I noted in a post a couple days ago that CIBC recently concluded that real estate is about 12% overvalued in Canada. Now this is a country mile from what the big banks were saying last year at this time, and it’s a country mile from what they’ll be saying next year at this time.
I noted the following in the post referenced above:
“They also weighed in with their own estimate of fair value for residential real estate, concluding that Canada is 12% overvalued, a fairly shocking admission from an entity that survives on generating new credit, which will fall precipitously in the aftermath of even a modest real estate correction. It begs the question of how bad it actually is.”
Today we get a little more insight into that statement with this beauty of an article courtesy of the Financial Post:
“While a lack of confidence in the U.S. housing market has downed dozens of banks over the past three years, a product used by confident Canadian homeowners helped Royal Bank of Canada both weather that storm and continue to grow.”
“The product is the home equity line of credit, or HELOC as they’re known, and Wednesday Dave McKay, head of RBC’s domestic banking operations, said it is one of the most successful products it has ever launched.“
No kidding! As Jonathan Tonge notes, growth in lines of credit, the bulk of them HELOCs, has skyrocketed since 2000, providing a fantastic source of secured lending revenue for the banks.
Now what happens to HELOCS when real estate prices begin to recede? For that answer, let’s turn to a fascinating graph courtesy of Calculated Risk. It shows home equity extraction over time in the US. In other words, it shows the dollar amount that people pulled out of their home equity via HELOCs by quarter. You’ll recall that the US housing market peaked in 2005. The peak home equity extraction was shortly afterwards. Clearly people don’t want to borrow against an asset that’s falling in value. It’s a great way to end up underwater.
You’ll notice that the blue line actually goes negative in 2008, meaning that on balance people actually began repaying those loans. Hey wait a minute; Isn’t falling demand for credit and increased savings a recipe for deflation? Why yes it is….and it’s coming to a neighbourhood near you!
Of note, you’ll also notice that the red line shows the percentage of their income that the equity withdrawals represented by quarter. At its peak, home equity withdrawals were essentially providing an extra 9% of income that was being spent in the economy. Once again we have a clear view of the great connection between real estate prices and the broader economy. When real estate is booming, people will tap their home equity and spend it as if it is income. This makes its way into the broader economy, boosting employment and consumer confidence, in turn boosting housing prices. It’s a virtuous circle on the way up, but cuts equally deeply in reverse, as the US is now experiencing.
You’ll note that the red line is also negative, meaning people are now diverting a portion of their income to repay that HELOC. This is money that is not being spent in the economy but otherwise would have been had there not been a debt bubble. So once again we see two important principles which are often emphasized on this blog:
1) Debt is inflationary in the short term (rising asset prices create new demand for credit), but deflationary in the longer term, paradoxically (debt has to be repaid meaning less demand for credit and slowing velocity of money).
2) Debt bubbles pull demand forward, creating false and unsustainable economies. When the gap in demand hits, that’s also about the same time the crap hits the fan.
So let’s review: HELOCs helped Canada’s largest bank (and no doubt the others as well) to ‘weather the storm’ in 2008-2009. RBC is counting on continued HELOC growth to make up for falling revenue as “traditional profit drivers such as investment banking and securities trading are under pressure“, as noted in the article. Yet if real estate price do fall, so to will demand for HELOCs. A catch 22 perhaps?
Which makes this quote by Dave McKay, head of RBC’s domestic banking operations all the more comical:
“Asked about whether personal borrowing had reached a danger point, Mr. McKay said the bank believes debt levels are still within a “prudent” range.”
But come on, when it comes to consumer debt or real estate prices, what can he say?
There’s a great quote that goes something along the lines of, “You can’t help a person understand something when their salary depends on them not understanding it”. Do the banks know real estate is overvalued? Of course they do! In their weaker moments they’ll even admit it, though it’s a watered-down admission. What else could they say?
Keep the BS detector cranked up! You’ll need it to help dodge the media and bank-flung cow patties as things continue to unfold.