Canada's Housing Bubble

Nov 28, 2010 Ben Rabidoux financialinsights.wordpress.com

Why are you here?

This is far from a philosophical question.  This lowly blog is not yet three months old, yet readership continues to grow at a rate that has me pleasantly surprised.  This site now frequently receives 2500 daily page views, nearly double from a month ago.

While I’d like to believe that people are simply enthralled by my witty and thoughtful insights, I know it’s more likely a reflection of the lack of insight and integrity from more traditional media sources, which seem increasingly satisfied to simply tow the line fed to them by sources of questionable credibility. I’ve been hard on the mainstream media on this blog.  For that I don’t apologize.  I’ve also been hard on the bank-employed economists, realtor groups, and politicians of all stripes.  Again, I’m not sorry.

Ours is a very different world from the pre-credit crisis world of just a few years ago.  We have entire nations being bailed out and having their debts guaranteed.  For who’s benefit?  The citizens?  No….it’s to the benefit of the big foreign and domestic banks holding those bonds.  The citizens will be stuck with the legacy of unrepayable debt and lower living standards so the banks don’t take hits to their capitalization ratios and can therefore continue to make risky bets so their top employees can make multi million dollar bonuses.  It’s certainly not politicians or bankers looking out for us.

Similarly, anyone who understands the immensly important role that real estate and the associated wealth effect spending has had on buoying our economy here in Canada can not help but question the credibility of  any politician declaring that there is no basis for fears of a housing bubble, particularly when that politician is the one person most responsible for inflating it.  Given the ‘not on my watch’ mentality of politicians who are quite happy kicking a problem can down the road for someone else to deal with, I have a hard time trusting them too.

Likewise, any entity that requires a perpetual expansion in credit to maintain maximum profitability is questionably biased on this same question.  Given that mortgages and HELOCs are by far the two largest generators of credit, and both are dependent on strong house price appreciation, it calls into question the ability of bank-employed economists to be entirely truthful about the potential for a significant housing correction.

And so people increasingly flock to independent finance and economics blogs like this one.  You may not like what I have to say, but you’ll have a hard time questioning my motives.  I don’t make a penny off this web site.  You won’t find advertisements anywhere.  That may change if it consumes an increasingly large amount of my free time, but for now, I receive no remuneration whatsoever for maintaining this lowly blog.

If you’re new to this site, let me welcome you.  I hope that at the very least you will see that I try to provide an insightful counter view to the prevailing ‘wisdom’ of our times.  We may disagree, but I promise you two things:  1)  I will never censor criticisms of my views….2)  I am happy to post guest posts that disagree with my position and aim to debunk some of my macro views using facts, stats, and strong logic.

The Financial Insights one-stop primer

If you are new to this blog, please check out the 6 primers.  They are required reading if you’re going to understand what we’re talking about on this blog.

Sometimes we just need things said several times before they finally sink in.  So while none of this is new to anyone who has read this blog, I will take a moment and highlight what I feel are the structural issues with our Canadian economy and how I feel these will resolve themselves over the next few years.

1)  Housing and GDP growth:

Our economy is too reliant on housing to generate growth. At present, housing constitutes 20% of our GDP and was one of the driving forces behind the great Canadian economic miracle of 2009-2010.  The last time that 20% of GDP was derived from real estate was in the early 90s, before real estate across Canada declined in real term for nearly 10 years and declined substantially in several major centres.

2)  Consumer spending and GDP growth

Our economy is also far too reliant on consumer spending, which makes up approximately 65% of total GDP.

3)  Debt and savings

Normally a high percentage of consumer spending is not an issue in an economy, unless it is financed by a perpetually increasing debt load and is coming at the expense of consumer savings, as is the case.  This implies that demand is being artificially pulled forward as this debt must at some point be repaid.

It’s difficult to know exactly when this ‘gap’ in consumer demand will hit, but when it does, it will have significant impacts on the broader economy.  If you understand that credit = money in our fractional reserve banking system and that spending money more often = inflationary pressure via increased velocity of money, then you’ll understand that the paying off of outstanding credit = shrinking the aggregate money supply and saving money = decreasing the velocity of money.  This will create deflationary pressures that will be felt particularly acutely by any asset market that is predominantly financed via debt…….namely real estate.

