The anatomy of a housing bubble

The anatomy of a housing bubble

Why do we repeatedly fall into the trap of inflating bubbles even though history shows they always end badly? Blame your brain.

(Julianna Funk/iStock)

(Julianna Funk/iStock)

Bob Thompson is a vice president and senior investment adviser at Canaccord Genuity Wealth Management in Vancouver. 

Every 20 years or so, investor dementia sets in. Memories are wiped clean, allowing individuals to make the same mistakes over and over again. My 20 years in the investment world have been on the money management side, looking at global trends and markets, then investing money to profit from what I see. I mention this as a pre-emptive strike against those who read what I am going to say about Canadian real estate and respond with: “This guy has no authority to say anything about real estate, he’s never sold a house or developed anything.” I haven’t, but if there is anything I know, it is how markets function. It doesn’t matter if it is real estate markets, stock markets, commodity markets, or tulip markets (I’ll get to this later). They are all the same.

Why? Because markets are a reflection of people, and people are hard-wired to have emotional instincts that don’t change. They never have and they never will. Besides, being out of the real estate industry, I will argue, allows for a balanced view. Being outside the industry makes you see the forest, not the trees.

Watch Bob Thompson speak with BT Vancouver  about the signs of a bubble in Vancouver’s housing market

Let’s talk very little about real estate, and a lot about people’s behaviour and the anatomy of bubbles throughout history. The anatomy is shockingly the same no matter what asset we are talking about. It starts with something actually changing, a new development—in the technology bubble it was the rise of the Internet, and the “new economy.” In the early part of last century, it was the building out of railroads, resulting in skyrocketing real estate prices and ending in yet another crash of both Florida real estate and railroad stocks. For sure, there is a valid game changer that starts the boom, and lots of people question whether the valuations of whatever asset we happen to be discussing are overvalued. That’s called climbing “the wall of worry.” The underlying asset continues to go up however, seemingly proving the disbelievers wrong.

This has been real estate in Vancouver and for many parts of Canada for the last few years. Market bubbles don’t pop during this phase, when there are rational buyers and disbelievers. Bubbles burst, and people’s financial lives are destroyed at the end of the next phase: euphoria. During this phase, caution is thrown to the wind, people’s hard-wired desire to “not want to miss out” comes into full play: “I have to get in now, my next-door neighbour is making money and I am not.”

This panic buying can suck anyone into its vortex. During this phase, even the smartest believe that we are in a “new paradigm” and the old ways of valuing things are thrown out. Whatever the asset is, it becomes too expensive for the average investor, which is especially true of real estate.

A necessary step in the euphoria stage is the occurrence of “irregular” lending practices, irregular sales practices, and financial engineering. Through magic, the impossible is made possible. People who could never otherwise afford real estate suddenly can. As the panic to buy increases, it is a self -fulfilling positive feedback loop. Prices go up, people panic to buy more and they outbid each other in an orgy of greed. Amazingly even the experts begin to extrapolate out recent trends well into the future, like in 2008 when oil was $140, and many targets had it going to $200. That didn’t happen, it’s just how powerful a euphoria becomes.

Even so-called experts get sucked in during the euphoria stage when all the news is good. That is another absolutely necessary component of any bubble: there is no bad news. This is another pre-emptive strike at all the gurus saying that Vancouver and other overvalued markets will go up forever. It ain’t gonna happen. A few months ago Maclean’s put out a chart extrapolating 17 per cent annualized gains on Canadian real estate. It showed that exponential growth would put the average house price at $20 million in 2040. You laugh, but that’s what extrapolation does, and the author made a good point of the ridiculous nature of it.

The problem is that massive amounts of debt are created in any bubble, and at the end, the market gets crushed under its own weight. I’ll tell you a little story. During the 1960s, millions of people moved to California. My dad told me that a news anchor came on one day in 1970 and did a little back-of-the-envelope calculation. His numbers were correct and showed that if the same number of people continued to move to California as had in the previous 10 years, then everyone in the United States would live in California by the year 2000. They were making a joke, but you get the point.

Lately there have been some obscene projections for the value of real estate in Vancouver over the next decade, by very reputable sources. This again is a very necessary component of bubble formation. If you haven’t figured it out yet, I am simply giving you the anatomy of any bubble over the last few hundred years, then overlaying it on the current real estate market. You can draw your own conclusions.

My degree in university was in anatomy and physiology, and human physiology hasn’t changed for eons. Neither has the anatomy of a market bubble. To paraphrase Jim Rogers, co-founder of the Quantum Fund with George Soros, if one wants to be successful in the markets, then skip the degree in finance and instead pursue philosophy, psychology and history: philosophy teaches you how to think, psychology is the one thing you can count on to be irrational in the markets, and history doesn’t repeat itself but it rhymes.

On this theme, here’s some more bubble anatomy. Politicians are generally oblivious to the bubble as it is happening, or at least do very little to get in the way of it. After the fact, however, when the catastrophic collapse happens, another necessary component is the blame game. Nobody ever blames themselves for getting caught up in euphoria, which always seems so obvious after the fact. People look to blame someone else for the collapse, pressing politicians and regulators to make an example of someone and to regulate something. Some messenger gets shot, and everyone is happy, and the politicians get to be reactive and the saviours of future generations.

