Business Reporter
Bubble (verb)
1) A thin film of liquid inflated with air or gas
2) Something that lacks firmness, solidity or reality.
•Merriam-Webster
Bubble. Balloon. Mania.
Anyway you want to describe it, an economic bubble is the bogeyman of financial markets.
And there’s certainly a lot of bubble talk going on today – especially in relation to the Canadian real estate market.
The bubble isn’t the bad part. That’s when prices inflate and living is good. As most economists will tell you, it’s the bursting that you should be worried about.
But what exactly is a bubble anyway?
Classic economic theory says a bubble is simply an overly rapid expansion of a good or investment followed by a severe contraction, also known as a crash. That’s the not-so-great part.
“A bubble forms when there is a hot new investment idea that capture’s everyone’s imagination,” says David Rosenberg, chief economist for Gluskin + Sheff & Associates.
According to Luis Seco, a professor of finance at the University of Toronto, the definition of an asset bubble is simple:
“It is when asset prices are for whatever reason unfairly inflated. But at the time, it is difficult to know whether it is overpriced unless you put it in relation to other goods and services, so it’s difficult to see it coming.”
Bubbles aren’t an unusual occurrence in markets. Just ask the folk who bought Nortel stock at the height of the technology bubble in 2000 at $1,245 a share. The company was worth more than a third of the entire Toronto Stock Exchange before it plummeted to penny stock status, eventually filing for bankruptcy protection.
“When people start using phrases like ‘this time it’s different, or we have a new paradigm, or I better buy now or I won’t be able to afford it,’ then you know you’re in trouble,” says economist Will Dunning.
In the case of the technology bubble, greed and speculation had set in. It was also difficult to value dot-com stocks since most companies were burning cash and traditional methods of valuing a company went out the door. The subsequent stock market crash caused more than $1 trillion in wealth to be wiped out.
While tech stocks were seen as the “hot new idea” back then, that concept can be extended to the housing market where people see property as a hot investment rather than as a place to live, says Rosenberg.
“The new idea becomes a bubble based on three criteria: excessive leverage, widespread participation and dramatic overvaluation.”
Perhaps the first recorded instance of an asset bubble was the Dutch Tulip mania of the 1600s. At the peak in 1637, a single most-sought-after bulb equalled the price of a luxury home on the finest canal in Amsterdam.
Many investors grew fabulously wealthy, with more people purchasing them with intent to flip them for a profit. But the market crashed spectacularly, wiping out parts of the Dutch economy. Substitute tulips for condos, and you pretty much have the Toronto market crash of 1989.
“When you think about it – it’s completely crazy that the Dutch would do something like that but when you are in the bubble you think it is perfectly normal,” says Toru Yoshikawa, a former professor of strategic management at the DeGroote School of Business in Hamilton, who now teaches at Singapore Management University.
Yoshikawa lived through one of the greatest stock market and housing bubbles in history. As a young executive at Canadian-based CIBC bank in Tokyo, he witnessed the implosion of the Japanese stock market in 1989 followed by the bursting of the real estate market. At one point the grounds of the Imperial Palace were said to be worth more than the entire state of California.
The fall of the Japanese economy followed two decades of stagnation. Some economists now wonder whether the American economy, which has seen a massive retraction, will suffer the same fate.
“Everyone said at the time that prices couldn’t go down, that there was only so much land available. It was like brainwashing,” says Yoshikawa. One banker friend ended up buying four condos in downtown Tokyo and almost went bankrupt as a result, he says.
“I was tempted to buy something myself, just because everyone was buying something,” says Yoshikawa. “Now I see many of the same things happening in Canada.”
Another definition of a bubble: They emerge when prices increase more rapidly than inflation, household incomes and economic growth, according to David Macdonald, an economist with the Canadian Centre for Policy Alternatives.
A number of factors can contribute to bubble conditions, including access to easy credit and low mortgage rates.
The bubble burst in the United States because there were other factors, such as sub-prime mortgages in loosely regulated financial markets which caused prices to peak in 2005 – and decline every year since, according to Macdonald. Currently, almost one quarter of U.S. households are “under water,” where the mortgage is more than the market value of the home.
