More thoughts on CAAMP report; RRSP use among younger generation at record lows;

Economic dynamics revisited

I recently took issue with a statement made by Will Dunning in the most recent CAAMP report.  Mr. Dunning made the dubious claim that housing demand has been created by strong employment.  Without a doubt that statement has held true through most of our nation’s history.  My position is that as our economy has moved away from production and manufacturing and towards consumption, the new driver of economic ‘growth’ has been the rapid expansion in consumer debt.  Consumer spending and consumption are obviously always a part of any economy.  The end goal of all manufacturing is consumption.  The problem arises when consumption as a percentage of GDP deviates rapidly and markedly from its long-term mean.  In Canada we have seen a rapid rise in consumption from 55% to 65% GDP. 

This has been driven by a new consumer mentality towards debt, which has seen total debt levels explode as a percentage of personal disposable income.  Tied at the hip has been a redefining of what constitutes ‘normal’ consumption.  This proliferation of household debt has permeated through our economy as bank-generated credit spends just as well as freshly minted currency.  And make no mistake, credit creation is running rampant.

This has buoyed sectors of the economy that would not otherwise have flourished were such a broad swath of the population not willing to spend more than they earn on stuff they can generally live without. 

All of this is connected to a secular shift in perceptions…..a change in mass psychology.  At some point we abandoned the collective notion that a house is a place to live and wealth is built by spending less than you earn and saving/prudently investing the difference.  Instead there was a wholesale embracing of a new paradigm….the house as a means to riches, while saving became viewed as something you do when you’re a few years from retirement.  We also became exceptionally comfortable with debt; Staggeringly so when compared to the mentality of past generations.

And so, as more people embraced this new paradigm, home ownership rates have risen markedly.  Lending standards have been loosened to allow more and more people access to the new-found Canadian dream.  ‘Unjust’ barriers to home ownership were torn down.  The down payment went out the window.  The 25 year amortization became a thing of the past.  The government stepped up its mortgage insurance business to such an extent that today 97% of mortgages to first time buyers are backstopped by CMHC, a government agency….taxpayers by extension.  Demand soared further.

The mentality that house prices could only go up became ingrained in our psyche despite all evidence to the contrary.  People who would never consider buying 300K worth of stocks with only 15K in equity nevertheless plunged headlong into home ‘ownership’, never considering that perhaps a home without equity really is just a rental with debt.  The renter has just gone from renting space to renting money….but with much more risk. 

The feedback mechanism was complete when people realized that they had home equity in abundance and could access it easily and cheaply.  Why save to buy that boat/second car/vacation/second property/toy/trinket/etc when you could pull it out of your home equity at prime plus 1%.  The simultaneous cratering of the Bank of Canada overnight rate certainly added fuel to this fire.

And as this money circulated through our economy, the economy prospered.  Jobs were abundant.  Lured by the easy riches of the housing market, more property virgins piled in.  Circle complete. 

This is the current dynamic we find at work in the housing market and broader Canadian economy.  Everything I have said above has been quantified and expanded upon using factual data in various posts, so none of this is conjecture. 

If you’ve read this site for any time now, you know what comes next.  The exact timing is impossible to nail down as it involves a change in the ‘animal spirits’ that drive mass psychology.  When that happens is anyone’s guess, but I’ve advanced what I feel is a pretty reasonable timeline.  The exact timing is somewhat of an academic issue….the (un)sustainability of our present economy is not in question.  We don’t face economic carnage or a Japanese style uber-deflation, but we face headwinds unlike any we’ve seen in this country in decades.

CAAMP report:

With that rant out of the way, let’s turn our attention to some of the key facts contained in Mr. Dunning’s report.  For this I will simply outline Mr. Dunning’s statement and my take on the same data:

There is very little evidence that there has been a speculative mindset and no evidence of excess housing development in Canada.”

 The report itself acknowledges that data on single family investment homes is sparse, so naturally there is ‘little evidence’ of a speculative mindset.  Well, not so fast.  We could certainly look at anecdotes.  Though they cannot be used to establish broader trends, when taken together they can provide meaningful insights. 

VREAA just made an interesting post about the ridiculous speculation taking place in Vancouver right now.  But Vancouver has long been ridiculous.  No shock there.  It will mark ground zero of the coming correction.