So let’s back up and ask, are there irregularities going on right now in the real estate market? Of course there are. Is there some form of fraudulent activities going on or at least a massaging of the truth? The answer is most likely—it is a necessary component of the bubble, an effect of the euphoria.

It is also a natural progression of the underlying asset, in this case real estate, which has become too expensive for the consumer to buy. In a competitive system, people will find creative ways to finance the boom. For it to continue, they must find ways to financially engineer it. All seems good during the boom times, then something, somewhere, comes out of left field, and the balloon gets pricked, never to reinflate in that manner again. Everything that seemed so sane, all of a sudden seems so totally insane. As Warren Buffett says: “You don’t know who’s swimming naked till the tide goes out.” For now, all is good in fairy-tale land, but this level of speculation has the ability to destroy the dreams of people for the next 20 years.

Vancouver real estate recently broke all records for volume. People can’t get enough. This is yet another necessary bubble component. Volumes are always highest at the top, never at the bottom. The panic to get in creates a gaping hole of demand in the future. For instance, let’s say over the next five years 100,000 people would normally buy real estate based on their family needs and other factors. The great euphoria and subsequent price rise, however, sucks that demand into this year, and it can be seen readily with today’s high volumes and skyrocketing prices. Who’s left to buy two years out? There has already been a massive flight of capital out of China of over $1 trillion. Will that continue endlessly? Of course not, the Chinese government will stop that at some point, leaving the locals of Vancouver and eastern Australian cities holding the bag.

Some readers who haven’t had the magical 20-year dementia will recall that during the tech bubble, the average NASDAQ share was held for a period of seven days, volumes were immense and speculation was rampant. The tech bubble was propagated on the same belief that drives any market bubble, the Greater Fool Theory. Speculators regularly convince themselves that there is always a greater fool who will come along to pay a higher price for their asset than they paid. It’s too much to get into here, but google “tulipmania” and see how that bubble formed in the 1600s. All I will say is that at the peak of that bubble, people found ways to profit from the time a tulip was bought and the time it was sold. Intermediaries flipped the tulip several times between the buyer and the seller, profiting each time. People think that the practice of “assignment” agreements in the Vancouver real estate market—whereby a newly purchased property is flipped to another buyer before the original sale even closes—is a new thing. It’s not. It happened in the tulip bubble more than 300 years ago, and it happens in every bubble. It must happen to keep the bubble growing bigger. It does tell us, though, that we are getting near the bursting. It’s a shame, because it’s not just Vancouver that will be impacted: real estate markets in many cities are red hot simply because of 240-year lows in interest rates. This type of thing ends badly.

When an asset is overly popular, it is most likely overvalued. You can’t find value in anything that is popular. However, you can almost always find value in things that make other people queasy. That’s why I have been buying gold stocks lately. By definition, nothing that is unpopular is in a bubble. That’s my next rule of investing: sell hubris and buy humiliation. This bubble cycle has only repeated itself 100 times or so in the last few hundred years, but I am sure “this time is different.” People have somehow got smarter.

If you believe that, I have a bridge to sell you.


The anatomy of a housing bubble

  1. Warren Buffett said it best on housing bubbles:

    “…there were a vast number of things that contributed to it. The basic cause, you know, embedded in psychology – partly in psychology and partly in reality in a growing and finally pervasive belief that house prices couldn’t go down and everyone succumbed –- virtually everybody succumbed to that. But that’s –- the only way you get a bubble is when basically a very high percentage of the population buys into some originally sound premise and – it’s quite interesting how that develops – originally sound premise that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action.

    So every – the media investors, the mortgage bankers, the American public, me, my neighbor, rating agencies, Congress – you name it – people overwhelmingly came to believe that house prices could not fall significantly. And since it was biggest asset class in the country and it was the easiest class to borrow against, it created probably the biggest bubble in our history.” FCIC Interview of Warren Buffett, May 26, 2010

  2. Great quote Franzese10 from Warren Buffett. You must have everyone capitulate and even the disbelievers throw in the towel, before the drop starts to happen. The same goes on the other side. The absolute most hated asset class is usually the best mid term performer going forward.

  3. Just as noted in the article, shadow flipping, massive flood of foreign wealth pricing locals out of their own real estate market, fraudulent methods being used, locals scrambling to buy in before ‘it’s too late’. These are all classic signs of a devastating bubble about to burst. If Canadians do not demand changes to limit the devastation, Canada will be left holding the bag and our children will be the greatest victims. If you agree that our prime minister needs to restrict foreign ownership and speculation in Canada before its too late, please SIGN & SHARE the petition @

  4. My personal library has dozens of books on investor psychology, market cycles and several on the danger of manias. I called the top of the US housing bubble in 2006 and in 2007 I warned about the impending financial crisis in a book I was writing called Slumphouse.

    I say this not to brag but only so you know who’s telling you: Bob Thompson is right on the money in this article. Bubbles have a pattern and that pattern is evident in BC’s real estate market.

