I will be making an original posting later today. In the meantime, it’s nice to have some insightful discussion on the comment section of this blog. Earlier in the week I set out to examine the likelihood of a ‘soft landing’ in real estate. The empirical data overwhelmingly rejects the notion that asset bubbles produce ‘soft landings’.
Now this doesn’t prove one way or the other whether or not we are in a bubble here in Canada, though everyone certainly knows where I stand on this issue. Needless to say, if we are in a bubble, the majority of economists reject the notion that it can or will deflate in a benign manner.
Despite the overwhelming consensus, there are dissidents. One poster was kind enough to repost a comment made by Ian Lee from Carleton University, who presents 10 points that he feels validates the notion of a soft landing or sideways market. John from Ottawa then kindly responds. Lest you think this is a debate between a well trained academic and a wanna-be armchair economist, I would highlight John’s extensive industry experience, as he notes in his own response:
“I should point out that Professor Lee and I have tangentially intersecting lives. While he was a manager at BMO I was teaching at the Faculty of Management, University of Calgary. He went back into academics and I went back into business.”
I’ve added a couple of my own thoughts in italics into his reply.
Enjoy this insightful dialogue!
1. we have only 6 banks in Canada – not the approximate 6,000 as in US – and which are regulated by a single authority (OSFI) and not the hodge podge of alphabet soup agencies in the US AND at state level
2. the Canadian Bank Act mandates that a bank may NOT make a mortgage with less than 20% down payment UNLESS insured by CMHC (please go look it up) – hence the “illegal” comment
3. CMHC required a minimum of 10% down payment throughout the 1960s, 70s, 80s and 90s. It was reduced to 5% in the late 1990s. In 2006, it was reduced to zero and when then Governor David Dodge learned of the change – as reported on the front page of the Globe and Mail in July or August of 2006, he went to CMHC Head office in person and objected very strongly. The policy was reversed shortly thereafter.
4. the 6 banks and CMHC have adopted common income standard ratios – called the Gross Debt Service Ratio (GDSR) and the Total Debt Service Ratio (TDSR). The monthly mortgage payment (GDSR) may NOT exceed 32% of the person or family’s gross monthly income and the TDSR (mortgage payment and all other debt payments including alimony) may NOT exceed 40% of gross monthly income. I noted that these equity and income standards did not prevail in the USA – indeed NINJA mortgages (no income, no job, no assets) were the norm in the US
5. in 1980-81 I was Mortgage Manager at Ottawa Main Office (opposite West Block, Parliament Hill and beside National Press Club), 4th largest branch of BMO at that time, when then Fed Gov Paul Volker ran interest rates from 10% through 20% and induced a deep recession. The housing market certainly dried up – but it did NOT collapse. Indeed, it was a remarkable time for any person willing to observe and learn about consumer behaviour by watching real Canadians struggle with very difficult decisions concerning tough choices – e.g. do I pay my car loan? do I pay my credit card? The 1980-81 recession was far more devastating than the recent 2008 recession – for Canadians. However, there was not a housing collapse nor a foreclosure crisis.
6. the national household balance sheet data provided by Bank of Canada reveals Canadians owe almost $1.5 Trillion – and many analysts have become deeply concerned. However, they fail to focus in the same report on the data that Canadians OWN over $6 trillion in assets or a coverage ratio of 4:1 (see recent excellent analysis by BMO Economics of this data and they concluded a housing collapse is unlikely)
Given that the lion’s share of the $1.5 trillion owed (75% I recall) is mortgage debt, we should be less concerned. Why? Because 1. mortgage debt is amortized over long periods of 25,30,35 years and 2. is offset by a hard asset called a home, which can be sold and the debt liquidated.
7. the unemployment rate is substantially lower in Canada than the US (if the US calculated their unemployment rate the way we do, the US rate would be around 17% vs our 8%
8. IF – IF there were a substantial number of defaults and foreclosures in Canada, the banks would be immunized – because CMHC insures approximately 75% of all high ratio mortgages. CMHC is a 100% Govt of Canada owned corporation and the NO Minister of Finance would allow CMHC to dump all the foreclosures onto the market at once – thereby causing a housing crash – as did occur in the US with multiple independent agencies.
