Canada's Housing Bubble

March 6, 2010 Jon Lansner lansner

Tom Davidoff, is an assistant professor at the Sauder School of Business University of British Columbia who has studied real estate cycles — including California’s wild home-price rides. We asked him to help us understand what’s happened …

Us: What made this housing bubble different?

Tom: We can compare the boom and bust cycle in housing in the late 1990s and 2000s to that in the 1980s. The increases and decreases were much sharper this time than the 1980s. This time around, I think it was more clear that there was a bubble. Where I disagree with some people is that it wasn’t the coastal areas like Orange County that made it clear — at least, after the fact — that there was a bubble. In the 1980s, the big price gains were in areas like the coasts where it’s hard to add new supply (there was an earlier oil boom and bust in some energy industry areas like Houston. Those “oil patch” markets are elastically supplied and I would guess the bust in prices was predictable). The problem with using prices in areas where it’s hard to add new supply to judge whether or not we’re in a bubble is that it’s hard to say what the right price of a home is in those markets, even relative to rent. Was there a bubble in the 1980s? In hindsight, hard to say yes, as if you bought a house in 1989 in New York or San Francisco and held it for 15 years you made out like a bandit.

In markets like Las Vegas or Phoenix, or arguably most of the Central Valley and Bakersfield, in the long run you can build lots of new supply, and the location of new homes isn’t much worse than the location of existing homes. You don’t have the same downtown or ocean premiums in those markets. So when prices get far away from the cost to build new homes in markets where it’s not hard to build new homes, you start to suspect over pricing. Like a lot of other economists, I personally didn’t suspect an impending bust probably until sometime in 2006. My problem was that I was too focused on the coastal markets. I wondered about Las Vegas, but felt like there was a world in which prices in places like Boston and coastal California were justifiable. I wish the Cassandras, who deserve credit for prescience, had been griping about Las Vegas instead of San Francisco. I think any economist who really gave prices in the relatively easily supplied markets serious thought would have been very worried as early as late 2004 and certainly mid-2005.

Another difference is where the bad loans were. In the 1980s, I think largely because of tax laws and regulations, the bad loans and excessive pricing was largely on the commercial and rental residential side. In the 2000s, exotic owner occupied residential loans were also a problem.

Us: If this bubble was different, will the recovery be of the unexpected variety, too?

Tom: The recovery may be fast or slow. I can believe that we are at a bottom, and I can also believe that there will be a continuing wave of mortgage defaults on both the residential and commercial sides that could certainly lead to price declines of 10 percent or more in many U.S. markets. The massive number of owner occupied homes with mortgages much larger than current market prices, and even market prices in the foreseeable future, is different from anything at least since the Depression. In the long run, barring very rapid global warming, prices should not be below replacement cost in a lot of the “sand” markets where they currently are. So price below replacement cost would usually be a good signal for time for prices to start rising. The potential for mass defaults and an attendant second dip in lending and GDP makes that argument harder to swallow.

Us: Are bubbles a quasi-natural economic occurrence that are going to happen in real estate every so often?

Tom: “Bubble” is a tricky word. In markets where it’s hard to replace the existing stock, like the coasts, people will always value homes in large part based on what other people think they are worth. That means that prices can fluctuate a lot even without anything changing in the real economy. So I suspect coastal U.S. prices will continue to look like a roller coaster. Ditto stocks like google, masterpieces of painting, etc.

Getting prices to move like that in places like Phoenix requires that both buyers and lenders are not motivated to consider the likelihood of huge losses. I hope we don’t see the lack of discipline in owner residential lending that allowed the giant bubbles in markets that should be disciplined by supply for a long time. Between the legitimate benefits to financial innovation and the political power of financial institutions, I suspect it won’t be too long before the next crazy price increases arise in some asset class. A guess is that it won’t be housing next, but housing will surely have another turn. By the logic of Willie Sutton, the money to be made in housing finance is too tempting to be ignored.

Us: What policy changes could prevent such economic distortions in real estate, if any?

Tom: I don’t think price volatility on the coasts requires much “economic distortion.” The problem in the real “bubble” markets of the 2000s was that both owners and lenders had the incentive to ignore the very real possibility of large losses. Both parties had valuable default options that left downstream investors and taxpayers on the hook for losses, so that only the upside mattered. For now, the market is probably self-policing. Once investors are no longer spooked, it may be necessary to (a) limit or tax high risk loans or (b) do a lot of work to make sure downstream investors are aware of risks and (c) force financial institutions to pay for the “too big to fail” burden that they place on taxpayers.