Tuesday, December 4, 2012

Oh No, Canada!?!

Christopher Matthews of TIME reports, Oh No, Canada! Are We Watching Another North American Financial Crisis Unfold? (h/t, Financial Iceberg):
For some time during and after the financial crisis, it was fashionable to point to Canada as a paragon of fiscal and regulatory prudence. In the years leading up to the crisis, the Canadian government ran budget surpluses, which enabled it to stimulate the economy without creating huge debt loads we now see in Greece and Spain. In addition, the Canadian banking system faced stricter capital requirements and were more risk-averse than their American and European counterparts. Perhaps most important, Canada avoided the sort of real estate bubbles seen in the U.S. and Great Britain due to tighter lending standards and the absence of mortgage interest deductibility — at least until recently.

For the past year or more, Canadian officials have nervously watched as household debt levels has risen to worrying heights, fueled by increased mortgage borrowing. As The Wall Street Journal reported this week:
“Borrowing to buy property has helped make Canadians some of the most leveraged consumers in the world, at a time when their counterparts in other heavily indebted countries—such as the U.S.—are digging out. Household debt is now 163.4% of disposable income in Canada, close to the U.S. level at the height of the subprime crisis.”
Just like in the U.S., housing prices in Canada steadily rose in the decade immediately preceding the financial crisis, soaring 198% over ten years. They dipped slightly during the global recession, but bounced back quickly between 2009 and the beginning of this year, fueled in part by a low interest rate policy the Bank of Canada put in place to nurse the Canadian economy through the global economic slowdown. Real estate prices have risen so high, in fact, that many housing analysts believe the bubble is about to burst. Housing economist Robert Shiller told CBC news in September, “I worry that what is happening in Canada is kind of a slow-motion version of what happened in the U.S.”

Indeed there are signs that the party is already over. Due in part to efforts by the Canadian government to strengthen lending standards, home prices in Canada nationwide dipped year over year in October, and declined in many of the key local markets as well, according to a recent report in Reuters. ”With cooling evident in several major cities, speculation has turned to whether the slowdown will be a soft landing or a crash,” the report said.

What will determine the difference between a soft landing or a thudding crash like the one the U.S. experienced in 2007? Lending standards are a big part of the equation. In the run up to the bursting of the American real estate bubble, many homeowners bought homes with little money down and financed the purchases with loans that had low teaser rates that would jump higher a few years into the life of the mortgage. Those sorts of products swamped many homeowners in short order, and also meant that they had virtually no equity cushion when lenders came to foreclose. The lack of equity cushion meant that banks — who were over-indebted themselves due to poor regulatory oversight — had to resell the homes at steep losses, feeding the panic that soon turned into a full-blown housing crisis.


Canada, on the other hand, requires homeowners to put at least 20% down on a home, or to purchase mortgage insurance from the the Canadian Mortgage Housing Corporation (CMCH), a federal agency. Furthermore, Canadian lenders are in a much better position than U.S. banks were to absorb losses from any housing downturn. As CIBC economist Benjamin Tal told CBC news:
“The Canada of today is very different than a pre-recession U.S., namely as far as borrower profiles are concerned . . . Therefore, when it comes to jitters regarding a U.S.-type meltdown here at home, the only thing we have to fear is fear itself.”
Of course, few analysts in America predicted that the U.S. real estate market would blow up in the spectacular fashion it did in 2007, either. As financial blogger Pater Tenebrarum puts it:
“This kind of thinking has things exactly the wrong way around. It is precisely because such a state-owned guarantor of mortgages exists that the vaunted lending standards of Canada’s banks have increasingly gone out of the window as the bubble has grown. Today some $500 billion, or 50% of Canada’s outstanding mortgages are considered ‘high risk’ according to the Financial Post . . . Through CMHC and government guarantees for privately held mortgage insurers Genworth Capital and Canada Guarantee, Canadian tax payers are on the hook for more than C$1 trillion in mortgages. In other words, there is no practical difference to the role played by the once nominally private GSE’s and credit insurers in the US and the Canadian version of them: in both instances these institutions have enabled vast growth in ever more risky lending, while ultimately tax payers are picking up the tab when things go wrong – as they invariably must.”

That is to say, the difference between a soft landing and a meltdown could boil down to the financial integrity of the CMHC. A report from the agency released yesterday stresses its health and ability to stay solvent in the event of a downturn, and the conventional wisdom is that the Canadian real estate market will go through a rough patch and nothing more.  But anybody who was paying attention during the American housing crisis can remember similar assurances, which turned out to be just plain wrong.
Indeed, the difference between a soft landing and a meltdown could boil down to the financial integrity of the CMHC. But critics have long suspected Canada's mortgage monster has been under-reporting the risks it's taking, which is why it's been dubbed the Canada Moral Hazard Corporation.

It's been a while since we've experienced a serious housing downturn in Canada but it's coming and when it hits, it will wreak havoc on the economy. Canada's housing is poised for a severe drop and there's little the government can do to cushion the blow.  Those who think otherwise are only fooling themselves.

But why hasn't it happened already? Two reasons. First, the financial crisis has kept global interest rates at historic lows, allowing Canadians to mortgage themselves to the tilt and rack up huge personal debt. Second, the demand for resources from China cushioned the blow of the US contraction, but it also contributed to the myth that Canada is an "oasis" that will be spared from the global downturn.

Of course, that's all rubbish. Sustainable trends in housing are a function of household  income. When the price to income ratio diverges significantly from its historic trend, it can only mean that Canadians are taking on more debt (financed by banks and insured by the CMHC) to buy their "homes and BMWs." But debt is a four-letter word, and since most Canadians are living way beyond their means, they're only one job loss or a 50 basis point rate hike away from experiencing serious financial hardship.

Finally, Caroline Cakebread, editor of the Canadian Investment Review, tweeted an article from the Financial Post, Condo buyers unfazed by rising fees, to which I replied "Mark Carney timed his exit well."

Yes, forgive me if I don't join the 'Mark Carney lovefest' but I'm not nearly as impressed as everyone else is about Mr. Carney's exceptional central banking acumen. He read the global economy right, kept rates low for a protracted period, but failed to respond to the debt bubble he and others were fueling.

In my opinion, Carney is smart, polished but doesn't hold a candle to his predecessor, David Dodge. And while Tiff Macklem is the name circulating as Carney's successor, I hope the Canadian government expands its search to include people like Steve Poloz, President and CEO of Export Development Canada, and former Chief of research at the Bank of Canada.

I worked with Steve at BCA Research and think highly of him on a professional and personal basis. Not sure he wants the job at this stage of his career, but he's the ideal candidate to steer our central bank in the difficult years ahead.

Below, Yale economist Robert Shiller discusses the Canadian housing bubble on BNN. He focuses more on Vancouver and Toronto but his analysis can be extended all the way to Montreal where real estate has been been bubbly for a few years now and is set to fall post PQ victory. Vive la différence? I don't think so.