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How speculators fed U.S. housing bubble, fuelled bust

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Of house 'flippers' and the U.S. bust Speculators played a major role in the U.S. housing bubble, researchers at the Federal Reserve Bank of New York have found, probably helping to drive up prices and then defaulting as the real estate market collapsed.

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Andrew Haughwout, Donghoon Lee, Joseph Tracy and Wilbert van der Klaauw recently unveiled new findings from their study of real estate investors, those who loaded up on credit to buy several properties in the run-up to the crash.

"These investors likely helped push prices up during 2004-2006; but when prices turned down in early 2006, they defaulted in large numbers and thereby contributed importantly to the intensity of the housing cycle's downward leg," they wrote.

"As mortgage lenders have long known, investors are more likely than owner-occupants to walk away from an underwater property," they added in their research, which is posted on the New York Fed's website.

"So when a borrower acknowledges on the mortgage application that she won't live in the house, the lender will typically require a higher downpayment and charge a higher interest rate to reflect the additional default risk. Within the category of real estate investors, some buy properties with the intention of renting them out, while others intend to simply 'flip this house,' selling quickly and reaping a capital gain."

At the market's peak, more than one-third of all lending for residential real estate purchases went to buyers who already owned at least one property. In the worst states, Arizona, California, Florida and Nevada, that level was a stunning 45 per cent. These speculators could continue buying up property as prices climbed because they weren't risking much money.

"We conclude that investors were much more important in the housing boom and bust during the 2000s than previously thought," the researchers said.

"The availability of low- and no-downpayment mortgages in the nonprime sector enabled investors to make these bets. This may have allowed the bubble to inflate further, which caused millions of owner-occupants to pay more if they wanted to buy a home for their family. In the end, even the value of the 20-per-cent downpayments made by responsible, prime borrowers was wiped out - leaving the housing market, and the economy, in the vulnerable state we find them in today."

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The U.S. housing market was, of course, where it all began so long ago, and the Federal Reserve warned again this week that the industry remains depressed.

Deep in debt As Merle Travis put it in his 1946 recording Sixteen Tons, we're another day older and deeper in debt.

Based on the latest Statistics Canada data, the debt burden of Canadian households is at troubling levels, which could be a shock for some when interest rates inevitably rise. That's because consumers are taking on more debt, but not bringing in much more pay, a worrisome development amid projections of slower economic growth and high unemployment.

The Globe and Mail's Tavia Grant reported this week that the ratio of debt to personal disposable income, a key measure, climbed in the third quarter to a record 152.98 per cent, from 150.57 in the second quarter. That's a measure that takes in not only debt but also outstanding liabilities, like taxes that are owed.

There's a separate measure, which is good for comparison with other countries, that looks at just credit market debt. That increased to 150.8 per cent, according to Statistics Canada. Mortgage credit reached $1-trillion and other consumer debt $48-billion.

What's important there, according to economist Diana Petramala of Toronto-Dominion Bank, is how uncomfortably close that second measure is to the the level of 160 per cent in the United States just before its housing market crashed.

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"We are of the view that household debt has become excessive," Ms. Petramala warned.

"If indebtedness continues to grow at this speed, the debt-to-income ratio will hit 160 per cent – the level at which both U.S. and U.K. households got into trouble – within the next few years. To stop indebtedness from rising, households are going to have to cool borrowing further and increase savings, both of which will imply a modest pace of consumer spending over the next few years."

At the same time, household net worth fell by 2.1 per cent in the quarter for the second month in a row, as declines in stock values more than offset real estate gains.

The report came in the same week that Bank of Canada Governor Mark Carney warned that too much of the capital coming into Canada is being used to fund household spending, though he doesn't see consumer debt as a "clear and present danger" like the euro crisis.

Douglas Porter, deputy chief economist at BMO Nesbitt Burns, doesn't see a slowdown in mortgage credit, given the buoyancy of the real estate market.

"By far and away, mortgages are the biggest component of Canadian household debt, and they are still chugging along at a 7-per-cent-plus pace," he said. "The single biggest driver of mortgage growth is the path of home prices. While we have seen some moderation recently, they are still up 5 per cent year over year. Unless and until home prices truly crack, don't expect a big slowdown in mortgage credit growth (and thus household debt). Again …careful what you wish for."

