www.globeandmail.com

The Globe and Mail
leaftheglobeandmail

  Why the housing bubble inflated

BENJ GALLANDER and BEN STADELMANN

Friday, May 30, 2008

According to figures published this week, the meltdown of the U.S. housing market is proceeding at an unrelenting pace. On average, housing prices have declined by 14 percent in the past year, led by harsh drops of 25.9 percent in Las Vegas, 24.6 percent in Miami and 23 percent in Phoenix. That's deflationary, folks, not inflationary.

Though there has been no shortage of recriminations levelled about the causes of the housing bubble and the fallout of its subsequent collapse, there has been little examination of why more people didn't see it coming. Some attribute this to the positive bias of the media, but to do so is simplistic. There was lots of lively discussion, and controversy sells. Business shows on television love inviting opinionated guests on opposite sides of an issue and letting the fur fly.

The problem for the viewer is who to believe. That was the critical point, not only for Americans deciding on whether or not to buy a home, or what kind of mortgage to take out, but for Canadian investors. Whether to buy stocks in everything from U.S. home builders to Canadian lumber companies, retailers to big banks, or whether it was a good time for a snowbird to buy a condo in Florida, all hinged on a correct assessment on whether the U.S. housing market was in a sustainable boom or a bubble waiting to be pricked with devastating consequences. For those who would like to review their skills at bubble detection, here are some of the factors we used to determine that the housing market was deep in the Hubba Bubba zone.

The limits of good fundamentals

Many experts pointed out that the price of housing was rising in response to favourable economic fundamentals. These included low unemployment rates, low interest rates, and government incentives designed to promote home ownership through mortgage interest deductibility and the federally sponsored lenders Fannie Mae and Freddie Mac. They believed that prices would continue to increase until these conditions changed. What such an approach overlooks is that there must be some limit to the benefits of these favourable factors. After that, the asset simply becomes more and more overvalued, which is an inherently unstable situation.

Ain't my job, man

Both former Federal Reserve Board chairman Allan Greenspan and his successor, Ben Bernanke, said they saw little evidence of a bubble, just a bit of "froth in local markets." Their intelligence and vast access to economic data, not to mention the prestige of their office, were very persuasive. But both men insisted it was not part of their mandate to try to defuse asset bubbles.

That point has been contentious, given that maintaining "price stability" is definitely part of the Fed's responsibility. One can argue that if the Fed had identified a housing bubble, there would have been a buildup of political pressure to do something about it. By refusing to acknowledge that housing prices were in dangerous territory, Messrs. Greenspan and Bernanke avoided making any unpopular moves to rein in the sector.

Beware of cheerleaders

David Lereah has taken a lot of heat for his adamantly bullish forecasts and best-selling books such as Why the Real Estate Boom Will Not Bust — And How You Can Profit from It. But the guy was chief economist for the National Association of Realtors! It isn't reasonable to expect objective information from people employed by institutions with vested interests. Not to say that it is necessarily wrong, but research from organizations such as this should be scrutinized with cynical eyes.

Listen to the rich guy

Billionaire Jim Rogers made no bones about it. In April 2005 he stated plainly that housing was indeed in a bubble, and further volunteered that he had shorted Fannie Mae. That was an excellent suggestion. The following month, a couple of other billionaires at the Berkshire Hathaway annual meeting concurred. The thing about people like Mr. Rogers, Charlie Munger, and Warren Buffett is they are unencumbered by concerns about what the boss or advertisers might say, political optics or group think. They are generous and straightforward with their opinions, and like all of us, they aim to be right. They make mistakes too, but they became super-rich due to their deep and profound understanding of how our capitalist system works.

Many people still believe that the Canadian real estate sector is insulated from a major price beating. To that we suggest, "Buyer beware." It would not surprise us to see, in melting ice cream parlance, a very rocky road ahead.


back