This article examines three meaningful basic questions: (1)-Would the US housing market confront any reversal given what is happening in the US and global economy? (2)-As expected by some pundits, would the Canadian economy undergo any serious correction? (3)-What are the meaningful macroeconomic factors which impact the Canadian and the US housing markets? And using this framework what predictions can we make both for short and long term trends of real estate markets?
The US Housing Market: Its Evolution from Crisis (2007-2008) to Present:
The US housing bubble was produced by “Steroids Banking” using “Securitization” course of action and taking advantage of low interest rates and enormous inflow of investment money from oversea. The housing prices in most regions almost doubled 2001 to 2006; and subprime lending escalated astronomically. The private Mortgage edges were applying their creativity and greed in designing highly risky esoteric mortgage products using the “Securitization” course of action.
What is “Securitization”? Put simply this is packaging of mortgages (including subprime) into structured products (Mortgage backed securities, Collateralized debt obligations). The manufacturing mortgage bank then removes these esoteric products from its balance sheets to minimize any risks and sells these products to institutional investors using SIV (Structured investment vehicles). The buyers of these products erroneously assumed that the inner mortgages of these securities were “safe collateral” given upward trending housing market. However, when subprime mortgages defaulted and housing market began to sink, these structured products built around defaulting mortgages fell severely in value, thereby halting the complete global credit system. additional to this turmoil was dilution of commercial paper because of possible default of big lending institutions. The global financial system was under siege. Ironically, the Credit default swaps, which average to insure against default of these mortgages collapsed under their own weight, thereby reinforcing the Credit crisis. The US Treasury and the Fed intervened and injected trillions of dollars to save the collapsing US Housing and Banking system.
This crisis is a typical example of “Moral danger” issue. Who was responsible for over-leveraging the system beyond its buoyancy point? Technically the Mortgage edges had packaged the mortgages and passed on the risks to the institutional investors. The institutional investors made the wrong assumption that the US housing market will move North forever. The Fed and other institutions did not have a proper regulatory-monitoring structure as conceived in the BASEL guidelines to avid such over-leveraging. Nobody knew who will be responsible if the edifice collapses. Worst of all, the institutional investors assumed wrongly that the “Credit default swaps” (CDS) instruments would work miracles; and bail out defaulting mortgages. This is known as Moral danger problem. Ultimately everybody was looking forward to the Fed and the Treasury to bail out the global financial system from reaching the doomsday.
The US Housing Market in the aftermath of Crisis:
The “Mortgage Delinquency Rate (MDR)” is a meaningful metric that speaks of the real fallout of the US housing crisis (2007-2008). It measures the percentage change in delinquency of residential loans. In June 2007, the MDR was 2.17% and reached its highest level in March 2011 at 11.36%. It recovered back to 2008 levels at 10.4% recently. MDR is a meaningful lagging indicator that reflects economic difficulties. Another meaningful metric reflecting the state of housing health in the US is the S&P/Case Shiller Home Price Index. This is an index reflecting change in housing prices of 20 (and 10) meaningful US metropolitan areas. The home prices in April 2012 for 20-city composite have reached the level existing in the start of 2003. In April 2012, the home prices have declined about 34-35% from its peak level in 2006.
The main reason for a stagnant US housing market as evidenced from the MDR data is a fragile labor market. Slow job growth rate is due to ineffective consumer spending, which is the 70% part of real GDP and meaningful driver of job creation in the US. Consumer spending is directly related to job growth rate, the saving rate and the consumer confidence. In an uncertain ecosystem, spending falls and both the US dollar and saving rate increases. Although savings are recycled by the intermediaries as investments for businesses, this does not necessarily translate onto investment spending and GDP growth. Companies in a high risk ecosystem aim to trim their balance sheets by paying off their debts, a course of action called as deleveraging. They do not want to burden their balance sheets by borrowing from edges. This deleveraging course of action slows down the level of investment in the economy thereby indirectly moderating the job growth rate. Deleveraging also runs counterproductive to low interest rates and impedes growth in jobs and consequently fast recovery of real estate prices.
Why the Canadian housing market is not poised for a serious correction?
The Canadian Mortgage system is more strong and conservative than the one prevailing in the US. First of all, the Canadian subprime market is only 5% of total noticeable mortgages while during its peak years 2004-2006, the US subprime market captured 25% of total noticeable US mortgages. The Canadian mortgage system executes better risk management tools including limited exposure to securitization and tight lending practices backed by insurance mortgage. The recent changes in the Mortgage lending have further tightened the belts to avoid any risks to healthy housing in Canada.
