When the Bubble Bursts: Surviving the Canadian Real Estate Crash
272
When the Bubble Bursts: Surviving the Canadian Real Estate Crash
272Paperback(2nd ed.)
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Product Details
| ISBN-13: | 9781459742031 |
|---|---|
| Publisher: | Dundurn Press |
| Publication date: | 07/17/2018 |
| Edition description: | 2nd ed. |
| Pages: | 272 |
| Product dimensions: | 6.00(w) x 9.00(h) x 1.00(d) |
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CHAPTER 1
Canada's Housing Bubble Defies Gravity
The market for real estate, particularly individual homes, would seem likely to display speculative booms from time to time, since the psychological salience of the price of the places we see every day and the homes we live in must be very high, and because homes are such a popular topic of conversation.
— Robert Shiller, Irrational Exuberance, 2000
One of the earliest uses in recorded history of the word bubble in relation to financial speculation was in reference to the South Sea Bubble — the South Sea Company was a joint-stock company founded in England in 1711. It issued shares to the public in 1719, and in less than a year increased its stock market value ten-fold. A short time later, its stock price had dropped back to close to the original listing price, a crash that reduced the value of the company by 90 percent. Fortunes were made and lost. Despite the huge devaluation in the share price of the company, it continued to exist; indeed, it eventually took over responsibility for the debt of the Government of the United Kingdom.
The Bubble Company, as it was known, copied the Banque Royale, a company that was formed in France in 1716, which was also organized as a joint-stock company and used to finance government debt. Both of these companies were created for the purpose of converting government debt into shares of stock in a listed company. This idea of paying off government debt with shares sounds crazy today, but, at that time, it fired the public imagination and many ordinary people got caught up — speculators would eventually lose their life savings. These two companies and other similar copycat companies became known as the bubble companies. The concept became so popular that the U.K. parliament passed the Bubble Act in 1720 to control them.
Another, more famous, instance of financial insanity and speculative fever was a period known as the tulip bulb mania, which started in Holland in 1634–37. It seems that this mania wasn't referred to as a bubble, perhaps because of the difficulty for the human tongue in saying "tulip bulb bubble." Some people, wealthy and poor alike, became besotted with the idea of owning and trading tulip bulbs for financial gain. Bulbs were listed for trading like a stock on one of the earliest stock exchanges, the Amsterdam Exchange. Prices soared to the equivalent of an average person's life savings for one rare bulb. The fad spread to England and many other countries. Even today, in Holland rare species of tulip bulbs trade at lofty prices, although nothing like the ridiculous values that were common four hundred years ago.
The principal attributes of these activities, whether called bubbles or not, were a degree of excessive speculation, inflated prices, and a subsequent crash, along with widespread public involvement and fascination.
Many writers and historians have tried and failed to make sense of the innumerable instances of inflated values for commodities, stocks, real estate, and other speculative vehicles caused by excessive greed and speculation. Economic theory doesn't do any better in providing explanations, since bubbles don't readily allow analysis using advanced mathematics. Modern economic theory avoids the difficulty of understanding bubbles and mania by assuming that all human participants in economic activities are rational at all times under the efficient markets hypothesis. Even Canadian-born economist John Kenneth Galbraith — who discussed many of the most extreme bubbles in A Short History of Financial Euphoria, and provided analysis that does a much better job of explaining economic cycles than do most of his peers and successors — fails to come up with a suitable definition of the bubble phenomenon. Galbraith merely states that they are recurring episodes of collective financial insanity, fuelled by greed, and that they are inevitable.
Given the difficulty of experts who have studied bubbles in detail in coming up with a coherent explanation regarding the origin of bubbles, their nature, or patterns, it's not surprising that it's next to impossible for the average person to detect when they are in the grips of a manic episode of excessive speculation. The only defence is to develop a healthy degree of skepticism, an attitude that comes naturally to few people.
One such person is Jeremy Grantham, the founder of the large investment firm GMO, manages over $120 billion of investments for institutional investors such as pension plans, endowment funds, and companies. I first met him in New York City after he presented at a conference in 2003. He opened his remarks by stating, "I've never been wrong." The room went completely silent as two hundred investment experts and portfolio managers mulled that over. After a very long, awkward pause, he continued, "I've been early," and the room erupted into laughter.
