The New Economy and Canadian Housing's Bubble Status

I have made the case on a number of occasions that the Canadian real estate market, or at least parts of it, have been in a bubble. As someone who grew up in Saskatchewan, it was mind-boggling to me to see the prices of homes in Saskatoon - a city surrounded by prairie with -40C temperatures in the winter - double in two years such that Saskatoon became a more expensive city to buy a house than any city in the United States outside of the pacific coast, New York City and Boston.

I do not often agree with the columnist Murray Dobbin, and I am not sure if I agree entirely with the conclusions in this article, but relying on a report issued by the National Bank of Canada, Dobbin argues that Canada may not be as different as America as some Canadians think.

Some have made the argument that there is no housing bubble in Canada, and that because there has not been a concurrent collapse in housing, everything is fine.

This, in my opinion, is a logical fallacy, not dissimilar to the arguments heard during the Tech Bubble, c1997-99. The fact that a market is different or has not collapsed does not mean it is so different and will not collapse.

US bank stocks did not look like they were in a bubble in 2006 based on any metric one looked at - current earnings, forecasted earnings, book value, tangible book value, and so on. And they were not. But they were dangerous investments nonetheless because the assets that supported those valuations were overvalued.

Similarly, the Canadian housing market may not look like a bubble, but the structural foundations on which those home prices are based are probably flawed.

Let us review points of the broad economy of the past 10 years, one in which most economists either dismissed or ignored.

• A tech and stock market bubble formed in the 1990s.
• The Federal Reserve pumped large amounts of liquidity in the economy to save the world from the collapse of Long-Term Capital Management in 1998 and Y2K in 1999.
• Mainstream economists focus on inflation in prices paid. They do not focus on inflation in asset markets. In fact, many economists believe asset bubbles cannot happen, though fewer do so today than 10 years ago I would imagine.
• The stock market bubble collapsed.
• In response, the Federal Reserve cut interest rates to 1% and held them there for a year.
• Monetary aggregates in the early part of the decade grew 20%+.
• Central banks around the world, particularly in Asia, begin buying dollars by the trillions to avoid currency appreciation, creating a flow of liquidity into global asset markets.
• Housing prices start to rise
• Wall Street ramps up securitization, creating all sorts of derivative products and off balance sheet structures, channeling more liquidity into the financial system
• Housing prices in many countries rise three, four and even five standard deviations above long-term trends and disconnect from other valuation metrics such as price relative to rent and affordability.
• Many economists say housing is not in a bubble, and that home prices are unlikely to fall much because they haven't since the Depression, including our esteemed Fed Chairman in testimony before Congress in 2006.
• Commodity prices explode because of 1.) Structural global supply/demand imbalances, and 2.) liquidity created by central banks and asset allocation decisions by large institutions such as pension funds. As it pertains to (2.), oil goes to $147 a barrel even as demand is dropping and supply is rising, and commodity futures markets such as oil go into almost permanent contango. (Pension funds buy further out on the futures curve to take advantage of the "roll," whereby outer-dated contracts are cheaper in backwardation and "roll" up the curve to the spot price. Roll accounted for roughly two-thirds of commodity futures index returns from 1950 to 2000. Everyone trying to replicate this strategy creates demand out on the curve, driving future prices up, creating contango.)
• The housing bubble pops.
• The financial markets have their worst collapse since the 1930s.
• The economy plunges into arguably the worst crisis since the Great Depression.
• The Fed drops the funds rate to 0% and supports much of the credit markets. Government stimulus, including both monetary and fiscal policy, accounts for an unprecedented 30% of GDP.
• Asset markets, such as stocks and commodities bottom and begin to take off.

Now, let us put this into a Canadian perspective, with some unique Canadian facts.