Karen Cordes Woods and Derek Holt of Scotia Capital take a different view than some others, wondering why there's such a "fixation" on the debt-to-income measure. They worry about slowing growth of consumer debt.

"Our concern is that the debt-to-income ratio is one of the worst metrics of household finances, whereas the evidence of a sudden deceleration in household debt growth is clear and provides a cautionary note against further policy tightening that could risk tipping the ship right over from a soft landing to a potentially harder one," they wrote in a report.

Two years gone Two years on, the euro zone debt crisis is now in a "chronic phase," with dire warnings and few expectations that it's going to ease any time soon.

Germany's Angela Merkel has warned that there's no quick fix, though she's confident of holding together the 17-member monetary union. But there's no confidence in the euro zone leaders that they can muddle their way through, and pressure has been unrelenting.

Christine Lagarde, the chief of the International Monetary Fund, for example, warned this week that the global economy could face the same issues as those that led to the Great Depression, and she called on all countries to work together.

There had been some hope after last week's EU summit, at which most of the governments in the group agreed to a new fiscal pact that will impose budget discipline. But it didn't take long for markets to realize that summit leaders agreed on little that would fix the mess now, leading to the same confusion and lack of action that have dogged investors for months. Along with that are the divisions that remain, notably now between Britain's David Cameron, who didn't sign on to the deal, and his colleagues.

"The euro crisis has moved from an acute to a chronic phase, a move mirrored by global risk appetite," said Kit Juckes, the foreign exchange chief at Société Générale.

"The crisis has not gone away - far from it - but this weekend will see the second anniversary of the move by Greek [credit default swaps]levels above 250 and we're learning to live with the possibility the crisis won't be resolved one way or another for a long time to come."

Like others, of course, Mr. Juckes hopes the crisis ends soon.

"Some people expect - and a few even hope - that the system will collapse," he said. "Some are daft enough to think that would be a good thing for growth. But the risk it would drag on all year was one of the themes of our 2011 outlook and there must be a risk that happens again."

What does it mean heading into 2012? It means more turmoil, no doubt more summits, and more pressure on Europe's financial system.

"The bottom line is that for the euro to survive it needs to go for full-blown fiscal union, or break up, it's as binary as that, and currently the odds are on it breaking up, given the obstacles in its way, on a political level, as well as a legal level," warned CMC Markets analyst Michael Hewson.

Europe's discontent We've seen the anti-austerity strikes, protests and riots flashed from across Europe. What we don't get to see is life on the streets. And by all accounts, it's ugly.

According to The Wall Street Journal, suicides have almost doubled in Greece. In some Greek hospitals, drugs have been withheld because of missed payments, while the country's consumer protection agency warns against scam artists. In Ireland, the latest statistics show a rise in emigration. And, in Britain, according to Reuters, students are turning to prostitution, gambling and other ways of raising money.

This is the troubling new era in the Old World, where governments are cutting deep and unemployment is a blight after the financial crisis and recession.

The Reuters news agency this week offered a disturbing look at Britain, where youth programs have been slashed and more than one million young people can't find jobs, the highest in records dating back about a decade. Many young Britons have taken to prostitution, gambling and taking money for clinical trials, the news agency reported.

The English Collective of Prostitutes, an aid group, told the news agency the number of people looking for its help has doubled over the past 12 months as students turn to alternatives.

"In some cases that's sex work, but we're also hearing about clinical trials, gambling ... dangerous work where there's very little, if any kind of employment rights," an official of the National Union of Students told Reuters.

Where RIM stands Who would have thought at the beginning of 2011 that shares of Research In Motion Ltd. would be worth less than $14 today?

The BlackBerry maker put on a brave face, and promised to work aggressively to regain its former glory, as it suffered another blow with the release of its third-quarter report late Thursday.

It's not so much what RIM earned in the third quarter - it had already announced that it would be taking a huge hit related to the inventory of it's PlayBook tablet - but more so what it projected for the current quarter and even further ahead.

RIM earned $265-million (U.S.), or 51 cents a share, in the third quarter. Without the hits from the PlayBook and the BlackBerry outage, earnings per share came in at $1.27. Revenue climbed 24 per cent to $5.2-billion, and the number of subscribers rose to almost 75 million. Shipments topped 14 million.

