The hidden Canadian housing bubble

Extrait de: The hidden Canadian housing bubble, Mike Brock,, Oct 04, 2011

Let me be provocative and say that our real estate bubble has the same fundamental problem as the one in the U.S., which exploded gloriously, kicking off the financial crisis.

The bubble in real estate has been extremely slow growing, but bubbles do have a way of going parabolic right before their collapse. Is real estate in Canada parabolic? It doesn’t appear so on a year-over-year basis. But it certainly does look that way when one looks at the 50-year trend, which is consistent with the rest of what I’m about to say.

You’re probably wondering how I could have the temerity to claim that we’re in no better position than the United States. You’re probably thinking that for two reasons, which describe the common Canadian exceptionalist narrative:

·         Canada has a sounder banking system; and

·         Canada’s lending practices are far more stringent.

Both of these points are manifestly wrong. And I can forgive people for buying these as fact. But the macro picture looks far different than the micro picture.

In 1971, the Nixon administration in the U.S. unilaterally exited from the Bretton-Woods consensus, completing the global economy’s move towards pure fiat monetary systems. Many have argued this was a natural consequence of the “archaicness” of commodity-backed commodities and have paid every little attention to long-term trends and how that inflection point affected capital distribution in our markets from that point forward.

The years following Bretton-Woods led to an inflation crisis in the late 1970s, culminating in central bankers raising overnight lending rates into the double digits. At the time, this was a palatable option, since government’s carried comparatively little debt relative to today and consumers were not highly leveraged.

Starting in the 1990s, central banks largely gravitated towards monetarist policy prescriptions and began using interest rate policy to stimulate borrowing and spending. And while Canada lagged behind other countries like the United Kingdom and the United States due to rate policy being tied down over the government’s credit rating during the first part of the decade, our journey into the largest bubble of the modern era may have started late, but it began nonetheless.

The capital structure of the economy began to follow a very similar course to the U.S. and the U.K. With consumer debt beginning to rise at the fastest rate in history, leveraged financing in financial institutions taking over as the primary source of revenue, and asset price explosions all over the map — starting first in technology stocks in the late ’90s, and then rolling into real-estate backed securities in the 2000s.

The fundamental problem with the argument that the U.S. economy imploded because of lack of regulation, is that it assumes the problems sparked at the periphery where themselves the problem, rather than the spark. I contend that the former is true. The rot began a long, long time before the subprime mortgage exuberance started in earnest. The problem wasn’t subprime. It was the whole mortgage market.

So, while Canada’s subprime market is tiny, and largely the vestige of small independent lenders, it does not detract from the problem that the distribution of debt in Canada looks a hell of a lot like the distribution of debt in the United States, prior to the financial crisis and, as a matter of fact, worse so.

It is considered an economic truism that “real estate is the backbone of the economy” and that real estate leads us out of recessions. So, governments focus on construction and home-buying subsidies as a first-measure to deal with economic downturns. But this “truism” is a recent phenomenon that finds its soul in the end of the Bretton-Woods consensus 30 years ago.

The fundamental measurement error is that we are comparing one economic cycle to another. But what we’re really missing is that the dot-com and the real-estate crashs were part of a meta-cycle: A long-term credit bubble that has been expanding precipitously, and without any reasonable relationship to economic output for over two decades.

The proof is in the pudding. For the 150-year period starting in 1800 and concluding in 1950, real estate prices followed a flat trend, which put them, overtime, in line with the general inflation trend. Then, starting in mid-1970s, throughout the western world, this underlying trend ended. It was replaced with a price appreciation trend in excess of the underlying inflation trend and, for the first time in measured history, developed a multi-decade trend divergence between income and price.

It is actually unsurprising that, when capital structure of the U.S., the U.K. and Canada are analyzed (these are the countries I’m an expert on), that manufacturing jobs would be a casualty of the ever-increasing move to real-estate investment as the primary investment asset of both finance and individuals. The relative marginal cost of manufacturing becomes higher in this light, given that capital demand skews towards real estate investment — which is a depreciating asset.

We’ve comforted ourselves in the misguided belief that this change in capital structure is a result of the natural economic development away from manufacturing and towards services (the “knowledge economy”).

As for the solvency of Canadian banks, the way in which Canada measures capital ratios is actually quite apples-to-oranges with the American and European method; Canadian banks use a risk-weighting formula to determine available capital. Using this formula, Canadian banks report capital ratios in excess of 10%, which is far higher than their American or EU counterparts. This seems cool, and risk-weighting receives a lot of credibility from the fact that mortgage debt is inescapable in the way it is in other jurisdictions. You can’t just hand your keys over to the bank — a fact that gives many analysts great comfort in the Canadian banking system and lends apparent credibility to risk-weighting scheme.

All good. But this risk-weighting assumes that the distribution of risk is such that a substantial amount of defaults could not simultaneously occur. This is built on the assumption that the vast majority of mortgages are prime, insured by CMHC and are unlikely to ever enter default. However, these assumptions assume a general constancy of market conditions. And these assumptions are not unlike the sorts of assumptions that U.S. regulators made relative to their situation.

In absolute terms — actual liquid capital — Canadians banks are less capitalized than many of their European and American counterparts. In fact, all big five Canadian banks, using the American and European method of capital ratio measurement, rank in the bottom ten of the biggest 50 banks in the world. Even the embattled French bank, Société Général, has a better absolute capital ratio than BMO, TD, CIBC, RBC and Scotiabank.

Are Canadian banks sounder? It depends. If you assume that Canadian mortgage default rates will never reach levels seen in the U.S., then I guess they’re potentially okay. But if we were to replicate the scale of the American downturn, our banks would be lesser equipped to deal with the losses than even Citibank was. So the “soundness” of Canadian banks cannot merely be measured as a function of the banks themselves, but general assumptions about the soundness of the Canadian economy and solvency of Canadian consumers.

Considering the average Canadian consumer has the highest debt-to-earnings ratio in the OECD (155%), there are many reasons to question the underlying assumptions of the Canadian banking system.

One also wonders if Canadian lending practices are so much better, why mortgage debt relative to income is actually higher right now than it was for Americans at the height of their bubble.

Il a tout à fait raison, si notre taux d’endettement est si élevé, peut-être nos banques pour faire des milliards de profits ont surendetté les concitoyens par le crédit facile, d’autant qu’ils sont généreux, car plus de la moitié des prêts hypothécaires sont assurés par la SCHL, qui malheureusement M. le peuple vous en êtres propriétaires.

Belle petite arnaque en passant, vous prenez le risque, mais eux font les profits,
enfin …

The point is that not everything is what it seems. If you’ve been living in a bubble for this long, you start to think that what economic activity in a bubble looks like is normal. And then policy-makers focus on replicating those conditions, which merely re-inflate the bubble and keep it growing over time.

If I had my way, I would end the CMHC and end the Bank of Canada’s control of interest rates — allowing rates to float according to market forces. This would bring a rapid and painful end to this debt bubble, which is going to happen eventually.

And the sooner it happens, the less painful it will be.