Widespread consumer sentiment towards real estate is also an excellent indicator.  Extreme positive sentiment in any market is very difficult to separate from speculation.  If people are overwhelmingly convinced that something is an excellent investment, do they not position themselves accordingly?  We know that current sentiment on real estate is extremely optimistic.  We also know that certain segments of the market such as the condo markets in most large centres have extremely high investor presence.

The data ultimately speaks volumes.  We know that net household formation in Canada has been very stable at 175K per annum for the past decade.  Yet in that time, housing starts have run at well over 200K.  I’d be curious to hear how Mr. Dunning would explain this without using the term ‘speculation’.

It seems to me that we have had additional supply created over the past decade.  Whether that has been absorbed as recreational property or investment property is a bit of a moot point.  I maintain that the primary motivator that has driven this excess demand has been the perception of future price increases.  The two questions that arise then are:

1)  How will housing starts respond to a flat/declining market?  If they fall as would be expected, it would certainly exert a toll on the employment count of the construction industry which currently stands at 1.3 million.

2)  How will people respond to a flat/declining market when the perception of future price gains is called into question? 

Mortgage arrears

The CAAMP report also highlights current mortgage arrears data-

“Data from the Canadian Bankers Association – which covers 7 major banks – shows that there was a rise in mortgage arrears during the recession. Prior to the recession the arrears rate was less than 0.30%. During the winter of 2008/09, however, the arrears rate increased rapidly. Since the end of the recession, the arrears rate has fallen slightly. The most recent data (as of October 2010) shows an arrears rate of 0.43%. While the increased rate is indicative of increased financial difficulties, it is lower than was seen during most of the 1990s (when the average arrears rate was 0.50%).”

Just a couple of quick thoughts on this point.  Let’s remember that mortgage arrears are at the highest point in a decade, yet interest rates are still hovering near historical lows.  The 90s saw a terrible real estate market in much of Canada, yet the 5 year fixed rate hovered near 9% for much of the decade.  Here we are today with an arrears rate creeping back towards levels last seen in the 90s, yet the 5 year rate sits at half of what it was then.  A normalization of interest rates would crush the housing market.  Contrary to what some commenters seem to believe, the 5 year fixed rate is not controlled by the Bank of Canada.  It is set in the bond market.  For those who insist that the government would never allow interest rates to exert such a toll on the housing market need to understand exactly how those 5 year mortgages are financed, especially since it is the 5 year rate that determines the amount of financing for ALL mortgage approvals.

RRSP use among younger generations at lowest point in a decade

I’ve always maintained that the government’s quest to ensure easier access to home ownership for first time buyers will have unforeseen consequences.  Here’s one of them.

“Nearly one half (45%) of young adults aged 18 to 34 have not yet started saving for retirement, according to the 21st annual RBC RRSP poll conducted by Ipsos Reid. Moreover, just four in ten (39%) young adults have an RRSP, a five-point drop from last year’s poll and the lowest figure in nearly a decade.”

When the government makes credit more abundant and encourages it to flow into real estate, this is one of the logical repercussions.  House lusting new homeowners are seeing a significant and rising portion of their income devoted to carrying costs, leaving little left over for other important tasks… saving for retirement.

No amount of ‘education’ on the part of the government will encourage this generation to save for retirement.  The prevailing public sentiment about home ownership and the associated stigma with renting is just too powerful.  Thankfully markets are wonderful teachers.  As I have long maintained, the housing correction will also usher in an era of ‘enlightenment’ where people realize just how tattered their finances really are.  Then and only then will this trend reverse significantly.  But of course, if a wide swath of society comes to that realization simultaneously, the decreasing velocity of money, debt deleveraging, and increased savings will all ensure strong deflationary forces.



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13 Responses to More thoughts on CAAMP report; RRSP use among younger generation at record lows;

  1. Earl says:

    Hey Ben.

    I think that your next post should explain the sources of these 5% mortgages. People should know that canadian banks use the mortgage securitizations the same as us banks. Once these sources of financing drop off as interest rates around the world increase no one will be able to find a 5% mortgage.

    Crazy times ahead.

    • pascal says:

      Yes good idea i dont get this part bond fixing the 5 years rate. Thanks

      • Hi Earl and Pascal

        It basically works like this: Banks make money by paying interest on deposits and GICs at one rate and then lending it out at another rate.