But the outlook for the fourth quarter indicates revenue of between $4.6-billion and $4.9-billion, shipments of 11 million to 12 million, and earnings per share of 80 cents to 95 cents. And, perhaps most key to the outlook, the company warned that its new BlackBerry 10s, equipped with an upgraded operating system, now won't be available until late next year.

Mike Lazaridis, who with his co-CEO Jim Balsillie cut his salary to just $1, acknowledged RIM hasn't met expectations, and he asked for patience and confidence. Together, the two men pledged to review their operations and press ahead, confident in the future.

"RIM continues to have strong technology, unique service capabilities and a large installed base of customers, and we are more determined than ever to capitalize on our strengths to overcome the recent execution challenges surrounding product launches and the resulting financial performance," they said in a statement.

The outlook prompted several analysts to slash their price targets on RIM shares again, to a depressing $8 for National Bank Financial, though much higher at others. Indeed, CIBC held its at $25.

Analysts were mixed in their outlook.

"We believe RIMM missed an opportunity on its earnings call to signal to shareholders that it is painfully aware of the gravity of the situation it is in and to send a clear message to investors on how it intends to rectify the situation," said UBS analysts Phillip Huang and Amitabh Passi, referring to the company by its U.S. stock symbol. "... With BB10 devices now being delayed to the latter part of CY12 and disappointing sell through for BB7, RIMM is now stuck in the unfortunate position of lacking any compelling new products over the next two to three quarters. In the fast evolving world of mobile devices, this would be comparable to eternity."

RBC Dominion Securities analyst Mike Abramsky suggested the delay in the new models makes RIM "significantly late to the high-end smartphone market, risking further share losses and competitive developer momentum."

CIBC analyst Todd Coupland was not as dire as his peers, maintaining his target at $25 and telling investors that the delay in the new devices "should not overshadow international subscriber growth," an area where RIM has had a strong showing with an increase of 30 per cent in the quarter.

Pierre Ferragu, senior research analyst at Sanford C. Bernstein in London, said he's "on the sidelines" for now, though his report was grim, citing a fourth quarter with shipments down 15 per cent to 22 per cent, and earnings slipping 25 per cent to 37 per cent.

Mr. Ferragu projects RIM earnings per share of $2.88 in its fiscal 2013, and a 13-per-cent drop in shipments to 43 million devices, but services revenues holding steady at $3.6-billion.

"Without any change in strategic direction, we think RIM's stock is unlikely to see any valuation floor in the near term," Mr. Ferragu said.

In the markets Investors had to wrestle their way through the week, disappointed first by the struggles of the euro zone and, second, left wanting by the fact that the Federal Reserve did nothing at its policy meeting, noted Robert Kavcic of BMO Nesbitt Burns. The S&P 500 lost 2.8 per cent, and Toronto's S&P/TSX composite 3.3 per cent.

Gold took it on the chin, helping to pull down the TSX.

Where do things stand as we near the end of the year?

"The Dow is the only major global index clinging to positive territory for the year, up 2.5 per cent," Mr. Kavcic said.

"The index of blue chips is in the sweet spot of the equity market right now, largely comprised of defensive large-cap multinationals, with stable dividends and little financial-sector exposure," he said in a research note.

"In fact, banks currently make up less than 3 per cent of the Dow. Not surprisingly, European stocks are among the laggards this year, with declines of more than 20 per cent in France, and Italy. Commodity-heavy markets in Canada and Australia have also disappointed, down 13.4 per cent and 17.9 per cent, respectively, amid cooling growth in China and relative weakness in cyclical sectors. China itself has also shed more than 20 per cent, while other emerging markets like Brazil, Russia and India have seen similar percentage declines.

Nine things 1. The best watch-your-credit-limit warning of the week, from the Get Rich Slowly personal finance blog: "Sexually transmitted debt (or relationship debt) is debt you 'catch' from your boyfriend, girlfriend, partner, or spouse by: Lending them money. Acting as guarantor for a loan. Taking a contract or loan for them perhaps for a mobile phone or a car. Sharing a bank account or credit card on which they run up debts for their benefit."

2. Oh, the troubles of trying to forecast oil prices. From the International Energy Agency's oil market report this week: "Random events present downside risk to the non-OPEC production forecast contained in this report. These events can include accidents, unplanned or unannounced maintenance, technical problems, labour strikes, political unrest, guerrilla activity, wars and weather-related supply losses."

