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Joy-ride about to end
Aug 26, 2005

From June 1881 to mid-April 1882, Winnipeg was in the midst of one of the greatest land booms in North American history. It was a time when inflated property values brought on by widespread speculation caused otherwise rational people to act irrationally. Although this was an extreme example of rampant speculation, it appears that somewhat similar conditions now exist south of the border.

“The excitement spread like wildfire all over the country,” wrote John Macoun in his book, Manitoba and the Great Northwest, published in 1882. “Cool-headed professors and businessmen (clerical as well as lay) left their callings in other parts of the country for the scene of the modern Canadian El Dorado.”

“I doubt if to-day any other city on the continent, according to its population, can boast of so many wealthy young and middle-aged men,” said a reporter for the Toronto Globe in March 1882.

George Ham didn’t share their optimism, in his book Reminiscences of a Recointeur, he called Winnipeg a “fool’s paradise ... Men made fortunes — mostly on paper — and life was one continuous joy-ride.”

Some did make a fortune and kept it, but most were the fools described by Ham. Any fortune they may have briefly  accumulated was on paper and they were deeply in debt and thus driven into bankruptcy when the land boom burst.

“Banks and other financial institutions which had encouraged and fostered the reckless inflation of boom days were now mercilessly exacting in their demands, and many a man, who in a more confident state of trade could have weathered the pressure with honour was forced into insolvency,” wrote the Winnipeg Board of Trade in its 1884 report of the land boom and the disastrous aftereffects.

Today, warnings are being issued of a similar fate — not in Canada, but in the United States where people are being saddled with debts from land purchases reminiscent of Winnipeg’s earlier “continuous joy-ride.”

A report by TD Economics, U.S. Expansion on Borrowed Time, said that the current American housing cycle has one variable that was not as prevalent in prior boom cycles of the late-1980s and early-1990s — “the size of personal debt burdens and credit made easy through interest-only loans and home equity lines of credit. This introduces an entirely new element of risk that has yet to be tested.”

In the Winnipeg land boom of 1881-82, credit was easy and little, and collateral for loans to buy real estate was based upon the expectation that the joy-ride would never end. At the end of the boom, lots that sold for $1,000 on one day sold for $10,000 a few days later. One person who had bought a parcel of land earlier at $15,000 was considered crazy until it sold for $115,000.

In the U.S. in the last five years, real estate prices have kept going up and up. In Washington, the average sale price per home has jumped 24.5 per cent to US $158,600. In Florida, the average price has jumped 31.7 per cent to $371,600. To pay for their home purchases, the value of home equity loans has gone from $156 billion in 2001 to $427 billion. Americans now hold debt of $11 billion, which is nearly double the total six years ago.

The expectation is that speculators in the housing market will be able to “cash-out” and make a bundle. But, not all of these cash-outs are being re-invested in real estate; instead, a lot is simply being spent, creating a false sense of economic well-being. As more and more people take their money out of real estate, the big question is, who will continue to fuel the upward climb in the housing marketplace?

A Globe reporter in 1882 wrote that speculation in Manitoba real estate was “perfectly safe and proper.”

The warning for the U.S. today is that it isn’t “perfectly safe and proper” to engage in speculation in the real estate market. Unlike Canada, where most people are entering the marketplace looking for a place in which to live, or are buying a vacation home, many Americans are entering the housing market for use as an investment vehicle and have no intention to live in the houses they have purchased. Some are buying two or more houses in order to quickly flip them for a profit since they anticipate that the market will continue its upward trend.

Merrill Lynch economist Kathleen Bostjancic warned in a recent report that a “nation putting more and more of our eggs into housing represents an alarming allocation of capital.”

It has been reported that housing has become the main engine of the American economy. “While it only represents five per cent of the overall U.S. economy, it accounted for half of all growth in the first half of this year and more than half of all private-sector jobs created since 2001,” wrote Barrie McKenna in a recent Globe and Mail column.

TD economist Beata Caranci said that speculation cannot sustain the American housing market. Real estate assets now total US $19 trillion as of the first quarter of 2005, and thus only a relatively small percentage change in its value could have a big impact on consumer spending.

“Using rather conservative assumptions that approximate the return to historical growth trends on real estate prices, realized capital gains and cashed-out equity, we found that the entire boost to spending from wealth could not only be wiped out, but would actually detract from real consumption growth for four to six quarters,” he added. “And, in all our assumptions a nominal price correction was never assumed.”

TD economist Carl Gomez said in a recent report on the housing market that conditions in Canada are markedly different than in the U.S. In Canada, housing prices are not irrationally overheating and are actually experiencing a cooling off period without any danger of collapse.

He said house prices are not being bid up beyond what their underlying fundamentals would justify. Low mortgage rates and a strong economy have maintained the equilibrium of homeownership value in Canada.

The U.S. is also now under a low interest rate regime, but the major difference between here and there is the amount of speculation which does not maintain the equilibrium of homeownership. In fact, speculation has had a negative effect on housing affordability. Potential home buyers wanting their piece of the American dream have been forced to shell out more and more money, placing them further and further into debt.

The TD report, U.S. Expansion on Borrowed Time, warns that by 2006 higher interest rates will increasingly pinch U.S. consumers’ wallets and refinancing activity will moderate — actually a trend already underway. With that, the wealth effect on consumer growth will wane and even turn negative for more interest-sensitive components like cashed-out equity. This makes it increasingly unlikely that the U.S. consumer will power the economy as it has in the past three years.

While Canada is not on the verge on the housing bubble, a projected collapse in the U.S. will still have an effect on the local economy. A consumption slowdown south of the border will stunt Canadian export growth to the U.S.

In effect, the conditions of 1881-82 are being duplicated in the U.S. During the “continuous joy-ride” of that era, real estate drove the marketplace to the near exclusion of other wealth generators and, when the fall came, it had ramifications for everyone down the line. It’s this “fool’s paradise” road that the U.S. is now heading down.