    If you know your market history you will see parallels with Japanese real estate in the 1980s. When the bubble burst in Japan real estate prices fell by 60%. Prices hit bottom in the mid-1990s and 20 years later they still have not recovered.

    As Bob says, Vancouver has sown the wind, and it will reap the whirlwind. In other words, a crash is baked in and it cannot be avoided. Which means one day soon the only way forward for local real estate prices will be down.

    In writing this article, Bob has done real estate investors (and in turn any investor in mortgages, banks and credit unions) a big favour. It’s not something you want to hear necessarily, but it could save you from financial disaster if you are thinking of helping the kids get into the market or buying that second house.

  5. I think that you are right. There is a bubble, and it will burst. Eventually. The million dollars question is when.

    So far houses are going up in astronomical values. At 15% per year, this market is outperforming the stock market and other markets. Any person who is sitting on a detached house today in vancouver or toronto is making theoretical 150K, tax free too since there is no capital gains tax if you live there.

    Now, there are some means to end this bubble. Interest rates need to go up / canadian dollar needs to go up / government regulations need to take effect / foreign investors need to take their money elsewhere.

    Looking at these things:
    1. Interest rates going up – canadian banks leverage are pretty bad right now, but the government is concerned that increasing interest rates will put people out of their homes. Considering the hit on Canadian economy by oil prices, this is unlikely.

    2. Canadian dollar needs to go up – with a slow economy the last thing the government wants is strengthening of the Canadian dollar as it will hurt exports.

    3. Government Regulation – the government right now is hooked on a drug. it is called tax revenue – and it goes up 15% every year. This helps the government to undertake big projects or simply mitigate the deficits. They will ride this wave until riots take place.

    4. Foreign Investors – Toronto/Vancouver are still cheap compared to other world class cities. Meanwhile, short term investments in vancouver and toronto seem great. Toronto was just ranked #1 best city to live in. They will continue until a crash will happen or regulations will take place. Canadian dollar is still attractive to foreign buyers who use us dollars.

    I believe that one two of these factors will take place simultaneously it will trigger a crash, but so far, it hasn’t happened. In the mean time, home owners should enjoy the ridiculous gains, and should keep their eyes on the market to be one of the first few to get out when it crashes.

    Roy Tal, Co-Founder, Homenova Inc., – Buy or Sell Your Home On Your Own!

    • or a recession comes. With the amount of debt people have, a recession where people lose their jobs will do it.

  6. There is a great deal of truth to the article if you rely solely on historic examples. It is easy to build a case for catastrophic ending of this real estate rise. The author points to psychology as holding the answer to this event. I agree, but I have several questions that add to the mix. I think there is more to this then bubble. Demographics show our population is aging substantially. Immigration is allowing for easier movement to our country, Vancouver and Toronto being the primary landings. Economics showing our tax policy and land values are substantially lower than other countries. Lack of law enforcement. The RCMP is unequipped to investigate white collar crime at the international level. TSX is considered a money laundering gateway. China is unstable, causing money to seek safe havens. The USA is difficult to imigrate to as well as do business. Canada is a gateway to USA markets without stepping foot into the country. The Pacific Rim is the new center of Economic power. Europe is unravelling. China and India are becoming the largest consumer nations of the world. I believe there is more than local pressure to this real estate bubble. Vancouver in particular is strategic to Pacific Rim. Canadian financial laws are slightly more then loose. My personal view is that Vancouver is becoming the Canadian version of Hong Kong before the hand-over. We will see Vancouver emerge as epicentre to Pacific Rim. Asian community is choosing Vancouver and Toronto because of the much more welcoming environment. Locally if you look at how small Vancouver is compared to other world renowned cities, it has much more to go. The question is will it do all this growth this time, or will it take several events? More questions then answers?

  7. I have had real estate in Vancouver for just over 30 years. I bought my first home in 1986 and I sold it for just over double the amount I had paid for it 3 1/2 years later. I built a home and purchased two more. The market went up for another couple of years and then went stagnant for the next eight. Then it doubled in the next two years. We all were told that it was a bubble and the market was going to crash. But it did not. It slowed to a crawl, going up only 4 to 6% the next ten years. Now it has sped up again, but it has not had the same gains as the two other jumps I have been in before. I now have 5 homes. I do not want more. My children will be OK. As for the people waiting to buy, look at real estate history in the last 30 years in Vancouver. Learn from it. And if the sky falls and real estate falls to 1/2 price, can you afford the 2 million versus 4 million of today?

  8. The reality is people are sheep. Governments are populated by the in-experienced of the day. Harper would have surely intervened in the Toronto and Vancouver markets because he has lived through bubbles before. Trudeau and his cast have zero experience. My view is simple when the ordinary person can not afford it,… it will fail. We essentially missed the 2008 collapse… but maybe we are just getting started. Ask yourself why Greece is where it is? Maybe read the article regarding their productivity. The legs are wobbly on this one. But wait until Canada experiences the baby-boom bubble of depopulation in 10 – 15 years. Huge downside coming to a city near you.