Canada's Housing Bubble

Analysis of the real estate bubble in Canada --

What is a Bubble? PDF Print E-mail

Lawrence Roberts

A financial bubble is a temporary situation where asset prices become elevated beyond  any realistic fundamental  valuations because the general public believes current pricing is justified by  probable future price increases. If this belief is widespread enough to cause significant numbers  of people to purchase the asset at inflated prices, then prices will continue to rise. This will convince even more people that prices will continue to rise. This facilitates even more buying. Once  initiated, this reaction is self-sustaining, and the phenomenon  is entirely psychological. When  the pool of buyers is exhausted and the volume  of buying declines, prices stop rising; the belief in future price increases diminishes. When  the remaining potential buyers no longer believe in future price increases, the primary motivating factor to purchase is eliminated; prices fall. The temporary rise and fall of asset prices is the defining characteristic of a bubble.
The bubble mentality is summed  up in three typical beliefs:

1. The expectation of future price increases.
2. The belief that prices cannot fall.
3. The worry that failure to buy now will result in permanent inability to obtain the asset.

The Great Housing  Bubble was characterized by the acceptance of these beliefs by the general public, and the exploitation of these beliefs by the entire real estate industrial complex, particularly the sales mechanism  of the National Association of Realtors.

Speculative bubbles are caused by precipitating factors. Like a spark igniting a flame, a precipitating factor serves as a catalyst to begin the initial price increases that change the psychology of market participants and activates the beliefs listed above. There is usually no single factor but rather a combination of factors that stimulates prices to begin a speculative mania. The Great Housing Bubble was precipitated by innovation in structured finance and the expansion of the secondary mortgage  market, the lowering of lending standards and the growth of subprime  lending, and to a lesser degree the lowering of the Federal Funds Rate. All of these causes are discussed in detail in later sections.

Real Estate Only Goes Up

The mantra of the National Association of Realtors is “real estate only goes up.” This economic  fallacy fosters the belief in future price increases and the limited risk of buying real estate. In general real estate prices do  increase because salaries across the country do tend to increase with the general level of inflation, and it is through wages  that people make  payments for real estate assets. When  the economy  is strong and unemployment  is low, prices for residential real estate tend to rise. Therefore, the fundamental valuation of real estate does go up most of the time. However, prices can, and often do, rise faster than the fundamental valuation of real estate, and it is in these instances when there is a price bubble.

Greed is a powerful motivating factor for the purchase of assets. It is a natural response for people to desire to make money  by doing nothing more  than owning an asset. The  only counterbalance to greed is fear. However, if a potential buyer believes the asset cannot decline in value, or if it does, it will only be by a small amount for a very short period of time, there is little fear generated to temper their greed. The  belief that real estate only goes up has the effect of activating greed and diminishing fear. It is the perfect mantra for creating a price bubble.

Buy Now or Be Priced Out Forever

When  prices rise faster than their wages, people can obtain less real estate with their income. The natural fear under these circumstances is to buy whatever is available before there is nothing desirable available in a particular price range. This fear of being priced out causes even more buying which drives prices higher. It becomes a self-fulfilling prophecy. Of course, the National Association of Realtors, the agents of sellers, is keen to exploit this fear to increase transaction volume and increase their own incomes. If empirical evidence of the recent past is confirming the idea that real estate only goes up, the fear of being priced out forever provides added impetus and urgency to the motivation to buy.

Just before the stock market crash signaling the beginning of the Great Depression, Irving Fisher, a noted economist at the time, was  quoted as saying “Stock prices have reached what looks like a permanently high plateau.” Of course, stock prices dropped  significantly after he made  this statement. This sentiment is based on the idea that inflated prices can stay inflated indefinitely. However, when  valuations cannot be pushed up any higher, prices cannot rise at a fast rate. In residential real estate markets, the rate of price increase would only match inflation because wages  and inflation are closely correlated. If the rate of price increase does not exceed ordinary investments, people lose their enthusiasm for residential real estate as an investment, and they begin to look for alternatives: people choose to rent rather than own. Also, when  the quality of units available for rent at a given monthly payment  far exceeds the quality of those available for sale at the same monthly payment level, people choose not to bid on the property and they rent instead. One  sign of a housing bubble is a wide disparity between  the quality of rentals and the quality of for-sale houses at a given price point. People choosing to rent curtails the rapid rise in prices and thereby lowers the demand  for real estate. This puts downward  pressure on prices, which  eliminates the primary motivation speculators had for purchasing the asset. Greed  created the condition of rapidly rising prices which in turn spawns the fear of being priced out. When   greed ceases to motivate buyers, prices fall.
Once prices begin to fall, the fear of being priced “out” forever changes to a fear of being priced “in” forever. A buyer who  overpaid and over-borrowed will be in a circumstance where they owe  more on their mortgage than the property is worth on the open  market. They  cannot sell because they cannot pay off the mortgage. They  become  trapped in their homes until prices increase enough  to allow a breakeven sale. This puts the conditions in place to reverse the cycle and causes prices to drop precipitously.

