The Tech Boom was the last “bubble” that most of the younger generations remember. A bit too young to truly grasp the Savings and Loan scandal long ago, most of us are able to remember the “creation” of the Internet. As far as the majority of the public was concerned at least.

With the housing bubble, Randy Johnson does a great job helping to explain exactly what it was that brought about the “Subprime Lending Reality Check” as he calls it:

Yet there are times when the “irrational exuberance” of people leads them to believe something different than what is reality based. For example, we know that the Price Earnings Ratio, P/E, is normally between 15 and 20. Growth companies that have an ability to grow faster and produce earnings faster than the economy in general command P/E ratios that are higher than average.

Yet during the dot com boom, even concepts like earnings went out the window. Valuations, if you can call them that, were based upon website traffic without any reference to how that traffic might be turned into revenue and, ultimately, earnings, at some point in the future.

Of course, we know how that turned out. Stock market losses wiped out investment value. Reality finally asserted itself.

We have had a similar situation with subprime lending. It was obvious to everyone in the business that the subprime lenders had departed from this reality and were operating in a galaxy far, far away. Initially, I think that the parties involved really thought that traditional underwriting practices as developed largely by FannieMae and FreddieMac were out-dated.

There is some evidence to support that contention, should anyone want to make it. For example, when they developed their automated underwriting engines in the late 1990s, we quickly found out that the criteria they were using departed significantly from what their own underwriting guidelines that were being used by human underwriters. The computers were being far more liberal in applying rules.

What happened with the subprime lenders was that they simply threw out the rule books altogether. The executives and other employees became so addicted to the massive amounts of money they were making, – two, three, four times or more than what ethical lenders were earning on comparable loans – that they just didn’t want to quit. They would approve anything!

Reality appears to be finally rearing its ugly head and we’re seeing the consequences.

There’s a reason that Stated Income loans earned the nickname of “Liar Loans”. And as a direct result, years later when homeowners are truly realizing their own earnings ratio and looking at their net income, we’re seeing a tidal wave of foreclosures.

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