The origins of the financial crisis and the deepening recession lie in the toxic combination of a housing bubble with high financial-sector leverage. The U.S. housing bubble had its extreme manifestations in the Sunbelt states of California, Nevada, Arizona and Florida, but it was part of a worldwide phenomenon. House prices soared in recent years from Australia to Iceland, from South Africa to Russia. Even Canada was not immune. Toronto prices rose for many years, though avoiding the bubble of 1989–90; Vancouver and Calgary saw massive price rises amid rampant speculation.
Leverage boosted the upside by providing fuel for homebuyers; now it’s playing havoc on the downside. Imagine if all those houses had simply been financed using mortgages with 30% or more downpayments, and then the loans had been held on local banks’ books, or even sold off as plain-vanilla bundled securities to be held as long-term investments by pension funds or mutual funds. There would have been less money to inflate the bubble, and much less grief when it burst. Instead, mortgages were extended with low or sometimes no downpayments, then bundled into complex securities to be held by highly leveraged institutions such as hedge funds and banks. When homeowners began to walk away, these leveraged firms had no choice but to unload fast, crashing the value of these securities, or else go bankrupt. As we have seen, some institutions were unable to escape the carnage, and governments around the world have been forced to take over banks and guarantee the financial system.
Market bubbles are not new. Most people have heard of Tulip Mania (Holland, 1630s), the South Sea Bubble (London, 1720) and the Wall Street Crash (U.S., 1929). Less well known are the emerging-market mining mania (London and South America, 1820s), the railway mania (U.K., 1840s) and many more in the 18th and 19th centuries.
In the middle decades of the 20th century, there was a curious lull. Bubbles were few and far between, and the focus was on inflation — rising prices for goods and services, not asset prices. But since the mid-1980s, about the time central banks finally got a grip on inflation, bubbles have returned with a vengeance. In the past quarter of a century, we have had the Japanese bubble (1980s), the U.K., Scandinavia and Canada housing bubbles (late 1980s), the Asian Tigers bubble (mid-1990s), the technology mania (late 1990s) and, most recently, the world housing bubble (2001–07).
Bubbles have become central to the economic cycle, driving both the upswing and the downswing. And when they burst, it is not only a few rich speculators losing out. The resulting crash brings a recession with rising unemployment and reduced income growth, while ordinary investors and their retirement plans are often damaged badly. In the worst instances, the financial system becomes unstable as losses mount. When banks are in trouble, they pull back on lending, making the downturn worse, and usually, as we are seeing now, governments are forced to step in to save the system, leaving taxpayers with the bill.
In each case, the story begins with a rise in prices, which then continue on upward to an extraordinary level of valuation, before crashing back. On the way up, the rise in values encourages a high level of business investment and consumer spending, boosting growth and prosperity and often creating a sense of euphoria. Following the crash, the economy is hit by a combination of reduced wealth and higher uncertainty, which leads to people being extremely cautious. Spending by consumers, investing by businesses and lending by banks can all be scaled back. At best, the resulting economic slowdown is only mild. At worst, it leads to a major depression, as in the U.S. in the 1930s or Japan in the 1990s.
The U.S. housing bubble is still deflating. Inventories of unsold homes are at high levels, while foreclosures are still rising. By my reckoning, prices measured by the S&P Case-Shiller index, down already by nearly 20%, have another 20% to go just to reach fair value. But when bubbles burst, markets often overshoot on the downside. With the stock market crash and collapse in business and consumer confidence of recent weeks added in, an overshoot now looks inevitable. This means the losses in the financial sector will mount further. Government actions around the world to support the banking system should restore a degree of stability. But nobody should expect banking as usual. Banks are going to be tightening their lending criteria and behaving with extreme risk aversion for a long time yet. This means businesses and consumers will find credit hard to come by, and cuts in official interest rates will not all be passed on to borrowers.
Reduced credit means less spending. U.S. businesses are already rapidly scaling back inventories, laying people off and chopping investment plans. But the real danger comes from consumers. The collapse in both house and stock prices leaves U.S. households with the lowest ratio of wealth to income since the 1970s. That points to a sharp rise in the savings ratio, as households try to restore their wealth. This will exacerbate the current recession and could easily make it the worst downturn since the Second World War. In such an environment, there are likely to be more unexpected shocks in store that will rock confidence.
Where does this leave Canada?
Until well into the summer, Canadians seemed relatively insulated from the problems south of the border. Manufacturing had been suffering for some time from the towering loonie and the travails of the auto sector, but high oil prices, along with the feel-good factor from past tax cuts and house price rises, kept consumers in fine form. That has all changed. The recession in the U.S. is inevitably dragging down Canada, too, while the fall in oil prices will hasten the end of the boom in the West. The collapse in stock prices hurts sentiment. But now I fear Canadian house prices will see a significant slide too, as prices are already falling in many areas. Most cities in Canada had nothing like the boom seen in California, and mortgage lending generally avoided the excesses of the U.S. sub-prime and Alt-A boom. But housing demand is now faltering, and new supply is coming through. With the economy already in recession and set to worsen, house prices have nowhere to go but down.
Is there any good news?
Many banks around the world, including Canadian ones, have done a good job of controlling their risks, while governments are gradually getting to grips with the problem banks. The fall in oil prices is a threat to Alberta but is great news for U.S. and Canadian consumers. It should provide an offset to reduced employment and slower wage growth, though the danger is that much of the benefit will be saved. Another positive is that governments are becoming much more activist in dealing with the stresses in the banking sector. A new fiscal stimulus for consumers is likely in the U.S. next year, and Canada has room for a fiscal stimulus, too. Canada also is seeing the benefit of a flexible currency.
The collapse of the world housing bubble is going to affect many lives and, eventually, I think will bring major changes to economic policy. We need to find ways to prevent or at least dampen asset price bubbles in the future. It is not enough for central banks to focus solely on controlling consumer price inflation. Better monetary policy is part of the answer. Better regulation and incentives for banks to avoid the alternating feast and famine of credit will also be needed.
Closer to home, we all need to look at our own attitude to investments. When everyone is buying and euphoria is in the air, it is not the best time to buy either stocks or houses. It merely inflates bubbles further. When prices are falling, the best response is not to run away but to look for value. There are opportunities now after the stock market rout of recent weeks and, given time, also in housing, though house price corrections take longer than for stocks. The more investors can come to see markets in a contrarian way, the less extreme will be future bubbles and busts.
John Calverley is head of North American research at Standard Chartered Bank, based in Toronto. The second edition of his book, Bubbles and How to Survive Them , will be published in spring 2009.