Confirming Fallacies

There are a number  of fallacies about residential real estate that either affirm the belief in perpetually rising prices or minimize the fears of a price decline. These fallacies generally revolve around a perceived shortage of housing or a belief that the higher prices are justified by current or future economic  conditions. These misperceptions are not the core mechanism  of an asset price bubble, but they serve to affirm the core beliefs and perpetuate the price rally.

They Aren't Making  Any More  Land

All market pricing is a function of supply and demand. One  of the reasons many house price bubbles get started is due to a temporary shortage of housing units. This is a particular problem  in California because the entitlement process is slow and cumbersome. Supply shortages can become  acute, and prices can rise very quickly. In most  areas of the country, when prices rise, new supply is quickly brought to the market to meet this demand, and price increases are blunted by the rebalancing of supply and demand.  Since supply is slow to the market  in California, these temporary  shortages can create the conditions necessary to facilitate a price bubble.

The fallacy of running-out-of-land plays on  this temporary condition to convince market participants that the shortage is permanent. The idea that all land for residential development can be consumed   ignores one obvious  fact: people do not live on land, they live in houses, and land can always be redeveloped to increase the number of housing units. Basically, builders can build “up” even if they can't build “out.” If running-out-of-land were actually a cause of a permanent shortage of housing units, Japan and many  European countries where there is very little raw land available for development would  have housing prices beyond the reach of the entire population (Japan tried it once, and their real estate market experienced a 64%  decline over a 15 year period until affordability returned). Since prices cannot remain permanently  elevated, it becomes  obvious that the amount of land available for development does not create a permanent shortage of dwelling units. Over the long term, rent, income and house prices must come  into balance. If rents and house prices become  very high relative to incomes, businesses find it difficult to expand  because they cannot attract personnel to the area. In this circumstance, one of two things will happen: businesses will be forced to raise wages to attract new hires, or business will stagnate and rents and house prices will decline to match the prevailing wage  levels. 14 During the Great Housing Bubble, many  businesses in the most inflated markets experienced this phenomenon. The effect is either a dramatic slowing of population growth or net outmigration of population to other areas.

Everyone Wants  To Live Here

Everyone believes they live in a very desirable location; after all, they choose to live there. People who make  this argument fail to understand that the place they live was just as desirable before the bubble when prices were much lower, in fact, probably more so. What  is it about their area that made it two or more times as desirable during the bubble? Of course, nothing did, but that does not stop people from making the argument. There is a certain emotional appeal to believing the place you chose to call home  is so desirable that people
were willing to pay ridiculous prices to live there. The reality is prices went up
because people desired to own  an asset that was increasing in price. People
motivated by increasing prices do not care where they live as long as prices
there are going up.

Prices Are Supported  By Fundamentals

In every asset bubble people will claim the prices are supported by fundamentals even at the peak of the mania. Stock analysts were issuing buy recommendations on tech stocks in March  of 2000  when valuations were so extreme that the semiconductor index fell 85%  over the next 3 years, and  many  tech companies saw their stock drop to zero as they went out of business. Analysts even invented new valuation techniques to justify market prices. One  of the most absurd was  the “burn rate” valuation method  applied to internet stocks. Rather than value a company  based on its income,  analysts were valuing the company  based on how  fast it was spending their investor's money.  When  losing is winning, something is profoundly wrong with the arguments of fundamental support. The same nonsense becomes  apparent in the housing market when one sees rental rates covering less than half the cost of ownership as was common during the peak of the bubble in severely inflated markets. Of course, since housing markets are dominated by amateurs, a robust price analysis is unnecessary. Even  a ridiculous analysis, if aggressively promoted by the self-serving real estate community,  provides enough emotional support to prompt the general public into buying. There is no real fundamental analysis done by the average homebuyer because so few understand the fundamental valuation of real property. Even simple concepts like comparative rental rates are ignored by bubblebuyers, particularly when prices are rising dramatically and such valuation techniques look out-of-touch with the market.

