrong?
Using a house as an investment turned out to be a bad idea for two reasons. First, many home buyers, seduced by the lending industry’s “easy money” marketing of home equity loans, were quick to scoop out any increased equity as soon as their home gained market value. This boom turned homes into giant ATM machines. When the music stopped, many homeowners had little or no equity left.
That’s helped make painfully clear the second reason that relying on rising home equity is a lousy way to save for college or retirement. Any investment that relies on borrowed money —using “leverage” — is automatically more risky. You can always try for a higher return by borrowing money to buy stocks on margin — or by playing the state lottery. But it’s not a great place to put your kid’s college fund. With leverage, if your bet goes bad, you can end up owing more money than you invested.
Today, roughly one-third of homeowners with mortgages are under water, meaning they owe more than their home is worth. Not only have they lost their savings, they now can’t sell their house without writing a big check to the lender when they move out.
Buy and hold stocks for the long term.
This piece of sage advance — along with its cousin, “buy on the dips” — was taken as Wall Street gospel for much of the past 25 years. That’s because the bull market that began in 1982 made stocks a safe bet as long as you were willing to hold your investments long enough.
The theory was severely tested in the Crash of 1987, but the market quickly came roaring back and went on to new highs. When stocks made up ground lost in the 2000 Internet bust — a much longer “correction" — Wall Street insisted it again proved the theory that if you hang on, the market would always recover and move to new highs.
But it turns out the long bull market that began in the 1980s was something of an aberration; it’s quite possible we won’t see one like it again for a long, long time. History shows that recovery from the kind of bubble and collapse we’ve just experienced, in which stock prices fell by half in less than 18 months, can take decades.
For example, the 1906 market peak was not fully restored until 1919. After the market crashed in 1929, it did not fully recover until 1954. The Dow’s February 1966 market peak of 995 marked the beginning of one of the worst stretches for buy-and-holders of the 20th century. The market did not see that level again for nine years, and then it lost half its value again the following year. It took another eight years before the market left the Dow 1000 mark in the rear-view mirror for good.
“Asset allocation” is a good defense against losses.
The theory is a variation on “Don’t put your eggs in one basket,” which still makes sense. But Wall Street undertook a heavy marketing blitz in the past decade to convince individual investors that if they divided their portfolio into asset classes that are “negatively correlated” they could lower the risk of losing money. When one goes up, the other goes down; and vice versa.
Stocks and bonds march to different drummers, the theory goes; so do stocks in the U.S. and elsewhere around the world. By keeping money in many different buckets, you reduce the risk that they’ll all go down at the same time. (Of course, by constantly shifting them around, based on your broker’s latest “optimal allocation,” you’ll also generate lots of fees and commissions for your broker.)
But asset allocators learned the hard way that there really is no place to hide from a full-blown financial panic — except possibly by burying cash in your back yard. (Even then, you risk losing purchasing power to inflation.) Dividing your nest egg among safe and risky investments may still make sense, but constantly shifting the mix turns out to have little impact on your long-term returns.
Financial regulators are there to protect homeowners and small investors like you.
The Great Depression left lasting psychological scars on those who lived through it and ushered in a modern regulatory structure designed to prevent a repeat of the financial suffering inflicted on millions of families and small investors. If Wall Street speculators wanted to make their casino-like bets, that was fine. But an alphabet soup of financial regulators — from the SEC to the FDIC — was created to wall off a safe place for Americans to save and borrow the money they needed to buy a home.
In the decades since, deregulation has left American families vulnerable to the rogue lending wave that created the bubble and has now tossed millions of homeowners into foreclosure. Mortgage and appraisal fraud were widespread — and widely ignored — during the boom. The Federal Reserve waited until most of the damage was done before enacting rules that would have prevented the worst lending abuses.
Various regulators ignored warnings that unsustainable risk was building up in the financial system. Congress and the Treasury were quick to provide hundreds of billions of dollars to bail out banks, but efforts to curb the rise in foreclosures have, so far, failed to help the majority of homeowners facing foreclosure.
The White House has proposed a major overhaul of financial regulation, including a new agency that would be tasked with protecting consumers. But the effort has been dogged by turf battles among existing regulators and opposition from various corners of the financial services industry.