3. École Polytechnique Fédérale de Lausanne researchers have made what's reported to be "the world's toughest 18-karat gold" by adding boron carbide, making it virtually scratch-proof. Boron carbide is the stuff they use in bulletproof vests and tanks. (With this bulletproof ring I thee wed?)

4. France's finance ministry desperately wants to hold onto the country's triple-A rating, and it's setting an example. Valerie Pecresse, the budget minister, says the ministry will only be serving biscuits at holiday events rather than the traditional petits fours, Reuters reports.

5. Even Bank of Canada Governor Mark Carney can't resist taking shots at the Toronto Maple Leafs. Here's what he told a luncheon speech in Toronto this week: "Canadians have now collectively run a net financial deficit for more than a decade, in effect, demanding funds from the rest of the economy, rather than providing them, as had been the case since the Leafs last won the Cup."

6. Embraer has hired action hero Jackie Chan as a pitchman for its executive jets, Bloomberg News reports. Note to Bombardier: Arnold Schwarzenegger is looking for a new role after leaving office in California.

7. A butter shortage in Norway has prompted the government to slash import tariffs, and has even led to the arrest of a man caught smuggling 90 kilograms in his car crossing over from Sweden.

8. New research indicates that the tagged photos of the average Briton on Facebook shows him or her drinking, or having just had one.

9. The Lloyd & Delphine Martin Prosperity Institute has chosen Guelph, Ont., as the best place for Santa Claus in a study based on numbers of milk producers, toy and game manufacturers, postal service workers and couriers, and department stores, on a per capita basis. Guelph beat out Williamsport, Pa., Sherbrooke, Que., London, Ont., St. John's, Peoria, IIl., Hamilton, Ont., Winnipeg, Trois-Rivières and Kitchener, Ont., according to the findings of the think tank, which is affiliated with the University of Toronto's Rotman School of Management.

Required reading this week A curious pattern has emerged through Canada's recession and rocky recovery: Employment levels have surged among older women. Tavia Grant reports.

Sun Life Financial Inc. is retreating from two staples of its U.S operation, stung by a bleak economic outlook and incessant market volatility that has made it difficult to sustain the traditional life insurance model, Tara Perkins and Tim Kiladze write.

As a bellwether for the crucial holiday season, the financial performance of consumer electronics giant Best Buy discouraging, Marina Strauss writes.

As tens of thousands of Russians take to the streets to protest against an allegedly rigged parliamentary election, and with Vladimir Putin's planned return to the presidency next year suddenly in doubt, investors are starting to wonder whether stabilnost is gone, Mark MacKinnon reports from Moscow.

TransCanada Corp. is raising the amount of crude it plans to pump through its Keystone XL pipeline, after receiving a boost in support from companies who hope to ship oil on the controversial project, Nathan VanderKlippe reports.

What to watch for next week Statistics Canada is expected to report Tuesday that inflation remained tame in November, certainly compared to some other countries. Month over month, consumer prices are believed to have changed little, while the annual pace of inflation may have dipped to 2.8 per cent from 2.9 per cent.

"While still higher than the Bank of Canada's targeted 2-per-cent pace, it's still one of the mildest inflation rates in the world," said deputy chief economist Douglas Porter of BMO Nesbitt Burns. "Recall that Europe's rate is 3 per cent, the U.S. is at 3.4 per cent and Britain's is above 4 per cent."

Later in the week, on Friday, markets will get their first sense of how the economy kicked off the final quarter of the year. Friday's report from Statistics Canada - it comes two days before Christmas - is expected to show virtually no growth in October.

"The combined impact of the swing back to a deficit in the trade balance, dented confidence, financial market turmoil, and a sharp contraction in employment is also expected to weigh on the other industrial sectors of the Canadian economy," said the economics team at Toronto-Dominion Bank.

"This forecast is consistent with a deceleration in economic activity through the end of the year to an annualized [fourth-quarter]rate of 2 per cent from the rebound-infused 3.5-per-cent pop observed in [the third quarter]"

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About the Author
Report on Business News Editor

Michael Babad is a Report on Business editor and co-author of three business books. He has been with Report on Business for several years, and has also been a reporter and editor at The Toronto Star, The Financial Post and United Press International. His articles have appeared in major newspapers around the world. More

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