The supply and need conditions in Canada are observed by all players actively. There is a great degree of transparency and authenticity in the housing data and practices. Supply dovetails both current and future need leaving little room for creation of bubbles. Remember bubbles happen when there is a huge undiscovered lag between supply and need. For example, there is an expected restriction of commercial real estate supply in the wake of surging need both in Toronto area and Western Canada.
A large number of Canadians are currently disillusioned by lower and volatile investment returns in the chief financial assets, stocks and bonds. The current volatility in the Capital markets is expected to last in the next few years, given some long lasting problems like risks of Sovereign debt crisis in Europe & the US. This situation has mobilized a great number of people to invest in real estate as most viable different investment in the wake of record low interest rates. This course of action might continue for some years as the chief financial assets (stocks, bonds and mutual funds) may not pick up momentum soon.
The concept of a bubble is not quite applicable in the context of the Canadian housing market. This is explained in terms of a typical sales cycle witnessed in Toronto and other places in Canada. The sales cycle woven around tighter need-supply conditions mitigates the probability of bubbles. For example, in Toronto, condos are sold or flipped by investors, who generally do not live in those condos. When interest rates would inch up in future, these investors will find it difficult to keep highly expensive condos. They will sell these condos putting downward pressure on prices of the condominium market. Intuitively, the falling prices will give opportunity to new immigrants and other investors to buy condos, as they could not before provide it. This course of action is further strengthened by different ethnic groups who sustain their new immigrant friends and families toward the buy of their first homes in Canada. Overall these processes would push prices upwards again. To conclude, given these tight supply-need conditions, the chances of any serious correction are quite minimal in Toronto.
What are the Macroeconomic factors which impact the prices of Real Estate?
Interest Rates and Inflation: Interest rate is the price of money. It is determined by supply and need of loanable funds. However the country’s Central bank can greatly influence the rate by tightening credit conditions or making those relaxed by pumping money into the system. This is typically done by Monetary Policy and open Market operations. Lower rates make it cheaper for possible buyers to borrow money and make purchases. It also helps current homeowners to refinance their homes and save money. All this will rule to stronger need for mortgages and housing. Increasing rates will have the opposite effect and dampen the level of sales activity in the Mortgage market.
Carry forward trades, borrowing at lower rates in one vicinity and investing it in other, also indirectly impact real estate. For example, foreign institutional investors can borrow money overseas at cheaper rates and invest in Canadian real estate market. More important, real interest rates equal moderate rates minus inflation. Rising level of inflation will lower the real interest rates and declining levels will inflate real rates. Inflation typically feeds into asset prices including real estate. Tightening of money supply is done to control inflation, and this course of action leads to rising interest rates. Easing of money supply is done to cause growth and this is accompanied with declining interest rates. However greater supply of money and rising oil prices (supply side) satisfy into inflation and ultimately inflates asset prices.
Economic Growth, Consumer spending and Employment level: Economic growth is measured by growth in the real GDP. Slowdown in economic growth-both global and regional-raises fears of “deflation” or declining prices, which does not bode well with overall economic wealth. Deflation can be compared to halting of an economy. Japan experienced consistent recession due to deflation for a long period. Fear of deflation due to declining growth can have negative impact on the real estate market.
Labor Market dynamics and in particular the level of unemployment has a basic relationship to the health of the housing sector. Rising unemployment during recession is often accompanied with low housing need and mortgage delinquencies. For example, when Enron crisis erupted, there was general softening in the regional housing market. Another example is the current state of the US housing market. Economists say that the slow speed of housing recovery is credited to a stagnant US labor market, which is stuck up at over 8% of unemployment rate.
Consumer spending plays a meaningful role in the US while the export sector plays an important role in China. in addition in Canada, consumer spending has correlation to the GDP growth. In case of the US, Consumer spending consists of 70% of GDP and is consequently most important driver of GDP growth rate. Higher consumption level, pushed by consumer confidence levels, leads to greater economic (job creation) activity and ultimately translates into greater need for housing. Surging consumer debt, as it is happening in Canada, is also not healthy for a sustainable consumption and GDP growth. Over-leveraged consumers do not have the capacity to absorb shocks like layoffs or increase in interest rates & inflation.
Institutional Capacity of Economy to absorb External shocks: The housing crisis of 2007-2008 polluted the global financial system. The Fed and G-7 countries had to attempt unheard of bail out measures to save the global financial system from getting derailed. Fortunately, the Canadian housing market was resilient enough to absorb the shocks and did not sink. This happened because of a comparatively conservative mortgage system prevailing in Canada. Regulatory measures also impact the resilience of the housing market. For example, tax credits in the US had triggered growth of the housing sector in the aftermath of crisis. Canada has applied its regulations to keep the housing sector strong and healthy.
