Canada's Housing Bubble

Aug 3, 2011 Ben Rabidoux theeconomicanalyst.com

This is the second part of a two-part series examining the necessary ingredients in an asset bubble.

Bubble Condition 3:  Investors experience a significant shift in mass psychology, often with a “new era” or “this time it’s different” mentality.

If we think back to the technology bubble that ended abruptly in 2000, we may recall that almost everyone was talking about these stocks.  It was common water cooler talk to swap favourite dot-com stocks.  Investors experienced a widespread love affair with these stocks and dot-com fever engaged much of the population.

At the peak of the market, the valuations given to some stocks were clearly outrageous.  A great example is the story of eToys.  This company was based on a website with the sole purpose of selling children’s toys.  While certainly a novel idea, the business model was dogged by one tiny flaw: the company lost money on every transaction.

At the time, the children’s toy industry was dominated by Toys “R” Us, which accounted for nearly half of the $20 billion in annual toy sales in the US.  Unlike eToy, Toys “R” Us was making nearly $400 million dollars in annual profits.

eToys went public (began trading on a stock exchange) in May 1999. Despite being a money-losing venture, by the end of the year, eToys was valued by the market at over $10 billion, or some 2.5 times the value of Toys “R” Us, a profitable company with actual assets like buildings.  By March of 2001, eToys was essentially bankrupt. Shares that once traded at highs of $84 each, were now sold for nine cents, an abysmal loss of 99.9%.

How could it be that a company that was losing nearly $10 million a month and had virtually no assets could be valued at more than double a company that was making over $30 million a month and had millions of dollars in physical assets?  The answer lies in a shift in mass psychology and a “new era” mentality.  The public was so enamoured with the limitless possibilities of the internet that people were willing to abandon all rational evaluation in favour of blind speculation caused by exaggerated expectations of future price growth.

The immutable fundamentals may have been ignored, but in the end they won out, as they always do.  As famed investor Benjamin Graham noted, in the short term, the stock market is a voting machine, but in the long term, it is a weighing machine.  In other words, while ephemeral bouts of emotional extremes may move markets out of line with their underlying fundamentals, in the long term, the fundamentals win out.  This is as true in the stock market as it is in the real estate market.

It is important to recognize that when it comes to a discussion of the future returns of any investment (be it stocks, bonds, gold, or real estate), if a large portion of the population believes that “this time it’s different” and have positioned themselves accordingly by loading up on that asset, it’s a tell-tale sign of a market in trouble.  This will be discussed in greater detail in part three of this report.

Bubble Condition 4:  Rising prices are often supported by cheap and readily available credit.

While not necessarily true of other asset bubbles, this is a necessary ingredient in the creation of a housing bubble as homes are purchased overwhelmingly with the use of credit.  Here in Canada, the vast majority of new home purchases are insured by Canada Mortgage and Housing Corporation.  This insurance serves to protect the lending institution from loss on their loan should the borrower default and the institution be unable to recoup its loan by selling the house in question.  This expansion in credit has been driven by the significant reduction in mortgage insurance standards, from a minimum 20% down payment, 25 year amortization mortgage to the current minimum 5% down, 30 year amortization mortgage with a brief experiment with 0 down, 40 year mortgages in 2007-2008.  Even the current 5% down payment requirement is not entirely true as all big Canadian banks have cash-back mortgage options that allow a home buyer to make a purchase with no equity.

If we consider just the impact of loosening the down payment requirement from 10% to 5%, as happened in the late 1990s, we can see the incredible impact this has had in buoying house prices on a sea of new credit.  With a 10% down payment requirement, a $10,000 down payment would qualify for a mortgage of $90,000.  With a 5% down payment requirement, that same $10,000 qualifies for a $190,000 mortgage.  It is not difficult to see how loosening mortgage insurance standards leads to a boom in house prices….not to mention consumer debt, now at levels past those experienced by our American peers prior to the bursting of their bubble:

In fact, the relationship between rising mortgage debt relative to GDP and rising house prices is remarkable:

For a detailed discussion of this concept, check out this post.

Bubble Condition 5:  Bubbles tend to occur during periods of economic prosperity, real or imagined.

Human beings have an incredible capacity to extrapolate current trends into the indefinite future.  Times of relative economic prosperity tend to be characterized by a widespread notion that the good times will never end.  People are more willing to borrow, spend, and engage in speculative investing during boom times.  Unfortunately, our inherent optimism encourages excess consumer spending and debt accumulation, while discouraging saving and frugality.

There is an element of self-fulfilling prophesy in this and herein lies the danger. If the commensurate expansion in credit is sufficiently large and if the participation rate is high among the broad population, the asset bubble can eventually create the illusion of growing economic prosperity. The flow of mortgage credit and credit associated with wealth effect spending (particularly home equity lines of credit) spills into the broader economy, buoying consumption, employment, and GDP growth in the short term, but setting the stage for potentially significant economic pain.

Now, consider these five bubble requirements within the context of the current Canadian real estate market.  Which ones do you see currently at play?  Are there any requirements you would add?

Cheers,

Ben