Understanding the driver of asset bubbles
Perhaps the greatest distinction between those economists who have correctly identified asset bubbles in the past and those whose economic models failed to identify them is the ability of the former group to recognize the role that mass psychology plays in building asset bubbles.
My personal belief is that an asset bubble needs several key components in order to be birthed. It’s difficult to say which comes first, but I do believe that an asset bubble requires the following:
1) A new and widespread optimistic sentiment towards an asset. This is often a ‘new era’ story in which all potential restrictions on growth are explained away. Consider the tech bubble of the late 90s in which the mind blowing prospects of a new internet economy caused people to abandon all reasonable skepticism. One company that sold toys over the internet and was in fact losing money on each transaction had a higher market cap (number of shares outstanding multiplied by the price of each share) than the largest and most profitable toy retailer, Toys ‘R’ Us. Similarly a company that sold plane tickets online and had razor thin profit margins was considered more valuable than some of the largest US airlines (and consider that these airlines actually had tangible assets like airplanes).
In hindsight, the whole thing was ridiculous. But you couldn’t help being caught up in the emotion and awe at the time. Lest you think this same dynamic is not at work at least to some degree in Canada, let me highlight just a few memes you’ll likely hear in any discussion of real estate in Canada: “House prices never go down”….”Buy now or be priced out forever”….”Wealthy immigrants will keep house prices high”….”Best investment I ever made”…..
In fact, we could look to the most recent RBC opinion poll which found that well over 90% of Canadians view real estate as an excellent investment. For why this is potentially problematic, check out this primer.
2) Abundant credit. Historically, the largest and most painful asset bubbles often involved significant leverage created by loose credit conditions. It’s the nature of leverage that makes the crash so painful. Consider real estate in the US. If a new home owner purchases a $200,000 home with a %20,000 down payment, they have a 10% equity position at first. But if real estate drops by 10%, they have now lost 100% of their equity.
It’s this leveraged element that generates fantastic profits on the way up, but cuts deep on the way back down. I think we’ve spent quite a bit of time examining how this dynamic of abundant credit is impacting our real estate market. Consider that a little over a decade ago, a $20,000 down payment would get you a CMHC insured mortgage of $80,000. Today that same $20,000 gets you a mortgage of $380,000. Not hard to see how this will impact house prices. This is where CMHC has played such a massive role in bloating house prices….despite their mandate to “help Canadians access…affordable homes”. Of course it’s even worse than that since you can actually purchase a home with zero equity. If you’re interested, here’s a step-by-step guide on how to blow your brains out on mortgage debt:
Step 1- Borrow the 5% minimum down payment on a credit card or from a family member…….Step 2- Take advantage of the 5% cash-back mortgage offered by almost all of the big banks…….Step 3- Buy the house you want. Make sure it includes granite, stainless steel, and double the space you really need…….Step 4- Once the deal closes, pay back the down payment with the cash the bank gives you as their thanks for signing up for a lifetime of debt servitude. Enjoy your new home (which is actually just a rental as we know that a home without equity is just a rental with debt).
3) A persistent and significant deviation from underlying fundamentals. For stocks, people often reference the price/earnings ratio. In the case of real estate, we can reference price/income, price/GDP growth, price/rent, overall affordability, etc. Once these start showing a significant and persistent deviation from their long-term norms, we should get suspicious…..and house prices are doing exactly this by the way.
4) A feedback loop where rising prices become the justification for rising prices. Once the three previous elements are in place, you have all the necessary components for a virtuous feedback loop. The power human emotions of fear, greed, and envy become the motivator for many to jump into the market, spurred on by the stories of easy riches made by co workers and friends and fearful of being left behind. Eventually the rise in prices becomes the justification for rising house prices.
It’s here that we are wise to remember the teachings of the Wall Street legend, Bob Farrell, whose rules for investing offer timeless wisdom. Two in particular are worth remembering:
“Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways”
Indeed it is the seemingly limitless supply of ‘Greater Fools’ who keep irrationally priced markets buoyant for longer than would seem possible. But alas there is a finite limit. Reaching that limit seldom (if ever) results in a sideways market while the pool refills.
“The public buys the most at the top and the least at the bottom”
Sad, but true. Remember this at times like these when sentiment towards real estate is exceptionally high and nearly everyone is convinced of a rosy future picture for housing.
As house prices have risen, no longer do people reference economic growth as the justification for high house prices since that correlation has long since been broken. No longer do they reference rising wages, inflation, or any other fundamental, since none of them serve to explain the rise in price. Instead they are left explaining that house prices rise simply because they rise. They respond accordingly by piling in and driving house prices higher…..which encourages others to dive in….rinse, repeat.
That’s a quick fly-by of the dynamic that creates asset bubbles. Now let’s take a minute and zoom in on the element of mass psychology.
Another look at mass psychology
Interestingly, Re/Max released a ‘report’ yesterday which nicely highlights the workings of mass psychology. (As an aside, I am constantly amazed that this self-serving propaganda is lapped up by the mainstream media as reliable and newsworthy information).
“Driven by the threat of higher interest rates down the road, first-time buyers are contributing to strong upward momentum in residential housing markets across the country”
I actually don’t doubt that this is true, though I question what that implies about sales levels going forward.
“Despite homeownership rates approaching 70 per cent, there is clearly room for growth as entry-level buyers make their moves from coast-to-coast, undeterred by higher housing values and changes to lending criteria”
This statement is highly suspect. We’ll take a closer look at home ownership rates in a moment.
“While some may feel discouraged by eroding affordability levels, the underlying confidence in the concept of homeownership is rising….“While market conditions are one thing that influences first-time buyers, few things trump the fundamental belief in homeownership”
Well that pretty much sums it up, doesn’t it?
My position has been that the overall impact of cratering interest rates by the Bank of Canada and loosening credit requirements via CMHC has been to pull demand forward. The propensity of humans to find comfort in herd behaviour and the impact of positive reinforcement as people have seen house prices rise well beyond incomes, inflation, and other underlying fundamentals have created the very mentality succinctly described by Re/Max. The big question is whether or not this is benign.
One way we can quantify this dynamic at work is by examining home ownership rates which we know are at historic highs and have increased across all demographics, firmly dismissing the notion that the rise in ownership is simply a result of an aging population.
Note that this data stops in 2006. Given the rise in ownership since that time, any guesses as to what the latest census data will reveal?
Furthermore, if we look at the new CMHC mortgage loans as a percentage of total population, we see the following trend:
Note that this includes those who have renewed their mortgage as well as new mortgage originations. This is CANSIM table 027-0017 if anyone wants to replicate the graph (you’ll also need to track down population data). Note also the significant difference between the 2000-2009 period and the earlier period. My belief is that our credit bubble began in the early 2000s and intensified since 2004 as CMHC lending requirements were eased and the element of mass psychology took root.
So just how high can the ownership rate go? This data suggests that the buyer pool is already thin. The danger from here is that those who have not yet bought are increasingly made up of people who either can’t afford to buy or those who see high house prices for what they really are. Given our propensity to think as a collective, all it takes to induce a buyer strike is to break that “fundamental belief in homeownership”. Exactly what will trigger that remains to be seen, though I suspect that a modest fall in house prices will be enough. Should this fundamental belief be shaken, the same dynamic of mass psychology that drove prices higher will act as a dead weight on house prices moving forward.