Bubbles, Valuations, and Speculation

The blogosphere has been running ragged over recent comments from Tsur Somerville regarding whether or not Vancouver is in a "bubble".

“'You can’t burst a bubble that wasn’t there,' said Somerville. 'But you can have prices above where they should be and it not be a ­bubble.'

'A bubble isn’t just defined by high prices,' he said.

Somerville identified a housing 'bubble' as conditions akin to what was happening in 2007. 

'It didn’t matter what the condo looked like or what it’s going to look like or who was building it, people were lined up around the block and snapping it up,' he said. 'They were saying, "I’ll take 12, please." That’s more of a bubble environment.'"

This piqued my interest because I don't think Somerville would state this without having some arguable justification for it, then I remembered a post on the subject written in 2005 from Calculated Risk. According to him, when we’re talking about "bubbles" we should be talking about speculation and over-valuation, and I think this recent post from him, and the one linked that he wrote in 2005, are must-reads. In the 2005 post he states:

"A bubble requires both overvaluation based on fundamentals and speculation. It is natural to focus on an asset’s fundamental value, but the real key for detecting a bubble is speculation – the topic of this post. Speculation tends to chase appreciating assets, and then speculation begets more speculation, until finally, for some reason that will become obvious to all in hindsight, the 'bubble' bursts. Speculation is key"

There is little doubt for me that Vancouver's fundamentals are out of whack. By my measure price-rent ratios are at least 70% higher than their long-term average.

What Tsur Somerville is stating is that “speculation” is not occurring so there is no “bubble”. What I think may be amiss in this reasoning is considering the possibility that "speculation" did occur but hasn't yet unwound. Instead the speculative excesses witnessed last decade in the means described by Somerville were held in stasis for 4 years with cratering real rates and opening the barn door to 100% mortgage loan underwriting during the aftermath of the 2008 recession. The speculative excesses Somerville is pointing to as absent could still be with us, the participants given a stay. Even that aside, speculation occurs in other ways besides the abject cases of flippers. As Calculated Risk noted:

"This type of speculation appears to be rampant only in certain regions, mostly the coastal areas. However, something akin to speculation is more widespread – homeowners using substantial leverage with escalating financing such as ARMs or interest only loans."

In the more recent article he concludes:

"...the real causes of the bubble were rapid changes in the mortgage lending industry combined with a lack of regulatory oversight. The speculators just added to the fire."

“Rapid changes in the mortgage lending industry” occurred in Canada in the form of falling interest rates through the 2000s and kicking out borrowing terms to 0-40 (zero down payment and 40 year amortization schedule), then slowly relinquishing them to the current 30 year amortization for uninsured and 5-25 for insured. The underwriting of loans via a 100% government backstop certainly helped to lower spreads. I have graphed the effect here by looking at a normalized maximum loan amount using average 5-year mortgage rates, assuming a fixed income and fixed debt-service ratio.

An insured or uninsured borrower could withdraw 60% more in income-flat terms than he/she could in 2000 at the peak in the three years after the 2008 recession. In current conditions there is a marked gap between those who are applying for insured and uninsured loans. An uninsured loan, all else equal, still commands 60% more loan than 12 years ago, an insured loan by contrast is now about 30% more.

The “lack of regulatory oversight” was true in the US and I don’t see the same severity in Canada. That stated, recent moves in Canada by OSFI indicate oversight is now being bolstered and they’re not finished. Despite Canada’s “sound” banking oversight, banks are looking like my dog after I come home and there’s garbage on the kitchen floor. Dogs do what dogs do, and I don’t blame her for being a dog.

A trip down to the epicentres of the US housing bubbles and reading of the lending practices allowed to occur over the last decade there indicate to me Canada is not in the same situation as the US but that is not to say Canada gets a free pass. Tracking lending malfeasance is difficult in part because it is necessarily obfuscated not only by borrowers for various reasons, but also by some lenders who understand they are obtaining free lunches at the expense of direct systematic risks borne mostly by the populace and the government. That should count for something.

Likewise the attitudes I hear in Vancouver regarding housing are markedly different from conversations I have with Americans six years after the US housing bubble peaked. That difference in attitude is interesting and perhaps cautionary as to how much outstanding "speculation" Vancouver still carries.