• Canada gets its house in fiscal order in the mid-1990s, becoming arguably the best run developed country in the world after being perhaps one of the most fiscally irresponsible during the 1970s and 80s.
• The Canadian economy, which is heavily reliant on commodity prices, takes off, particularly in western Canada. However, the strong loonie hits the manufacturing base of eastern Canada.
• Hedge funds became far more prominent in the financial markets. With the advent of technology, they search the world to take advantage of arbitrage opportunities and carry trades. (A carry trade is when a fund borrows in a country with a lower interest rate and lends in another country with a higher interest rate.)
• Hedge funds and other financial institutions begin to allocate more money to Canada because of the commodities boom and because of Canada's fiscal position. The Canadian dollar, aka "the loonie" rises above par vis-a-vis the greenback and hits a multi-decade high.
• Liquidity floods into Canada, driving up asset prices, including home prices.
• Canadian banks were not as reckless as American financial institutions. Banking is better regulated in Canada and banks hold more capital than their American counter-parts. Banking is essentially an oligopoly, with six banks accounting for about 80% of the market in the country.
• Because Canada's financial system is stronger, there is less forced selling of financial assets. A "death spiral" - whereby lower financial asset prices leads to impaired capital in the banking system, which leads to more selling, which leads to lower prices, which leads to more impaired capital, which leads to more selling, and so on - is fairly absent in Canadian fixed income markets.
• Therefore, Canadian housing prices fall less than their American counterparts as capital is not as constrained.
• Governments and central banks institute enormous amounts of stimulus around the world, depreciating the value of fiat currencies and increasing the prices of real assets, including commodities. Stimulus in China is rammed through the financial system as banks are told by Beijing to lend, leading to stock piling of raw materials in China, and higher commodity prices
• The Canadian economy is highly reliant on the United States. Roughly 40% of the Canadian economy is dependent upon exports, and 80% of Canadian exports go to the United States.
• The US government's and the Fed's actions are bearish for the US dollar. The US dollar becomes the currency to finance the global carry trade. The dollar begins to fall and the loonie begins to rise.
• In response, the Bank of Canada keeps interest rates low to offset the weakness in the US and to avoid the loonie from rising too high against the greenback, lest the strong loonie wipes out the manufacturing base of eastern Canada.
• Low interest rates spur borrowing for mortgages. Sales of Canadian homes reaccelerate. In some cities such as Vancouver, home sales over the past few months are breaking all-time highs.

Because both the Canadian financial system and Canadian fiscal policy are better run than in the United States, the fall-out in Canada has been less severe than in America. Canada is a beneficiary of global liquidity creation as it lowers Canadian interest rates and keeps commodity prices strong. This liquidity is being channeled into the Canadian housing market. Canada does not need as much stimulus as the rest of the world, but the global carry trade is channeling liquidity and capital back into the country, igniting the Canadian housing market once again.

This is very similar to what happened in the US housing market in the early part of this decade. In 2001-03 in Silicon Valley and Manhattan, even though thousands of people were being laid off in northern California and New York City as a fall-out from the tech bubble implosion, home prices rose. There was a brief dip in home prices in Silicon Valley but the massive amounts of fiscal and monetary stimulation stabilized and buoyed housing markets across America. The Fed's policies at the beginning of the decade created vast secondary and tertiary unintended consequences, leading to the housing bubble.

Now, in the "New Economy," where asset prices are of the utmost importance, similar distortions are being created. The fact that home sales are breaking records in some Canadian cities does not reassure me. It frightens me. It tells me that we have merely delayed the inevitable and are setting up for possibly worse consequences down the road, as we did at the beginning of this decade.

There are structural reasons for higher asset prices in Canada. However, there are still enormous imbalances in the global economies, and Canada may now be more vulnerable than most countries to the massive global liquidity creation now occurring, given that the imbalances favour commodity-based economies.

We now live in an era where governments actively support asset markets. I dub this "The New Economy," whereby asset prices are a major input into the decision-making process by policy makers. The enormous flood of liquidity and support by governments of asset markets is having secondary and tertiary unintended consequences, which are likely to be massive and have major ramifications in the future. The Canadian housing market is a major benefactor of The New Economy. The end-game is unlikely to be pretty.

Comments

[Dave Wrixon:]

Its about supply and demand. Demand collapsed in the US and there was massive over supply. Whilst arguments have been made for a housing collapse in London, it hasn't really happened to the same degree because there is still enormous demand even if credit is tight and the supply side is still tight. I am sure if you look at your Saskatoon in detail the story is there in the supply and demand. If you have a big influx of people due to mineral exploitation that can have a big effect on a comparatively small town.