Grantham captured in a very succinct manner the universal difficulty of talking about bubbles and the inevitability of them bursting. Any prognosticator who calls for a crash in a bubble asset invariably looks like a fool for a period of time before eventually, perhaps, being proven right. In the interim, the forecaster predicting the collapse is contradicted by higher and higher prices leading to greater and greater wealth for the bubble participants who ignore the warnings. Inevitably, the public (and clients if the advisor is in the investment business) develops disdain for the person making the unfortunate "early" prediction. As Grantham says in an April 2014 GMO quarterly letter, "the pain will be psychological and will come from looking like an old fuddy-duddy." However, in the big picture of cycles, those who were forecasting a collapse in the U.S. housing market in 2004 and 2005 were only a year or two early. In real estate, one or two years is a short time. It takes that long sometimes to get a house ready to sell, put it on the market, and wait for the right buyer to offer the right price. Grantham was very early in 2003 with his predictions about a stock market crash, but eventually he was more than right. When the financial crisis hit in 2006, it began with housing, and the next year spread to the financial industry, eventually resulting in the collapse of Bear Stearns, and, in 2008, Lehman Brothers.
Grantham described his research into bubbles. His research showed that "all [twenty-eight] major bubbles ... eventually retreated all the way back to the original trend, the trend that had existed prior to each bubble, a very tough standard indeed." The definition used for a bubble was any event that was two standard deviations from the mean. Standard deviation is a statistical tool that tells how unusual an event is. Bubbles of that size, according to Grantham, are expected to occur at a frequency of once every forty-four years. The U.S. housing bubble exceeded 3.5 standard deviations from the mean, an event that would be expected to happen very rarely, only once every five thousand years. The U.S. housing bubble started to take shape in 2000, reached one standard deviation about the trend line around 2001, exceeded two standard deviations during 2003, and peaked above three standard deviations in 2005, going to one standard deviation below the mean in 2008. All done in about eight years, a very compact and devastating bubble and bursting that will have repercussions for the United States and the world for decades.
The 2000–2008 U.S. housing bubble was unique at that time, since a crash had never happened before for residential housing on a nationwide basis. Before that bubble, all housing market bubbles were local, and there have been many. Real property or real estate, in the form of raw land or housing, provides fertile ground in which to grow a bubble. Especially in North America, where the history of widespread land ownership is only about two hundred years old, the episodes of mania that have developed from time to time are legion. After all, many of the people who moved to North America from Europe came because of the opportunity to own land; something that was difficult in their country of origin.
Robert Shiller, professor at Yale, Nobel Laureate in Economics in 2013, and recognized expert on market bubbles, discusses recent real estate bubbles in his 2005 book Irrational Exuberance: "We have no shortage of recent examples of real estate booms to consider. There were sharp home price increases after 2000 in cities in Australia, Canada, China, France, Hong Kong, Ireland, Italy, New Zealand, Norway, Russia, South Africa, Spain, the United Kingdom, and the United States." If bubbles or booms are a recurring phenomenon in the history of human finance, then individual homes and those who own the homes are ripe to exposure to the bubble activity. Houses will be the target of widespread speculative activity since almost everyone is interested, has a view on what the proper values are, and has a lot at stake given the size of the investment.
Speaking about the psychological aspect of the formation of bubbles in a November 2013 National Public Radio interview, Shiller stated, "It's like a mental illness. Symptom one: Rapidly increasing prices. Symptom two: People tell each other stories that purport to justify the bubble. Symptom three: People feel envy and regret they haven't participated. Oh, I would add one more — the news media are involved." The emotional pattern that Shiller describes here is known as FOMO or "fear of missing out."
Canada's house price increase since the late 1990s fits well with all four categories. Of course, there is no bubble if it doesn't come to an end at some point, with a large decline in prices. And there is no bubble if prices don't rise above the long-term sustainable fundamental or intrinsic value. Both of these requirements are difficult to prove in advance of the post-bubble price collapse, so there is always room for debate until after the deflation period. And no one can predict precisely when a bubble will end. Canada's bubble is even greater than the 2000–2008 bubble that took place in the United States. Reversion all the way back to the original trend line in Canada will mean a devastating real estate crisis.
According to Shiller, while real estate cycles are as old as private ownership of land, the development of cycle peaks and valleys in several countries simultaneously is a recent development, only becoming widespread during the last two or three decades. In the 1980s, 1990s, and especially in the 2000s, bubbles formed in real estate and housing in many countries. Canada took its place front and centre with this new trend, along with Australia, which experienced even more extreme levels of elevated prices that rendered housing unaffordable.