Figure 1 - Ratio of House Price to Income in California, 1980-2006

When  rental cashflow models fail, which they do during the rally of a housing bubble, the arguments  justifying prices turn to an owner's ability to make payments. The  argument is that everyone is rich, and everyone  is making enough money  to support current prices. It seems people began believing the contents of their “liar loan” applications during the bubble, or perhaps they counted on the home-equity-line-of-credit spending to come  from the inevitable appreciation. Even when  confronted with hard data showing  the everyone-is-rich argument to be fallacious, people still claim it is true. One unique phenomenon  of the Great Housing Bubble  was the exotic financing which allowed owners the temporary luxury of financing very large sums of money  with small payments. There was some  truth to the argument that people could afford the payments. Unfortunately, this was  completely dependent upon  unstable financing terms, and when  these terms were eliminated, so were any reasonable arguments about affordability and sustainable fundamental valuations.

It Is Different This Time

Each time the general public creates an asset bubble, they believe the rally in prices is justifiable by fundamentals. When  proven  methods of valuation demonstrate otherwise, people invent new ones with the caveat, “it is different this time.” It never is. The stock market bubble had its own  unique valuation methods as described previously. The  Great Housing  Bubble had proponents of the financial innovation model. Rather than viewing the unstable loan programs of the bubbles with suspicion, most bubble participants eagerly embraced the new financing methods  as a long-overdue advance in the lending industry. Of course, it is easy to ignore potential problems when  everyone involved is mak-ing large amounts  of money  and the government regulators are encouraging the activity. Alan Greenspan, FED  chairman during the bubble, endorsed the use of adjustable rate mortgages in certain circumstances (Greenspan, Understanding Household Debt  Obligations, 2004), and official public policy under the last several presidential administrations was  the expansion of home  ownership. When  everyone involved was saying things were different and when  the activity was profitable to everyone involved, it is not surprising events got completely out of control.

The  Importance of Financial   Bubbles

Why  should anyone care about financial bubbles? The  first and most  obvious reason is that the financial fallout is stressful. People buying into a financial mania too late, particularly in a residential housing market, will probably end up in foreclosure and most  likely in a bankruptcy court. In contrast, stock market bubbles will only cause people to lose their initial investment. It may bruise their ego or delay their retirement, but these losses generally do not cause them to lose their homes  or declare bankruptcy like a housing market  bubble does. In a stock market collapse, a broker will close out positions and close an account before the account goes negative. There is a safety net in the system. In a residential housing market, there is no safety net. If house prices decline, a homeowner  can easily have negative equity and no ability to exit the transaction.
In a housing market decline, properties become  very illiquid as there simply are not enough buyers to absorb the available inventory. A property owner  can quickly fall so far into negative territory that it would  take a lifetime to pay back the debt. In these circumstances bankruptcy is not just preferable; it is the only realistic course of action. It is better to have credit issues for a few years than to have insurmountable debt lingering for decades.
The real problems  for individuals and families come  after the bankruptcy and foreclosure. The debt addicted will suddenly find the tools they used to maintain their artificially inflated lifestyles are no longer available. The stress of adjusting to a sustainable, cash-basis lifestyle can lead to divorces, depression and a host of related personal and family problems. One can argue this is in their best interest long-term, but that will be little comfort to these people during the transition. The problems for the market linger as well. Those who  lost homes during the decline are no longer potential buyers due to their credit problems. It will take time for this group to repair their credit and become buyers again. The reduction in the size of the buyer pool keeps demand  in check and limits the rate of price recovery.


The Great Housing Bubble, like all asset bubbles, was  driven by the belief in permanent, rapid house price appreciation, an unrealistic perception of the risk involved, and the fear that waiting to buy would cause market participants to miss their opportunity to own  a  house. These  erroneous beliefs were supported by group think; if everyone else believes it, it must be true. As with any mass  delusion, it is difficult to see beyond  the comforting fallacies to understand the deeper truth; however, it is essential to do so because the cost in emotional and  financial terms of getting caught up in the mania is very high. Foreclosure and bankruptcy are bad for individuals, bad for families, and bad for society.

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