Buying High to Sell Higher Ushered in Housing Crisis

"Buy low and sell high" is a surefire way to make a profit. But during the recent housing run-up, homeowners tried to buy high in hopes of selling even higher. While we're still suffering from their mistakes, hopefully we can learn from them by not becoming the proverbial "Greater Fool."

Older investors recite the story of the Greater Fool as a way to remember the lessons of history and impart wisdom to less experienced youngsters. As the story goes, "I bought investments at foolishly high prices, knowing that there was always going to be a Greater Fool I could sell to at an even higher price. Then, one day, I woke up and discovered that nobody else was buying. In the end, the Greater Fool was me."

Greedy in real estate

Making money during a bull market isn't difficult, and it can be a source of great encouragement to a novice. Just two to three years ago, mortgage rates were dirt cheap, lenders were reckless, and people who bought houses could turn right around and sell them for impressive profits. Many bought with low introductory mortgage rates and no money down, so they had almost no out-of-pocket expenses. Then they sold, paid off their loans before the mortgage rates went up, and bought bigger and more expensive houses to repeat their get-rich-quick strategy. They felt invincible, and borrowed against their newfound wealth with home equity loans or through cash-out refinancing. Then they reinvested the proceeds in other properties. In 2006, for example, the majority of home sales involved second homes, vacation homes, and investment properties-not primary residences.

The more the real estate bubble expanded, the more we heard amateur investors boasting about making fast money by flipping properties. Instant wealth-like instant fame-is exciting and intoxicating. But in a room full of Greater Fools, a fool and his money are soon parted. And, as any fallen star can tell you, when the party's over, the hangover is dreadful. Now, those giddy bragging rights have turned to urgent pleas for a taxpayer-funded bailout.

Lenders as villains

Without the complicity and cooperation of lenders, the surge in housing prices-and the short-lived success of rookie investors-would not have been possible. Lenders facilitated the mayhem because investors on Wall Street, who were making fast cash by reselling mortgage-backed securities, had an insatiable appetite for loan paper. They were flipping mortgages just like homebuyers and sellers were flipping condos.

While hedge fund managers bought whatever mortgage loans they could get their hands on, banks and other lenders behaved like amateurs and, neglecting the hard-earned lessons of history, kept lending at a frantic pace, even as the precariously overpriced market peaked. They hoped to sidestep the obvious risk by just selling that risk to investors. But they, too, soon looked in the mirror and saw the face of the proverbial Greater Fool glaring back at them like the Grim Reaper.