        Suppose someone deposits a bunch of money into a 5 year GIC at a bank. The bank will pay them a couple of percent and then look to make additional money on their deposit. If the 5 year Government of Canada bond yields 7%, would they lend it in a mortgage at 5%? Clearly they would prefer to make the better return by buying the GoC bond. Bond prices and interest rates are determined in the open market. The BoC has no direct influence over the 5 year bond rate. Therefore, if a bank is considering lending you money for 5 years as a mortgage, they would at least make you pay the same rate they could obtain by purchasing a GoC bond with the same maturity length.

        There’s a bit more to it than that, but that’s the basics.

        Does it make sense?

      • Earl says:

        Well what you say is true is Ben, but there’s another aspect I recall reading about. I might not have all the facts straight but the way I recall…

        The securitization of bonds allows the banks to sell off bulk mortgages to investment companies (for a spread), that allows them to reduce the amount of mortgage liabilities on their balance sheets.

        Once the big hedge funds stop buying these AAA bonds (because the yield elsewhere is higher), that’s when the financing of mortgages stop.

        With your example, the amount of liabilities on their balance sheets increase with the amount of assets. With this arrangement, assets increase along with shareholder’s equity (revenues).

  2. Ray says:

    Ben – the quality of your writing is amazing. It is so refreshing to read your blog everyday. Look at some of the crappy writing we’ve had to read for so long:

    Some bloggers can’t string together a single sentence properly and then there’s you with impeccable writing and succinct points. Thanks!

  3. Alex says:

    My biggest concern about RRSPs are the rates at which the government will tax you in the future. I would rather have paid the taxes up front and have the money at my disposal and control, to use at my decided rate of consumption. If you’ve saved all your life in an RRSP your Canadian benefits may be clawed back in the future depending on how much income you derive from your retirement investments and or pension.

  4. Lumpen says:

    The 45% figure for the youngsters is hardly surprising – very few will have started an RRSP before their first full-time job. Throw in some grad school, and you’re mid to late 20s before you start to earn enough to think about saving.

    The declining RRSP use could be offset by TFSA use, which is probably a better place to put $ when your income is comparatively low.

    • Very good points Alex and Lumpen

      Certainly the RSP is coming under increased scrutiny while the TFSA has given people another excellent option. I would still be concerned with the overall decline in savings rates, particularly among the demographic highlighted.


  5. Pax says:

    Great blog, Love it!

    I have one point to make regarding housing starts vs. household formation. One thing you need to consider is that some people own second homes not as an investment, but as vacation homes. Additionally, some old homes are condemned and torn down. These two items might account for some of the discrepancy between the two figures.

    I do, however, agree with you that speculative investments are occuring

  6. John in Ottawa says:

    There are a number of factors that affect the savings rate.

    Age is one factor. The young traditionally are not great savers. Most savings by age are can be attributed to the middle aged, and seniors (boomers like myself) are dis-savers.

    Two other key factors are interest rates and unemployment. People often point in alarm to the high savings rate in the 80’s compared to today. However, interest was running as high as 15% as was unemployment. Today’s low interest rates provide little incentive to save and unemployment is relatively subdued.

    These three factors alone are enough to account for today’s relatively low savings rate.

    As for RRSPs, I think the Gen-X generation has figured out that the RRSP is a poor investment vehicle for many reasons beyond just future tax and claw back implications.

    Consider this email to Garth Turner highlighted on his blog just today.

    Hello Garth: My Gen-X husband and I are having a “lively discussion” about whether to put any more money in RSPs. Maybe other blog dogs are wondering about this same question.

    If taxes are going to go higher and higher over the next 10-20 years, then why should we put money in an RSP now just so that it will be taxed under those higher rates when we convert to a RIFF? Wouldn’t we be better off paying today’s taxes and investing outside the RSP?

    Also, in a few years, the amount people have in RSPs might be used to justify clawbacks. Maybe the lower the RSP, the better. There would be some peace of mind knowing that our income taxes have already been paid on our life savings. We’re just wondering what your Hamlet-esque musings on the “to RSP or not to RSP” question might be. The bank ads make it sound so straightforward.

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