The Core of a Bubble

November 4th, 2010 by Potato

From RFD, but not an uncommon viewpoint:

Basically, the argument of the pro-bubble crowd here has been: ‘it happened in the US, therefore it must happen here’. But they fail to appreciate the magnitude of the mortgage mess that created the US bubble. Canadian banks are much more prudent, and we never had that sub-prime mess here. It is safe to say that 99% of home-buyers here are able to afford their mortgage payments in the long-term, therefore there is no ‘bubble’.

One sad thing about the US subprime contagion was that it lead many to believe that such terrible, terrible mortgage lending was a necessary condition for a real estate bust to take place. It’s entirely possible to have a real estate bubble form even with ostensibly sane lending — we had it happen here in 1989, and several times before that. Back then property speculation was much harder to accomplish than it is now… but it still happened. Bad lending standards can make bubbles inflate faster and higher, and the waves of foreclosures that then follow can make the correction sharper and deeper, but the bad lending is not the bubble. Over paying for real estate (or whatever asset is in question) for whatever reason is the bubble.

Imagine if you would a small, remote town. Let’s call it “Ft. Mac” for the sake of this example. Then, have some event happen that changes what people are willing to pay for real estate in that town, for instance the opening of a new business, call it “Tarco”, that’s paying high wages to workers. More people decide to move to Ft. Mac, chasing the money. But, there aren’t enough houses built and ready for the influx of new workers. People get into bidding wars for houses, paying far more than they ordinarily would so they they can get a shot at one of the lucrative jobs with a roof over their heads too. The construction guys move in and start building more houses. Eventually though, the hiring spree at Tarco peters out, and the influx to the town stabilizes. Now when a new worker comes to town and is looking for a house, they’re the only one bidding. Without the insanity of a bidding war, they don’t see the logic in paying 5X their income for a house in Ft. Mac, and so they don’t… prices fall back down.

This little story is the core of how price distortions can happen and later correct. No need for the construction guys to over-build and create a glut of houses that will never be lived in (though in real life that often happens and makes the bubbles worse); no need for speculators to buy houses and take out mortgages they have no intention of servicing (but in real life the speculators would probably show up too), and then get foreclosed on when they can’t flip for a profit. It doesn’t have to be real estate in the parable, it could be playstations, internet stocks, or tulip bulbs. Leverage definitely adds to the severity of these situations, especially when handed out like candy on Halloween, but it’s not a necessary part to the story.

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