The Great Unravel

How will it all unravel?

We have price bubbles in housing and stocks – at least.  Rising interest rates at the end of a business cycle will cause these bubbles to collapse. In fact, this process has probably already started.

What follows is what happens when these bubbles start to unravel, and this is what is about to happen…again.

Housing Prices:

Falling house prices causes speculators to panic. These people cannot be caught with losing investments because they likely do not live in their investment properties, and they have no intention of paying them off - they will sell/dump, and take whatever profits that have now – or they will get out whatever cash they can, while they are still able to do so. This will drive prices down even more.

Recent buyers will be in the red as prices fall. Most prices of recent buyers will be below the value of their deposit plus the mortgage. Those with variable rate mortgages will be in serious difficulty as their monthly mortgage payments will rise on homes that can only be sold at a loss. Some may even see the value of their homes drop below the value of the mortgage itself, meaning they have no equity in their homes at all.

This will spark even more selling – both on the part of owners who are in the red to avoid even deeper losses, and more so as a result of creditors panicking and foreclosing on mortgages before prices fall so far that they are in the red on the mortgage book as well.

Most homeowners will initially be fine in this scenario – the above situation may only affect a maximum of 5% of homeowners. But home prices reflect most recent sales not historic values, so the price action around these speculative and distress sales by variable mortgage/underwater owners will be enough to collapse the prices of everyone’s home by a significant margin. Prices in Toronto fell 30% from 1990 to 1996.

The biggest issue at this point in the bubble’s collapse will be what is evident in every single very collapsing bubble driven by rising interest rates – prices will be lower, but it does not matter how far prices fall, as there will be very few buyers as almost no one will have any money to buy, especially in Canada where we have never been more in debt. 

Housing Industry:    

The above price drop and drying up sales will devastate the entire housing industry. The unemployment rate rose from 4% to 12% in Toronto in 18 months from mid-1989 to the end of 1990 during the last major real estate collapse. Anyone employed by this sector will be at risk – builders and trades people; building materials producers; lenders and bankers; real estate agents; support staff. It could take years for employment in the sector to recover, and employment recovery will match price recovery – prices did not recover in Toronto after the last collapse for 12 years.

These are very good jobs. The hollowing-out of real estate sector employment will have a similarly devastating impact on the wider economy, affecting everything from clothes retailers, to coffee shop and restaurant owners and workers, to car salesmen and women. In this scenario, the collapse of the real estate sector becomes the driving force behind a general economic slowdown and recession.

But it gets worse. 

As noted, the first round of speculative and distress sales will drive down the value of every single property. This will catch even some people who are not recent buyers with variable rate mortgages or speculators, and will force even more distress sales. 

A key point - The initial price drop is not a one-time, time-limited thing. It sparks a vicious cycle of further price drops as buying dries up as those who still have money stay on the sidelines waiting for ever lower prices, and more and more people go underwater on their mortgages often becoming unemployed at the same time in the more general slow-down, forcing these people into ever more distress sales. With time this cycle subsides, but it could take years to get back to a virtuous cycle of price appreciation. 

Again…house prices in Toronto dropped for SIX STRAIGHT YEARS the last time this happened, and did not recover for 12 years.

The Stock Market:

When the stock market and equities bubble starts to burst, many people who have invested “on margin” face a call to pay up what they have borrowed. Investing on margin allows those who do this to borrow cash from their broker to buy many more times what their initial investment could have bought, searching for gains that are a multiple higher than could have been provided by just buying a given stock. 

But just as their gains could be many multiples higher, so can they suffer a multiple of losses. When prices drop, massive losses by people who invested on margin spark demands to repay their margin loans by their brokers, resulting in borrowers selling at distress prices – they often sell at any price they can get to pay their debt. At times, some brokers actually sell the stocks of those investors at a loss just to recoup their loans from these people.

So as with collapsing real estate bubbles, a collapsing equities bubble also sparks distress sales which drives falling prices even lower because these sales often swamp normal buying and drive prices of all equities down significantly as margin investment occurs throughout the market.

While some people will continue to buy while prices fall, falling stock prices usually freezes most investment. This drying up of buyers usually forces the market even lower as Fear takes over from Greed, and people decide to take profits and sell. As with the real estate vicious cycle, there is such a cycle in equity markets as well drive by the fear of losses, although it does not last as long.

Again, as with the real estate sector, a declining equities market drives increasing unemployment especially in the investment and banking sectors, and in the wider economy.  While not contributing as much to the general economic downturn, the employment effects on this industry are often far more severe than those even on the real estate sector.  Many people who lose their jobs in the investment and banking sector in a general stock market collapse and economic downturn never work in the sector again.

Government:

Governments do not plan for recessions. The above scenario will cause revenue to dry up while demands for government services increases as more and more people become unemployed. 

The result will be a massive increase in deficits, and a turn to austerity financing as governments slow or stop public sector hiring and wage growth, as well as cut program spending. Governments also usually take action to try to "Keynes" their way out of recessions by spending on things like infrastructure, driving deficits even higher, and central banks lower interest rates, reversing one of the primary causes of the recession in the first place.

Eventually, growth returns courtesy of private sector recovery, and public sector efforts, but by dropping rates and spending borrowed cash, governments and central banks inaugurate the start of the next great bubble…

Query – can we borrow and spend our way out of the next recession given how much we owe now?