When the Bubble Bursts. Hilliard MacBeth
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housing a good investment?” Alternatively, how about this: “In the long run do you think house prices will rise?” or “Is it a good time to borrow money to buy a house?” The answers, I am sure, would be: “Yes,” “Yes,” and “Yes.” A similar survey taken in the United States after the housing crash of 2007–09, or in Canada after the real estate crisis of the early 1990s would get responses with a more mixed outlook, including some very negative views on the future of real estate.
An unqualified belief in housing as an investment (which really means a belief that house prices will rise indefinitely) causes many people to take out bigger and bigger loans, which invariably means larger risks. However, Minsky would point out that, as the credit cycle extends in time, the system is also becoming more and more fragile while complacency grows, leading to the inevitable crisis.
The term, “Minsky moment,” started to gain popularity when, in the summer of 2007, two New York–based hedge funds collapsed. The funds specialized in subprime mortgage-backed derivatives and were run by Bear Stearns, a global investment bank and brokerage firm based in Manhattan. Bear Stearns had been named “most admired” firm in the securities division of a Fortune magazine survey for two of the previous three years prior to 2007. The start of the global financial crisis, can be traced back to the collapse of these funds, named the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leverage Fund. Both funds were based on subprime loans to highly indebted people with poor credit histories that were acquiring residential real estate at elevated prices, although you couldn’t tell that by their exotic names. The funds specialized in a type of derivative called a collateralized debt obligation (CDO).
Bear Stearns, the sponsor of the funds, folded on March 14, 2008, after eighty-five years as one of the top U.S. financial institutions. The assets of the firm were bought for pennies on the dollar by JP Morgan Chase & Co. and with the help of a government guarantee. Minsky couldn’t have foreseen the collapse of those Bear Stearns hedge funds and the worldwide mayhem that ensued, but he would not have been surprised.
The term Minsky moment describes nicely the ultimate crisis that follows a period that starts with complacency, leads to rising indebtedness, and grows to include rampant speculation on borrowed money. At some point, the debt levels become too large and the cash flow from the assets purchased is not large enough to cover the interest costs. However, the lenders realize belatedly that some of the borrowers are unable to cover the interest on their loans and they demand repayment of the loans. But the only assets borrowers have to sell are ones that they have purchased with borrowed money, and once they start to sell them, the value of their assets fall, and more loans get into trouble and the situation spirals out of control. As borrowers declare bankruptcy, the banks seize the assets that were used as collateral, and try to minimize their losses by selling those assets. But if the number of speculators was large and the asset class they were buying was illiquid, the banks will have huge difficulty selling the assets. In the process of selling, the banks will push asset prices even lower — forcing more borrowers into trouble. Eventually, even cautious borrowers who were careful not to stretch their borrowing to the maximum amount find that they are under-collateralized for their loans. At this point, the banks are in trouble since leverage ratios in banks don’t allow for losses of 30 percent or greater in the value of collateral. Once the banks are in trouble, the government must step in to stabilize the situation. This happened in the United States, Ireland, Iceland, Spain, Portugal, Greece, and other countries within the last six years, as a result of situations that were often triggered by excessive borrowing to buy illiquid real estate assets.
In Canada, if a Minsky moment were to arrive in the next couple of years, the government would be heavily involved. More than 60 percent of all mortgages outstanding carry some form of mortgage insurance guaranteed by the Canadian government. As of December 2013 the CMHC had outstanding insurance coverage valued at close to $600 billion (the limit set by government). Genworth Canada, a private mortgage insurance company (56 percent-owned by Virginia-based Genworth Financial), carries up to $250 billion (90 percent government guaranteed) of outstanding insurance obligations, bringing the total of those two close to $900 billion. Obviously, if housing values were to collapse due to a Minsky moment, both of these organizations would run into difficulty. The government would have to step in to fill the gap and cover the losses. If the government didn’t step in, the impact on Canadian banks and the financial system would make the collapse of Bear Stearns and Lehman Brothers seem like a Sunday picnic on a sunny day by comparison. After all, the gross domestic product (GDP) of Canada is only $1.8 trillion annually and there are more than $1.2 trillion in mortgages outstanding plus hundreds of billions of other debt.
The credit cycle, fuelled by the availability of cheap and easy credit, allowed Canadian housing prices to soar and residential construction activity to reach record high levels. Excesses such as these are normal at the peak of a real estate cycle, and reversion to the mean is the rule. Reversion to the mean is a statistical term meaning that observations well above average tend to move back to average and similarly for observations well below average. Every bubble in real estate and property prices that has ever formed has subsequently reverted to the long-term average (mean), and most over-correct well beyond (below) the long-term trend line due to the excessive pessimism that participants develop during the correction.
The housing market peaked in the United States in 2006 at levels that were elevated to an extreme similar to current levels in Canada. The difference is that, since 2006, U.S. home prices have corrected by a huge amount, enough to eliminate most of the excess above the rate of inflation and the bubble completely deflated back to the trend line.
In Minsky’s terms, the U.S. housing market went through all the stage of hedge, speculative, and Ponzi finance, culminating in the collapse of two funds specializing in CDOs and bringing down Wall Street firms like bowling pins. In Canada the finance of houses and condos is in the speculative stage or the Ponzi stage with lots of investors subsidizing monthly payments from other income.
Canadians shouldn’t need to look any further than the financial crisis in the U.S. to see what will be in store for housing markets. However, we know that denial can be unshakeable when it comes to housing. Everyone seems to be an expert and most people have a personal stake in clinging to the belief that house prices can only rise, never fall.
Some Canadians will need more convincing, however, so next we will look at the American Minsky moment as well as booms and busts in housing markets around the world, including Spain, Ireland, and others.
Many people believe that it can’t happen here, or that it can’t happen to me. As we’ll see, not only can it happen, it’s only a matter of time until it does happen.
Chapter 3
Bubbles, Bubbles Everywhere
I can calculate the motions of the heavenly bodies, but not the madness of people.
— Sir Isaac Newton, 1720, observing the frenzied speculation over The South Sea Company and reflecting on his own enormous losses.[1]
Having seen what a bubble looks like in Canada, we can compare that situation to other bubbles around the world to see how house prices react before and after they burst. We have lots of examples to look at. There are a number of other countries that are still experiencing bubbles such as China, Australia, Belgium, and Norway. There are many more jurisdictions that were in a bubble and now are in the process of correcting the excesses of a past bubble (United States, Ireland, Portugal, Iceland, Japan, and Spain, to name a few).
Bubbles are all different in the details but they are all very similar to each other in a few important ways. When they finally burst, the associated financial and economic difficulties are transmitted through the banking system in a process of unwinding or deflating of the bubble. This process of unwinding can take years or even decades. So it’s not like trying to observe a Higgs boson particle that exists for only a millionth of a second. The events surrounding bubbles and their aftermath unfold in slow motion.
The U.S. Housing Bubble and Its Aftermath
We needn’t look far for examples: the United States experienced both a housing bubble and a crash, all in the past decade. Their housing