(Note from Ben: The following is a guest post from ‘John in Ottawa’, a frequent commenter on this site. I have added a few of my own thoughts at the end of the post)
Recently, Canada’s Finance Minister Flaherty announced new regulations tightening CMHC insured mortgage and lending standards.
The consensus view is that Flaherty tightened lending standards to take the pressure off the Bank of Canada. Carney has expressed considerable concern over a rising level of consumer debt. The normal response by the Bank would be to increase interest rates to take some of the sizzle out of consumer lending.
I have long believed it is inappropriate for the Bank to use interest rates to control consumer spending and borrowing. It is too blunt an instrument. Were Carney to increase rates in order to slow down consumer borrowing, he would also slow down business borrowing at a time when the recovery is still quite weak.
It is easier, and much more appropriate, for the government to change regulations to control spending.
But is regulation also too blunt an instrument? Is there a housing bubble that must be gently deflated? Is the housing bubble responsible for too much consumer debt?
The first chart below is taken from the Teranet Canadian House Price Index going back to 1999, the first year for which there is data on all six cities covered by the index. The index for all six cities is set to 100 as of June, 2005.
An economic bubble is loosely defined as a significant, usually exponential, departure from an underlying long term trend. From the chart, there is a linear trend from 1999 through the present. During the prior ten years from 1989 to 1999, house prices were relatively unchanged. After June, 2005 only Vancouver and Calgary depart from the trend in a meaningful way.
The linear regression trend line shown is for Ottawa (chosen arbitrarily as representative) and shows a high confidence for a linear trend.
The second chart zooms in on the period from June, 2005 until October, 2010, the latest figures available. Again, it is clear that only Vancouver and Calgary deviate from the trend. All other Canadian cities are continuing to track a very linear trend.
Vancouver and Calgary may fit the criteria of a bubble. They broke away from the trend of other major Canadian cities as well as their own trend for the preceding twenty years. It is impossible to determine whether a bubble exists without also examining coexisting events, facts, and timeframes.
Over the past ten years, house prices have gone up faster than the underlying rate of inflation. Some would argue that any asset appreciation that is out of line with inflation is a bubble, but that isn’t the general view. Certainly, Canada’s house prices have not appreciated on anything near the order of the dot com bubble where prices went parabolic.
If we go all the way back to 1981, the furthest I can go for Canadian house data, house prices today on a national level are exactly in line with inflation over the past 29 years. $100 dollars of purchasing power in 1981 requires $228 today, or in terms of the house price index, today’s national composite index of 137 discounted for inflation would be 63.5 in 1981. In other words, the inflation line in the charts above intercept current prices on the right of the graph and intercept 1981 prices on the left off the graph. So it can be argued that over the past 10 years and more we have simply played catch up.
Even Vancouver and Calgary are not terribly out of line with long term inflation, although the absolute value of Vancouver houses is difficult to fathom.
What is it called when an asset class is priced significantly below the rate of inflation: a deep hole?
It is apparent from both Flaherty’s and Carney’s comments that they believe excessive consumer borrowing and debt is a direct result of withdrawing equity from over inflated house prices, and that this may lead to serious problems down the road when interest rates go up.
I postulate that the excessive borrowing against home equity is most likely to have occurred where house prices are the most inflated in relative terms – Vancouver and Calgary. The evidence shows that there is no housing bubble in eastern Canada. It follows that it is unlikely there is undue credit risk in eastern Canada due to Home Equity Line of Credit (HELOC).
I agree that the Bank of Canada should not punish business in order to reign-in consumers and I think changing federal regulations was clever and appropriate. However, I also believe the government should not punish eastern Canada in order to reign-in Vancouver and Calgary.
Perhaps it is politically untenable to target one particular region of Canada in preference to another region, but it would certainly be technically feasible for the government to have tightened lending rules solely for those regions of Canada where there is undue risk.
Flaherty’s action this past week feels a lot like Dad took away the car keys because the boy down the street got caught speeding.
Ben’s two cents:
I have a great deal of respect for John. Though I agree that the Canadian bubble is most pronounced in a few larger centres, I would not be so quick to accept that easter Canada is off the hook. Nor am I entirely convinced that HELOC growth has been concentrated in the West.
I’d like to dig deeper into those questions. In the meantime, here are my three major unanswered questions after reading John’s post:
1) The inflation data is certainly interesting. Since the Teranet index has nearly tripled the rate of inflation over the past decade, it suggests that we must have had almost two decades of negative real growth in Canadian real estate prior to 2000. Can this be? This strikes me as being highly suspect. Something about that data is not quite sitting right.
2) Inflation is certainly one factor in determining fundamental value of real estate. However, I would caution that inflation alone can be misleading. Cost-push inflation caused by increased input costs when those costs are driven up by more expensive imports from other nations would have the net effect of squeezing margins. Though it would show up in the CPI, it has no true bearing on sustaining real estate prices as the ‘inflation’ can not not passed on in the form of wage increases. I’m not suggesting this is necessarily the case, but I’m just highlighting the reality that inflation, if not paired with an accompanying increase in income, does nothing to support house prices. Ultimately if inflation and housing both rise at 5% while incomes rise at 2%, you’ve still got a problem.
I would be far more swayed by data showing that house prices have paced income gains over the same period. The fact that we are approaching all-time highs in the price/income multiple across much of the country greatly concerns me.
3) I’m curious why the Teranet index shows less of a growth in house prices than other house price indices? Other data sources (OECD for example) certainly show a parabolic rise in house prices. As the Teranet index tracks paired sales, it could suggest that the average new house is getting larger and more ‘luxurious’. Thus the bulk of the house price increases would be driven by new home prices which would only register in the Teranet index after their first sale. This data is only presented as a percent change over the previous sale price.
Could the effect of the McMasion generation be lost in the Teranet index but caught in other indices? If so I see major implications with regards to demographics and the general trend in downsizing over the next decade.