4) Present real estate valuations

Now I said that it is extremely difficult to know exactly when the gap in demand will hit, but two things give us clues.  One is the fact that our housing market is extremely pricey by any measure of fundamental value.  On a national level, we have a housing bubble.  As in the case of the US housing bubble, this simply means that some areas will be hit harder than others.  Perhaps you live in an area where real estate prices are still in line with historic measures of fundamental value.  If you live on the West Coast or in T.O, don’t count on it.  While our housing market has not yet reached the same levels of irrational exuberance experienced by our American cousins, it is nonetheless problematic.

Whether you fall in line with the bank economists who are predicting a mild 10% correction, or whether you fall in line with other economists who see substantially greater overvaluation, one thing is for certain:  You are a fool if you think that real estate can continue to substantially outpace inflation and wage growth into the indefinite future.  Mark my words: The next 10 years in the Canadian real estate landscape will look nothing like the last.

5)  The wealth effect

One of the blessed side effects of real estate appreciation is what is called the ‘wealth effect’.  It’s basically where people feel richer, therefore they spend more money on stuff that they wouldn’t have bought otherwise.  The wealth effect associated with real estate is often calculated at 6-10%, meaning that for every dollar in real estate appreciation, consumers are likely to spend an additional 6 to 10 cents.

Nowhere is this more evident than in the latest CAAMP report which was discussed at length on this blog.  Basically, it revealed that home equity withdrawals were goosing household spending to the tune of 8.5% annually.

This provides a glorious feedback mechanism whereby increased house prices create increased consumer spending and increased demand for houses, which creates the appearance of an economic boom as unemployment becomes a distant memory and good times roll.  As the good times roll, people feel good about the economy and their job security and project those feelings into the infinite future, bid up the price of houses, and the process repeats itself.

But when real estate corrects even mildly, this mechanism goes into reverse.

Predictions

Timing the exact start of a secular shift and a mean reversion is virtually impossible given the fact that there is an element of human psychology involved.  If humans were perfectly rational creatures, we wouldn’t be in this predicament in the first place, now would we?

That being said, it’s fairly obvious that all of the points above are tied to the strength of the real estate market.  Therefore it is highly likely that the whole mean reversion will begin about the same time that people realize that they are not as rich as they think they are, and maybe they should pay off interest rates before they rise and consume even more of their income, and maybe they should have saved for a rainy day.

Given the weakness in home resales, which have been registering at some of the lowest sales volumes in the past decade in most big boards, I think that the first hints of year-over-year price declines will be any time.  I’ve been predicting a drop of 5 to 10% by the new year, with another 10 to 20% off in 2011.

That being the case, we should see housing starts weaken even further in 2011 as well as consumer spending significantly muzzled.

If I’m right about this, we should see negative GDP readings by Q3 or earlier, with an outright recession by Q3 or Q4.

In addition, unemployment is set to march steadily higher and remain stubbornly high, perhaps above 10% for several years.

Deflationary forces and a secular shift back towards frugality will ensure that real estate prices don’t see their highs again for at least 5 years, and more likely a decade.

The caveat

2008 and 2009 were interesting years for me.  I’ve never been so right and so wrong at the same time.  I was one of only a few people I know of who was warning about a global debt issue before the credit crisis hit.  I also warned that house prices in Canada were set to correct….and they did.  Where I was dead wrong is that I had no idea to what lengths the government would go to ward off a depression.  In the process, they reignited a housing market that would still be dead today.

Could the same thing happen again?  Well, certainly the shock and awe factor of historically low interest rates is now gone.  I don’t expect much of a jump in demand even if they cratered them again, which wouldn’t surprise me.

However, there is nothing stopping the government from introducing zero down, interest only mortgages, 50 or 100 year amotizations.  All of these are terrible ideas, particularly when backed using taxpayer dollars.  The further down the road of irrationality we travel, the greater the fallout.  But that doesn’t mean they won’t try.

And so I will add this caveat:  My economic predictions are useful only as far as governments will allow free markets to roam.  At the end of the day, the free markets will win out.  But that’s not to say that government intervention won’t necessitate an extra inning or two.

In conclusion, welcome to this lowly blog.  I hope you find it worth at least the price of admission.

Cheers

Ben