9. demographics – yes I did discuss it in the interview but it was cut out – I noted that we bring in over 300,000 immigrants annually and is scheduled to increase to 350,000 – the highest in the world as a percentage of pop. I also noted that our birth rate – well below breakeven at 1.6 – is not as low as e.g. Japan or Italy. In conjunction with our very high immigration, this produces a steady annual increase in demand for housing
10. aging of boomers – boomers are about 1/3 Cdn population. It is an extreme fantasy to believe that Canada is going to build seniors and nursing homes for most of these boomers. The vast majority of elders remain in their own home and will continue to do – as did my 91 year old mother who passed away in her own home last year.
My “insight” is that house prices are sticky downward as well. Setting aside deaths, marriage breakups and job relocation, most housing sales are discretionary within a city. Thus, the owner can always take the house off the market if he does not like the price offered.
I concluded that, going forward, we will experience what we experienced in the past with housing prices that overshoot. In the early 1980s, house prices went flat line for several years as they did again in the early 1990s.
John from Ottawa responds….with some minor insight from yours truly
Vancouver is certainly “ground zero” of the debate about a possible housing collapse. It has the dubious distinction of being the most unaffordable city in the world. A recent RBC report put the proportion of household income allocated to mortgage debt service at approximately 80% if I recall correctly. I have trouble with this number and, frankly, wonder if it is not an unfortunate artifact of aggregation. It simply isn’t possible for any one family to pay 80% of income towards a mortgage. Not if they also wish to buy gasoline and eat.
(It was also identified as the most unfordable city in the world by Demographia, which calculated it’s mean multiple (mean house price / mean household income) at a shocking 9.3 -Ben)
That said, this weeks placement of the Olympic Village into receivership seems indicative of a market that is cooling off. The prices at the Village are unlikely to go sideways and the tax payers of Vancouver are unlikely to recoup all of their investment.
I will now address Professor Lee’s points as you have asked and it is not my intention to reject his points, rather add my comments as best I can from memory. I should point out that Professor Lee and I have tangentially intersecting lives. While he was a manager at BMO I was teaching at the Faculty of Management, University of Calgary. He went back into academics and I went back into business.
On to his points.
1. It is true that we have only 6 large banks and they have been held up to the world as an example of good banking practice during this financial crisis. However, the US also has only a handful of large banks and they required a bail out through TARP. So there were different operating standards and some of these differences will be addressed in later points.
(The point is also both factually incorrect and looks to be deliberately misleading. Of the total mortgages outstanding, roughly 50% are held by the big banks. About 12% are originated and held by credit unions and Caisse Populaires. While they are still subject to the same lending requirements as banks, they are governed by the provinces. Additionally, nearly 10% of all mortgages are originated and held by pension funds, insurance companies, mortgage loan companies, special purpose corporations, non-depository credit intermediaries, and other financial institutions. The argument that we only have 6 banks in Canada involved in the mortgage market is completely false -Ben)
2. It is correct that CMHC must insure high ratio loans. However, this puts the risk of default directly on the Canadian tax payer. In the US, in addition to the FHA, private companies provide mortgage insurance. GM’s financial arm contributed to GM’s bankruptcy. AMBAC went into Chapter 11 this week and MBIA is a basket case.
(I wouldn’t have even addressed this point as it is a strawman argument and proves nothing nor adds any meaningful information to this discussion. We now have the riskiest loans backed by CMHC and taxpayers, indirectly. In the US, they have now been guaranteed via government-owned entities like Fannie Mae and Freddie Mac. The fact that taxpayers are on the hook for mortgages has no bearing whatsoever on how the (potential) housing market will deflate. -Ben)
3. During the period of the 60′s through 90′s, Canada’s housing market (and the US housing market) was relatively stable. The general trend was house prices increasing in line with inflation. It is the period over the past ten years during which bubbles have grown in the US and in Canada. Low interest rates and ill advised loosening of down payment requirements are major contributing factors.
