A piece appearing on Yahoo Finance quotes at length from Warren Buffett’s response to the Financial Crisis Inquiry Commission about what caused the housing bubble and related 2008-09 financial crisis. Buffett began by quoting his mentor, Benjamin Graham: “Ben Graham made an observation 50 or so years ago to me. . . . He said, ‘You can get in a whole lot more trouble in investing with a sound premise than with a false premise.'” Buffett explained: “When you have a sound premise, you may also have a ‘This can’t go wrong’ mentality. And when you add money to that equation, the price action quickly takes over.”
He went on to discuss the causes of the Great Depression, noting that a 1924 study argued stocks always outperform bonds. “[A]fter a while,” Buffett observed, “the original premise, which becomes sort of the impetus for what later turns out to be a bubble, is forgotten and the price action takes over.” Similarly, he said, the dot-com bubble had origins in a sound premise: “The Internet was going to change our lives,” Buffett recalled, “But that didn’t mean every company was worth $50 billion. . . . And price action becomes so important to people that it . . . takes over their minds.” The housing bubble, he explained, had the same dynamic: “It’s a totally sound premise that houses will become worth more over time because the dollar becomes worth less.” And given the importance of homeownership to many people, “if you really believe that houses are going to go up in value, you buy one as soon as you can.” But, “at some point the price action takes over, and you want to buy . . . it with nothing down and you want to agree to payments that you can’t make . . . because it doesn’t make any difference: It’s going to be worth more next year.” Further, he said the dynamic also affected lenders “because even if they have to take it over, it’s going to be worth more next year.” Buffett suggested that “once that gathers momentum and it gets reinforced by price action and the original premise is forgotten,” a bubble has developed, just like in 1929.