Canada's Housing Bubble

Analysis of the real estate bubble in Canada --

About Housing Bubble PDF Print E-mail

The Real Estate Bubble Phenomenon

A. The  Formation  of a Real Estate Bubble

Formation of a real estate bubble traditionally results in a rapid rise in real estate prices and mortgage  credit.  In an economic  recovery, improved  job outlook and increased buying power  promote real estate investment by households and businesses. Demand   increases, supply  is fairly tight in the short term  (it takes time  to build new  housing  and rental accommodation),  and prices and rents go up. Eventually, builders and investors increase supply.
As climbing prices attract new buyers seeking appreciation, cyclical acceleration promotes  speculation. A  prolonged and self-sustaining acceleration in prices signals market over-evaluation, i.e., a real estate bubble. Because  of the rise in both price and demand, the volume  of outstanding loans increases and mortgage  credit accelerates.  Lenders contribute indirectly to market  price increases when  they support demand   by arranging financing for potential buyers.

B. Identifying a Real Estate Bubble

Although everyone can see the cyclical growth of housing markets and recognize the existence of a real estate boom, not everyone agrees on whether or not we are experiencing a real estate bubble. How   can one tell if the rise in prices is based on solid and sustainable economic  or demographic factors rather than irrational optimism among  market  players? A number of criteria have been defined for detecting the existence of a real estate bubble:

1. steep increases in the real price (housing prices adjusted for inflation) of new  and existing houses;

2. price increases affecting all segments of the real estate market;

3. price increase not restricted to a few urban centres;

4. widening gap between price growth and household ability to pay;

5. in rental markets, prices that rise more quickly than forecast return to landlords.

The relationship between housing prices and mortgage payments on the one hand and household income on the other is a good indicator of  whether or not a real estate bubble is forming. It is almost impossible, however, to measure the actual presence of a bubble; the fact that it existed is confirmed only when  it has burst.

C. The Bursting of a Real Estate Bubble

Interest rates play a key role in the formation and bursting of a real estate bubble. Initially, falling or relatively long-term low interest rates stimulate price increases and an influx of buyers and capital. At a given moment  in the price expansion phase, some  people hesitate to enter the market due to the high prices, some property owners  see returns shrink, others wish to sell to realize equity or because they are unable to keep up with mortgage payments following a downturn in their personal financial situation.
A rise in interest rates signals that the market has peaked. From  that time on, the cost of owning  a dwelling increases, demand  decreases, and price increases decelerate. If rate hikes continue, prices drop fairly quickly and the bubble eventually bursts. Thousands  of households suddenly find themselves with a debt level greater than the market value of their property.

D. The Repercussions of a Bursting Bubble: Deterioration of the Banking System, Household  Debt and Credit Rationing

The immediate effect of a correction in housing prices or the bursting of a bubble is depletion of the wealth effect and an attendant negative impact on household  consumption.
This mechanism  is only partly offset by  a downward  adjustment of rents and  the attendant positive impact on income. These features mark the cyclical slowdown  of the economy.
A downturn  in the real estate market can have  the same  sort of destabilizing effects on the banking system as that witnessed in relation to the meltdown  of the information technology and telecommunications industries. Investors drawn by expected capital gains can find themselves unable to pay off their debts, especially short-term loans made when  interest rates were on the rise. During a sharp downturn in economic activity, some households that took out mortgage  loans may, if their financial situation deteriorates, be unable to honour the debt.
Finally, the access of economic agents to credit (including non-mortgage credit) is more restricted. Financial institutions make many  loans secured by collateral, more  often than not real property assets. When  prices fall, everything else being equal, the borrower's capacity is reduced.
The bursting of a real estate bubble can also produce a crisis in the banking system:  consider Alberta in the early 1980s, the Savings and Loan  crisis in the United States and, even more  spectacular, the Japanese crisis in the early 1990s.  For financial institutions, the rising volume  of   non-performing loans reduces profitability. In the most  extreme cases, the bankruptcy of some  financial institutions can have an impact on the entire financial system, even on industry. Once  that happens, government  intervention seems inevitable, with the attendant net increase in public debt.

Another version of Housing Bubble Defination:  What is a Bubble?

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