"When the Wind Blows Hard Enough, Even Turkeys Fly" or "Temporary Religions of Convenience"

I found this to be a most excellent summary of the psychology underlying asset bubbles in general and the housing bubble in particular.

The tech stock bubble was psychologically supported by a repeat of the mass delusion of an economic New Era. The very same term was used four times in the 20th century to explain a temporary suspension of well understood principles of market pricing: in the US in the 1920s, in the US in the 1960s, in Japan in the 1980s, and in the US in the 1990s. Each New Era period ended with a repudiation of the New Era idea that a fundamental change had occurred in the way the economy and markets operate, thus explaining the enduring elevated securities prices. Why re-cycle the old New Era concept? The old New Era tale apparently works over and over again, and will no doubt work again some day.

Mass belief in the New Era myth was supported by the media, elected officials, venture capitalists, and every other institution and organization that benefited. The deluded masses got some crumbs off the New Era cake as well; the apparent free and zero risk money flowing their way as the stock market rose was surely the result of their investment acumen. And why shouldn't they partake in the benefits of the New Era that the experts in the press, and honorable and credible representatives of the US financial system's institutional representatives such as Abbey Joseph Cohen, and even the head of the US central bank, Alan Greenspan, proclaimed as the real deal. Of course, what made the illusion of a New Era possible, and pushed the value of the stock of now bankrupt pets.com to absurd levels, was a hurricane of money, first supplied by the Fed, later by the markets themselves as money was recycled via the public markets back through venture capital and back out through new IPOs. When the wind blows hard enough, even turkeys fly.

...an asset bubble is supported by an underlying belief system, a kind of temporary religion of convenience that evolves during bubbles to explain, as in John Ciardi's children's poem, "Why the sky is green, why trees are blue/Why kittens caw, and crows mew." Faith allowed millions to suspend disbelief and put large amounts of money at risk. When a market is imbued with a misperception of risk, investors begin to lose the ability to distinguish between gambling and investing. The New Era religion even spreads to the Fed itself, in the form of the usual assertions that the masses of investors know best, even when they are in the grips of a mass delusion.

The mirage of low risk is further enhanced by the observation of market participants that speculative bubbles, even when acknowledged as such, can collapse with little consequence. The reason is that the Fed has as its primary mission to rescue the markets to prevent a knock-off collapse of the real-economy. Market participants see that the Fed has apparently succeeded at this mission over and over. It's human nature to continue to engage in risky behaviors that are repeatedly survived, whether it's free diving that results in 100 deaths per 5,000 divers per year, or investing in assets that one fully expects will certainly get pumped back up again by Keynesian monetary and fiscal policy.

Asset bubbles collapse in increments. Starting in 1999, Fed rate hikes started to lower the wind speed and a few turkeys fell to the ground. Along with bankruptcies and layoffs, as I predicted in my Bankrate.com article, revelations of fraud -- fraud is a standard feature of all asset bubbles, including the real estate bubble -- started to chip away at investor confidence and undermine bubble mass psychology, causing many to start to lose their faith. In the atmosphere of lingering greed but growing doubt that happens at the end of an asset bubble, what economists refer to as a random exogenous event occurs that gets the inevitable panic selling started.

As in the case of all bubbles, belief in its foundations is for a while self-fulfilling. Real estate is a good example. The believers' valuation process is tautological: the value of housing is rising because prices are rising, attracting more money, causing prices to rise further.