(I would add that I’m not convinced that Mr. Lee is even correct in his assertion that you could buy a home with 10% down in the 60s, 70s, 80s, and 90s. According to CMHC’s own documents, “In 1954, the federal government expanded the National Housing Act to allow chartered banks to enter the NHA lending field. CMHC introduced Mortgage Loan Insurance, taking on mortgage risks with a 25% down payment.” It wasn’t until 1999 that the National Housing Act and the Canada Mortgage and Housing Corporation Act were modified, allowing for the introduction of a 5% down payment. Perhaps I’m missing something, but I couldn’t find concrete info about CMHCs minimum downpayment history. -Ben”
4. Certainly Canada’s lending standards are a major mitigating factor with regard to any future rate of foreclosure and I am not predicting the rate of foreclosure that has occurred in the US. I believe the great majority of Canadians can afford their homes, even if those homes go under water. As I said above, I find some of the published income ratios suspect.
I’ll come back to it later, but the mortgage market in the US became a looting ground, rife with fraud at every level. The stories of field hands being put into $500,000 homes make for interesting reading.
However, an underwater home, even if it is still affordable, creates dislocations in the labour market. In many US states one can simply mail in the keys (jingle mail) and, with only a hit to the credit rating, move on. In Canada mortgages are recourse loans. Default on the mortgage and the debt stays with you. If house prices revert to the mean in Canada, this is going to be disruptive to individuals and business as labour mobility decreases.
(Contrary to popular belief, there are numerous states with some element of recourse. The Richmond Fed calculated that an element of recourse reduces foreclosure by 20%. Yet, there are numerous recourse states with exceptionally high foreclosure rates. The biggest motivator in foreclosure is negative equity, not affordability. It’s all outlined for you here. We won’t see nearly the same high level of foreclosures as the US, but it will be more than people think if our bubble deflates in a symmetrical manner. -Ben)
Finally, the psychology in the US towards the “honourable obligation” to pay the mortgage is changing. US citizens are seeing too many instances of businesses walking away from mortgages that are under water. The Mortgage Bankers Association’s high profile example of jingle mail was a real eye opener for the average joe struggling with high mortgage payments on an under water house.
Under water homes are the most significant factor affecting “strategic default” in the US. That is, people who can afford their homes are refusing to continue to pay for a bad investment.
5. I remember the 80′s recession well. Business would come to the University and recruit in the Fall. The student’s worst problem was choosing between the 15 to 20 job offers received. When Spring came, all the offers were withdrawn. It was a tough time.
Bear in mind, there was no “housing bubble” in the 80′s and mortgage standards were much tougher leading up to the 80′s. It was a tough time and I’m sure many people lost their homes.
As bad as the 80′s recession was, unemployment in the US only increased by 1.3% and all of the jobs were recovered within 10 months. Contrast that to today’s 9.6% unemployment and the unemployment level still bouncing along the bottom 34 months later.
(I would also add that such simple comparisons miss the fact that consumer debt was less that 80% of income while today it is pushing 150%, while the savings rate was in the high teens, as opposed to about 2% today. Bottom line, consumers had the savings and cushion to absorb the increase in interest rates. We don’t anymore. Furthermore, Mr. Lee fails to understand the importance of consumer spending to the broader economy. Even a marginal rise in interest rates will choke off consumer spending. Consumers are very near, if not already at the point of debt saturation. What is the economic fallout of a non-spenidng consumer in a consumer-driven economy? Think about it! -Ben)
6. This is an area of speculation for everyone involved. Canadians do have a great deal of equity in their homes. Frankly, if my home lost 25% of its value, I wouldn’t run screaming for the exits. I would be disappointed, of course.
The problem occurs at the margin; those last “greater fools” that buy all the house they can believing it is a great way to gain margin and get rich on little investment. Speculators fall into this category. To the degree they have an influence, they alone can do a great deal of damage to a housing market. I honestly don’t know how much, but they will do the most damage where the market is bubbliest. Vancouver continues to be the market to watch.
