Saturday, May 28, 2005
Real Estate: what if the Boom turns out to be a Bubble ?
NOW that even David Dodge, the Governor of the Bank of Canada, is talking about "froth" in real estate markets, how concerned should people be - not just about the value of their own homes, but about the entire country? After all, we just had a big stock market bust and it barely dented the economy. Outside of brokers, speculators, and a few unlucky sellers, would a real estate crash really matter to the country as a whole? In a word, yes. To understand why, we must first look at how pervasive the effects of real estate are throughout the economy.
Start with the so-called wealth effect. If people tend to spend more when their net worth increases, they'll spend less when it decreases. Economists use this rule of thumb: a $1 change in household wealth leads to a roughly 5-cent change in consumer spending. By that measure, a 10 percent decline in real estate prices would knock about half a percent off the gross domestic product. Even more significant for the economy, though, would be a collapse in home equity lending. The industry has been booming as housing prices have soared. But if prices stop rising, new borrowing against home equity will drop, and may disappear. This is important, because home equity lending in Canada amounted to more than $20 billion last year - or nearly 4 percent of the economy. If all that borrowing - which freed up cash that was spent on new furniture, appliances, vacations, cars and the like - simply vanished, the effect could be large enough all by itself to send the economy into recession.
But that's not all. The housing sector has even broader effects on the economy, by some estimates accounting for 25 percent of all activity. A decline in property values would most likely lead to declines in other industries, like construction, brokerage, banking and insurance. And these are important for future growth. Construction, for example, amounts to 7 percent to 8 percent of the economy, according to the Economic Council of Canada. Then there's banking. Because of the leverage associated with real estate, a fall in values would affect banks and other lenders. It would probably lead to tightened credit standards, less lending and higher interest rates. If lenders begin to suffer steep losses, there is always the danger of financial contagion, in which problems at one institution ripple out to others it does business with.
And there is yet a new wild card factor for the economy. In 2004, variable-rate mortgages made up a third of new mortgages. No one knows what the effect of the widespread use of V.R.M.'s would be in a down market. A climb in interest rates, of course, would put downward pressure on real estate prices, but V.R.M. borrowers would feel the pinch rapidly. If those borrowers started to default, lenders would be hurt. Adding it all up, it's easy to see how a drop in real estate prices would spell trouble for the economy. To put that in perspective, the Bank of Canada has conducted a detailed study in 2004 that assessed the potential economic impact of a property slump. Reviewing the experience in the United States and 13 other industrialized countries, the Central Bank found that a real estate bust is far more dangerous to the economy than a stock market bust. The Bank of Canada has calculated that a housing-price decline less than half as large as a decline in stock prices typically causes twice as big a drag on the economy and that its effects last twice as long as those of a stock market crash. Moreover, while a large decline in housing prices might come as a shock to many Canadians, especially these days, the Bank of Canada has found that busts happen every 15 years, on average, thereby giving credo to the popular belief that real estate is a cyclic, periodic industry.
So if a housing bubble is a bigger risk to the economy than a stock market bubble, what can be done to prevent it from bursting? The most attractive way for policy makers to cool the housing market is to put pressure on lenders to tighten their credit standards. Some small steps in this direction have already been taken: Regulators have issued new guidelines on home equity lending, and new rules on first-mortgage loans are expected to follow soon. A more drastic way, of course, is to raise interest rates progressively, both short and long term. And steps in this direction have been taken as well.
Regardless of the monetary policy applied, the situation calls for persistent and continuous monitoring. Real estate in Canada is far too important for central policy makers to ignore.
Luigi Frascati
Real Estate Chronicle
Comments:
<< Home
Hard to believe that this hot market will cool off. Until interest rates remain low, real estate sales will not slow down. In the Vancouver - Victoria corridor they say there is going to be tens of thousand of people coming the next few years, and no matter what real estate will continue to boom. No bust in my dictionary.
Post a Comment
# posted by 
: May 28, 2005 10:00 PM
: May 28, 2005 10:00 PM << Home