The United States, and several other developed countries caught up in a synchronized cycle of real estate speculation, suffered a sudden collapse in housing prices starting in 2006. This collapse required a recapitalization of the banks in those countries that continues to this day. The bank bailouts that government authorities decided to fund in the United States, Ireland, Spain, the United Kingdom, and elsewhere created enormous debts for governments and significant political tensions that will remain for years. People resent the fact that, while people lost their homes and jobs, most bank executives were protected and continued to award themselves huge bonuses after the bailouts.
CANADA'S BUBBLE SURPASSES MOST OTHERS
We don't fully understand why Canada has escaped (so far) the housing sector collapse that hit these other countries. We know that Canadians, and some foreign investors, continued to buy and speculate on houses and condos with borrowed money, and the housing bubble continued to grow bigger, making the situation even more dangerous than what prevailed immediately prior to the U.S. housing crisis in 2006. Although there was a decline in the housing market starting in the latter part of 2017 and early 2018, until then prices continued to grow rapidly, particularly for detached homes. In later chapters we will explore the peculiarities in Canada that led to this delay in the correction.
How did Canada get into this state of heated housing markets, excessive real estate investment, and speculative euphoria? In normal times the primary determinants of the price level and value of residential real estate are household income (including the job market) and household formation, mostly young people getting married, starting a family, and buying into housing for the first time. In Canada the working population has enjoyed superior gains in income relative to other countries, mostly due to the Canadian economy's exposure to the commodity super cycle that started around 1998. As well, the good fortune of being in close proximity to the largest consumer market in the world — the United States — has made wealth and incomes grow more rapidly than many other developed countries. Especially in the last twenty years, Canadians have seen large gains in income related to mineral exploitation, conventional oil and gas production, and increasing oil output from the oil sands. This run of good fortune continued until 2015 when Alberta and Saskatchewan were hit by a sudden collapse in the world oil price to below $30 from a peak of $100.
In the 1980s and 1990s the North American Free Trade Agreement (NAFTA), signed by Prime Minister Brian Mulroney and President H.W. Bush in 1992, and its predecessors, the Canada-United States Free Trade Agreement (1987) and the Canada-United States Automotive Products Agreement (1965), allowed southern Ontario — actually all of Canada — access to the United States for many exports, including autos and auto parts. Hydroelectric power exports from Quebec and British Columbia fuelled income gains. Up until 2005 the housing-construction boom in the United States heightened demand for lumber and other wood products. In the last thirteen years the Canadian dollar appreciated from a low of about 63 cents to a peak of about 5 cents above par against the greenback and back below 80 cents in late 2017.
Canada enjoyed unique good fortune compared to the other G7 countries (the United States, France, Germany, Italy, the United Kingdom, and Japan) as a result of its abundant resources and commodities. According to the Department of Finance Canada, and recounted in an October 2008 speech to the Calgary Chamber of Commerce by the late finance minister Jim Flaherty, Canada has the second-largest known reserves of petroleum resources in the world (mostly oil sands) and is the largest exporter of oil to the United States. Since 2008 Canada's dominance in oil (mostly bitumen) has increased to the point where almost one half of all U.S. crude oil imports come from Canada. Canada is also first in the world in hydroelectric power generation. It is the largest producer of potash and high-grade uranium in the world, the third-largest producer of nickel and aluminum, and the world's largest producer of forest products. None of the other countries (Brazil, Australia, Indonesia, and Russia) that are large producers of these minerals or resources are located next to the United States, except for Mexico, a country that has managed its resources poorly compared to Canada (although that is changing).
A major side effect of these unusual gains in wealth due to resource revenue and commodity pricing is the effect on house prices. Canadians, with their improving incomes, have found the cash and the borrowing power to bid up the cost of housing.
SEVERELY OR SERIOUSLY UNAFFORDABLE
While Canadian incomes were rising more rapidly than elsewhere, housing prices grew even faster. According to an eleven-city index of single-family homes called the Teranet-National Bank House Price Index, between 2000 and 2017 prices surged from an index level of 68 to 217 — more than a three-fold increase. This rapid increase means that house prices grew much faster than household incomes.
One of the best measures of housing affordability is the ratio of median house prices to median household income — this ratio indicates that a bubble has formed that is even more extended than the one that preceded the housing collapse in the United States. To calculate median household income the incomes of all households are surveyed and then divided into two groups, with half of the households having lower incomes and half having higher incomes. The house price index for Vancouver grew to four times the 2000 level while household debt grew by three-and-a-half times over seventeen years. After-tax income lagged behind by a significant margin, meaning that prices became extremely unaffordable.
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Copyright © 2018 Hilliard MacBeth.
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