Demographics and Migration: These play an important role in shaping the long term prospects of the real estate market. In Canada and the US, the aging population of baby boomers will create more need for residential and vacation homes in the next decade. International migration to Canada is also an important determinant of housing market in Canada.
Technology, Oil-Commodities expansion and Exports: The Canadian economic and housing activity is also impacted by three external forces: Chinese Investors, Oil-commodities prices and economic activity in the US. The Western Canada is impacted by the level of Chinese and foreign investments, mainly in the Mining and Oil sector. The Eastern vicinity, mainly Ontario and Quebec, is impacted by the level of exports to the US and consequently indirectly on the state of the US economy. Stronger Canadian dollar does not augur well for exporters. Overall, the Canadian economy and dollar are strengthened by rising need for Oil and commodities.
National Level of debt: In the US, the national level of debt is reaching about $14 trillion and will continue to grow in the years to come. National debt piles up due to persistent fiscal deficits in the economy. In the US, there is a challenge of twin deficits-both fiscal deficit and external imbalances. The twin deficits not only rule to faster growth of national debt but cause anticipation of higher interest rates and inflation. This happens by the following mechanism: Higher debt in the US is monetized by either selling bonds to China (or other surplus countries) or by printing money from thin air. In either case it leads to greater risks and consequently higher interest rates, fast depreciating currencies and consequently more inflation. Some economists say that if debt is not contained by the US policy-makers, we may go into an era of hyperinflation where all asset prices (including real estate) will become very costly.
Applying Macroeconomic Framework to analyze current & future trends:
(I)-Current Global Economic Outlook: The global economic growth is expected to moderate in 2012 (and perhaps 2013). Concomitantly, the global real estate market is cooling down a bit. The moderation in growth is spread unequally across different geographical regions. In the US, which been the central point of housing crisis, there is some improvement in meaningful housing indicators. Given consistent low rates, minimal probability of deflation (halting of economy) and complete preparations by European Central Bank to cope with Eurozone debt crisis-there is less likelihood of any major reversal to the US economic fundamentals and consequently the housing market.
The meaningful emerging Global housing trends are captured in the following summary:
(A)-The battered US housing market is comparatively stable, with less increase in foreclosures and mortgage delinquencies. The US market is currently an ideal buyers’ market. However, there will be a substantial lag time before we can observe a complete turnaround in the US housing market.
(B)-The vibrant Canadian housing market is generally perceived to be ready for some correction in 2012 and 2013. Chart V shows meaningful housing trends in Canada.
(C)-The European housing market is (and will in future) undergoing a degree of correction. This stems from recent fiscal crisis in Europe in addition as fragility of the German economy exposed recently. The housing market in the emerging global economies is also cooling down a bit.
(II)-Some Predictions using the Macroeconomic Framework:
The short term perspective of the Canadian housing market might observe come corrections in 2012 and 2013, but as argued in this paper this will be minimal. Also, as argued further, the commercial real estate market will stay steady and strong in 2012 and 2013 in Canada.
Given the complicate interplay of global economic forces and what is happening in the Eurozone and the US in terms of debt crisis, it is rather difficult to make any certain long term predictions. However, growing complexity warrants a more holistic inter-market examination to predict about the real estate trends. The seven meaningful global economic trends of the next decade can help us understand the future real estate prospects in addition. These seven trends are as follows: (1)-The bubble of Sovereign debt crisis in the US and Europe will last for sometimes, at the minimum next decade. Governments in this part of the world are running unsustainable enormous debts, which will ultimately put an upward pressure on inflation and interest rates. (2)-The clear outcome of (1) above will be depreciating value of currencies. (3)-Another consequence of (1) above will be fragile and volatile bonds and stock markets. (4)-Commodities, gold and some different investments will become attractive as they will be perceived to store real value. Currencies, stocks and bonds will depreciate fast. (5)-Inflation will be triggered by enormous monetization of debt (printing money from thin air). This situation may be exacerbated if China pulls out trillion of dollars of US bond purchases it made in the last decade; and if oil prices continue to move north. (6)-Demographic trends require growth of baby boomers in North America and Europe leading to migration to North America. (7)-The US dollar will not evaporate because of spectacular performance of the US companies and technological advancement in North America.
Given these seven meaningful economic trends of the next decade, the housing market will stay vibrant and steady in Canada and the US. Baby boomers, foreign investors and immigrants will continue to play a basic role in strengthening the housing need in North America. Hyperinflation, as worst case scenario, might pull down need of assets because it would stoke prices of those assets including real estate. At this stage, however, it cannot be expected whether the European and the US governments will take concrete measures to contain their debts and put in place sustainable debt management policies. Future events will separate the political commitment of these governments. At this stage, one thing is certain: the current debt monetization policy of these governments is not sustainable in the long run.