Understand the severity of the housing bubble and avoid making a mistake that would impair your finances for years, even for the rest of your life.
The Psychology of Bubbles
A bubble involves a degree of excessive speculation, inflated prices, and a subsequent crash, along with widespread public involvement and fascination.
It's a mental illness with three symptoms:
- Rapidly increasing prices.
- People tell each other stories that purport to justify the bubble.
- People feel envy and regret they haven't participated.
Additionally, the news and social media add fuel to the fire.
Any prognosticator who calls for a crash in a bubble asset invariably looks like a fool for a period of time before eventually, perhaps, being proven right.
In the interim, the forecaster predicting the collapse is contradicted by higher and higher prices leading to greater and greater wealth for the bubble participants who ignore the warnings. Inevitably, the public (and clients if the advisor is in the investment business) develops disdain for the person making the unfortunate “early” prediction.
Canada's house price increase since the late 1990s fits well with all symptoms of the bubble. 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.
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.
The Minsky Moment
How the world came to accept the idea that we must load ourselves with unsustainable debt and suffer through repeated booms and busts.
A Minsky Moment refers to the crisis that follows a long period of complacency. The period prior to the crisis is characterized by rising indebtedness and eventually includes rampant speculation on borrowed money.
Speculative finance
Banks are seduced into expanding their lending business by the rising values on the collateral side (houses are collateral) and the very low level of defaults. Borrowers are comforted by their ability to borrow more and more, often borrowing enough in new loans to pay off previous loans and the interest on those loans, too.
As long as borrowers have sufficient cash flow to pay off the interest and qualify for new loans, the cycle continues to build in the speculative phase. Government contributes by relaxing the standards for loans and leverage ratios for banks. Because of rising asset prices, foreclosures and bankruptcies are rare.
Ponzi finance
The longer the lending cycle and the related boom in asset prices continue, the more comfortable, complacent, and confident the participants become.
Individuals who were originally reluctant to borrow large amounts become willing to take on larger loans; the ease with which the interest payments are covered, and the loans that are rolled over into new loans, convince them that there is no danger. Lenders, who should know better, are also lulled into complacency by the feeling that there is a permanent upward trend in asset prices.
A "euphoria state" is a state that inevitably precedes a collapse in asset prices and the withdrawal of credit.
Preparing the Ground
As economic agents who have relatively short lifetimes, humans must adapt to the economic circumstances that exist at the time they make key decisions, such as getting married, starting a family, buying houses, choosing careers, saving for retirement, and earning a return on savings.
While that environment is fluid and constantly changing, people cannot cope with that much uncertainty, so they choose to accept certain themes as permanent, especially when it comes to things they don’t understand very well. Their beliefs are primed by the attitude of their parents and easily swayed by statements from financial leaders and people they admire.
House prices always go up.
All mortgage debt is good debt.
Paying rent is like throwing your money away.
These simplistic beliefs do not begin to explain the complicated world of savings and investment. Nor do they recognize the major, life-changing consequences those decisions impose on people’s lives when aggregated to the macro level.