Most economists have ruled out a U.S.-style housing bust in Canada, particularly because we didn’t have the same volume of sub-prime loans. Tougher mortgage restrictions introduced this year means that risky zero-down, 40-year mortgages are no longer allowed.
“Canadian housing policies…continue to mitigate the risk of a massive wave of defaults in the future,” says economist Jim MacGee, author of a C.D. Howe Institute study saying a crash is unlikely.
Still, MacGee’s more bullish report came out only a day after Macdonald’s study, which was titled: “Canada’s Housing Bubble – An Accident Waiting To Happen.”
The case of the dueling reports led to more confusion over the direction of the housing market.
But in reality, the two economists did not have completely diametric views. Macdonald gave three scenarios for a housing bubble bursting, and the U.S.-style example was the most extreme and unlikely he looked at.
Rosenberg, one of the most influential economists, and formerly chief North American economist for Merrill Lynch, says determining if we are in a bubble remains a “close call. If it wasn’t a bubble at the recent peak, then it was one giant-sized sud.”
While most economists agree that sales of homes have gone beyond historical and demographic norms and prices are likely over-inflated in comparison to income, they disagree on whether the third element to be found in most bubbles truly exists in the Canadian housing market: Mass hysteria.
“The human part of it, the psychology is missing – are people really buying these homes because they expect values to rise constantly?” asks Dunning. “Most of the buying we’re seeing is from people who are not being speculators.”
“In a bubble market you have to find that greater fool, the persons who will always buy that good from you at a higher price,” says CIBC Economist Benjamin Tal.
Economist Yoshikawa agrees that Canadians have been much more conservative than his Japanese counterparts.
“In Japan, no one was questioning anything. It was a pure psychological euphoria. That is a key ingredient of a bubble. In this case, Canadians are not that extreme.”
Tell that to frustrated buyers who were caught up in bidding wars earlier this year. Only a few months ago, buyers lined up overnight to be first in line to get condominiums in North York. It was the same scene when buyers camped out at a housing site in Mississauga for three weeks to get first crack at buying a property. Justin Beiber fans could identify.
Still, most consumers don’t care about the semantics of whether the market is in a bubble or not. They just want to know whether prices are coming down.
Here, most economists at least agree that prices will have to fall or level off over the next several years.
“I don’t think you should be surprised if we see a 10-per-cent drop in average housing prices,” says CIBC’s Tal.
Dunning says the market is not in a bubble, but simply in a corrective phase, with prices coming down by 5 or 10 per cent.
The bursting of a bubble, as in the U.S., would be far more radical, with prices dropping by 30 per cent in three years. In Toronto, starting in 1989, prices fell 28 per cent in four years. A variation of this scenario might be possible if interest rates keep going up and government does not clamp down further on mortgage regulations, argues economist Macdonald.
A correction, meanwhile, is a short-term realigning of the market, but not severe enough to be called a crash – the aftermath of the bubble bursting.
“There is a difference between a popping of a bubble and a correction,” says Tal. “What we have seen are house prices overshooting and coming back to earth, but I don’t think it is going to be a dramatic fall.”
So why talk about bubbles?
“Because they’re a lot more sexy” says Tal. “People immediately understand what you’re talking about – and boy do they pay attention.”
Smart-shelter rules of thumb
• Buy a home you want to live in, not flip. Most studies show that in the short run, renting a home is cheaper than buying one. In the first years of purchase, your monthly payments are mostly paying off interest and the only person you’re making rich is your banker.
• Don’t buy during a boom. Markets move in cycles. We’ve been in a strong up cycle over the last decade, but the laws of market gravity will not be defied. What goes up can eventually come down.
• Make the biggest cash down payment you can afford. It’s simple. The more money you put down, the less interest you will have to pay on your property. This could result in substantial savings in the long run.
• Location, location, location. All the funds you’ve invested to improve your home’s “curb value” will be for naught if the neighbourhood is a no-go zone. It’s better to buy a fixer upper in a good neighborhood than having the best house in a run down area.
• Be Realistic. Buying a home is an emotional purchase, but don’t bite off more than you can chew. Make sure you keep within your financial comfort zone. A pool and a picket fence might be ideal – but not when you’re stressed out about paying the monthly dues.
http://www.yourhome.ca/homes/articlePrint/862717
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