(I agree that all you have to do is squeeze the margins to cause serious pain to the broader economy. Mr. Lee also misses the fact that debt to assets always looks great at the tail end of a credit bubble. The notion that our liabilities as a percentage of debt is healthier than other countries is also extremely questionable. The Certified General Accountants Association of Canada released a report earlier in the year where they note on page 42 that consumer debt to financial assets is the worst among 20 OECD nations, including some that have recently experienced rapid drops in housing prices. This ‘argument’ only holds water when that number is considered on its own and not compared to other nations. It’s bunk! -Ben)
7. Now this is an area where I must respectfully disagree with Professor Lee. Canada calculates its unemployment in almost the same way the US does. The popularly quoted unemployment number in the US is U-3 at 9.6%. Ours is, I believe, just over 8%. Both numbers have been sticky. The less quoted U-6 number is around 17% in the US as Professor Lee states. We don’t publish a U-6 number, but it would be similar in difference.
Ben Barneke said last week that he fears the unemployment rate will increase next year. I agree, both in the US and in Canada. Couple this with a decrease in the participation rate, those citizens who would be counted in U-6, and matters get worse than they would seem. Given that we don’t have 99 weeks of unemployment insurance payout, our participation rate may have dipped more than in the US. And they call us a socialist country.
Bottom line, our unemployment isn’t very different from that found in the US. This is a real drag on GDP.
8. Now this is an interesting point. CMHC is for the most part the only mortgage insurer in Canada. If they are insuring 75% of mortgages, then it may be safe to assume that roughly 75% of mortgages have less than 80% equity. Bearing with me for a minute on this logic, that means that 75% of mortgages would be under water if housing prices dropped just 21% in Canada. Given recent reports from The Economist, the OECD, and Canadian banks, in many markets this is not out of the realm of probability.
(Once again I fail to see how Mr. Lee’s argument is relevant to the current discussion. There’s no question that our banks are largely insulated from a housing collapse. So what? -Ben)
And as Professor Lee says, CMHC is government owned. That means that the tax payors will bail out the banks.
It is worth noting that last year CMHC was the mortgage market. Harper loaned CMHC $50B as part of the stimulus to buy mortgages from the banks. Not only does CMHC insure over a $T of mortgages, they now own $50B of them.
A similar situation exists in the US, where Fannie Mae and Freddie Mac represent 95% of the mortgage market. They are the market. The Federal Reserve has purchased $1.25T of those mortgages, something our Bank of Canada will not quickly duplicate.
Marked-to-market one can only wonder what those mortgages are really worth. Some estimates put their value at anywhere from 30 to 60% of face value. This, along with QE 1 and 2 will put the Fed into a huge bind going forward, but that’s another topic.
The large number of bank owned or REO houses in the US that are not on the market is called the shadow market. Good business dictates that they not all be dumped on the market at once. However, the shadow market is a huge overhang and will depress housing prices for years to come. Should Canada find itself in the same situation, with CMHC holding a large inventory of housing, it will be forced to sell them off at some reasonable pace (empty houses deteriorate) and it can be expected to be a drag on prices.
9. Canada currently ranks 12th in immigration, the US 22nd. However, we have a low illegal immigration rate and the US has an illegal immigration problem, so the statistics are unreliable.
What I don’t know is how many immigrants buy houses in the short term, and the bubble is in danger of causing a short term problem.
(I wouldn’t let Mr. Lee off so easily with this blatant lie. We are not first in the world for immigration as a percentage of population. Check for yourself. Mr. Lee continues to spew hollow arguments which call his credibility into question-Ben)
10. Well I certainly hope my wife doesn’t stick me in an old age home! My experience is similar. My adopted mother died in her own home at the age of 92. However, she came from a different age and she saw the Depression. Her house was paid for and she could stretch a penny into a fine wire.
My biological parents live in Southern California. They have seen the value of their home plunge 25 to 30%, but it is paid for and doesn’t factor into their life style decisions. What has affected their life style is the depreciation of their portfolio and the termination of dividends.
As I said above, a 25% reduction in the value of my home would be no more than disappointing and frankly, I have postulated that homes in my particular micro-market will only move sideways for the next ten years. Even I like to see the world through rose coloured glasses, but this is my honest expectation. I must stress “micro-market”, however.
(I would also add that our demographics are not dissimilar to other industrialized nations that have seen their housing markets gutted. Not a particularly convincing point. -Ben)
John adds some more insights at the end of his comments, but I think we’ll leave it there for now. Decide for yourself! At least it’s nice to have a balanced perspective.