How did we get here?

It's a fact: the housing bubble has begun deflating in Central Florida since sales peaked in August, 2005 and prices peaked in July, 2006.

10 year Zillow Orlando/USA average prices

The bubble occurred for the same reasons all bubbles do- the basic instincts of greed and fear humans unconsciously rely on when making decisions.

How it works.

1. In the formative stages, the bubble begins with the "smart money." These are the buyers who see the conditions are right for an asset price bubble- whether it be tulips or tech stocks- and get in on the ground floor. Negative real interest rates, lenient mortgage terms, and a desire to store wealth close at hand after 9/11 starts to push housing and land price appreciation rates above historical averages at the beginning of the decade.

2. Speculators see prices begin to rise above trend and want to get in on the action (greed). Their demand reinforce this cycle and prices rise with increasing demand. Speculative activity distorts the natural balance between supply and demand, and prices begin to detach from typical valuations based on the buyers' income. The 4-6% average annual price increases in housing from buyers' incomes and price inflation are gone.

3. The media and general public begin to pay attention to the great wealth, both paper and tangible, generated from real estate. New buyers who would not have been able to buy during a normal housing market are approved for loans based on this appreciation, and successful buyers may leverage assets to increase their gains. The self enforcing cycle begins to go into overdrive with annual increases of 20, 30, even 40%.

4. A new paradigm is reached. Housing prices are no longer tied to a buyers' income or assets. If buyers don't get in the market today, it will be more expensive tomorrow. Maximum leverage is used to get into the market. Despite historically high prices, loans are easy to get because the past enormous gains are assumed to continue. Standard practices of 10 to 20% down payments are no longer the norm.

5. The "smart money" sees the end game and some may begin to sell. The supply of buyers trying to get into the market becomes smaller than the number of sellers trying to get out. Even with ARMs, no down payments, and NINJA loans, the cycle cannot be sustained.

6. Eventually, housing prices begin to revert back to fundamental-backed prices. Loans are much more difficult to obtain as the market's psychology turns from "always up" to "always down." Patient buyers, even those whom are qualified, will wait on the sidelines for prices to stabilize. A new set of distortions may take the market price down below where it can be justified in relation to wages.

7. The market regains stability as prices bottom out and smart money returns. The cycle may begin again.

Uh oh.

So here we are in March, 2008, somewhere between #5 and #7. The questions potential speculators in the future bounce should be asking now are:

How will we know when the bottom is reached?

Will it be economically wise to speculate on prices climbing back up the greed/fear cycle when market psychology and prices hit #7?

What can a speculator do to minimize risk when calling the bottom?