Nov 01 01:42 PM

[nomorries:]

LOL. Same thing is happening here in Australia! With a very similar scenario.

But, always remember what goes up must come down and the higher they go the further they fall. Im looking forward to a 80% price decline over the next 12 yrs much like property prices in japan during they're "lost decade" which is really close to 2 decades now.

Noworries

Nov 01 03:30 PM

[Toronto Res...:]

This article seems to focus on why Canada's housing bubble has grown on a slightly different path than the others, vs. why it will pop very very soon.

The 3 biggest factors in the Real Estate market today:
1) near-zero federal prime interest rates
2) the CMHC (Canada's Fannie/Freddie)
3) lack of supply (listings in some areas are 50% less than last year)

The majority of all new home buyers in Canada are now sub-prime. Our definition of "sub-prime" is 5% down / 35-year amortization (after 0% / 40-yr were eliminated in late 2008). The Canadian Mortgage and Housing Corporation (CMHC) insures 100% of these mortgages. This has transformed the CMHC into the largest insurer of sub-prime mortgages IN THE WORLD with about $500B CDN on the books as of today. Even better, our dim-witted Finance Minister (Jim Flaherty) even buys these risky mortgages from the bank monopolies to clear the risk off of their balance sheets. This all happens while our Prime Minister (Stephen Harper) and his cabinet all deny that a housing bubble exists whenever the question comes up.

Any buyer can also get a 2.25% variable mortgage, or sub-4% fixed rate mortgage... both right near all-time lows. Pushed by these artificial rates, Price-to-Income ratios have grown PAST where the US was at the peak of the bubble (over 5-to-1 for the country as a whole I believe, and 7-to-1 in places like Vancouver).

All of this is happening while unemployment grows (we have lost all of our manufacturing jobs too), and taxes rise (new property tax increases and sales tax increases have shown up in the last couple of years).

Put all of this together, and the whole thing is a disaster waiting to happen. Our mathematically-challenged Finance Minister bet the farm on the housing bubble, thinking that this would somehow grow the country out of recession.

The Canadian media is just starting to catch on - if not for H1N1, the average person in this country might start to clue in to the insanity.

This will not end well.

Nov 01 04:52 PM

[bob adamson:]

Toro has presented a well considered and well written assessment of both the current Canadian economic situation and, in particular, its residential housing sector.
It is useful to add the observation that the typical pattern for Canada since WW II has been late entry into global recessions (i.e. there is a lag before foreign orders for products dry up) but its recessions deepen and drag on longer than those for her trading partners (i.e. recovery must be underway abroad before foreign orders for Canadian products pick up). Arguably this is because Canadian producers and manufactures sell a large share of their production into foreign markets and a large portion of Canadian foreign sales are tied to commodities.
For the reasons Toro summarized the Canadian domestic economy held up especially well through 2007 until recently. There was a decline in foreign demand for Canadian products and Canada fell into recession but it was mild compared to that in the US and Europe. However, in recent months the lag in foreign orders for Canadian products, the impact of the rapid recent increase in the exchange rate for the CAD$ in US$ terms, the problems in the automotive manufacturing industry and the slowdown of development in the high cost, capital intensive oil sands sector have all served to accentuate the impact of the recession in Canada. In short, the historic trend for global recessions to deepen and be prolonged in Canada may still apply; especially if the global recovery is anemic and slow.

Turning to the Canadian housing sector itself, it is true that the recessionary dip in prices was much more modest than was the case in many of the hotter (in both senses) US markets and that many markets in Canada have recovered significantly recently. This reflects the mild nature of the recessionary atmosphere in Canada over the past couple of years (for example, for much of Canada the recession was not locally apparent until about 12 months ago). It also reflects historically low interest rates and the relative health of the Canadian banking sector and its willingness to make mortgage loans.
While the bubble Toro predicts may form, the following factors should forestall or mitigate this trend:
1. Unless the global recovery is strong and emerges decisively soon, the lag recovery pattern for Canadian recovery noted above will apply (there are some recent indications that this softening of the general Canadian economy, if not yet the housing market, is now occurring).
2. Unemployment and underemployment, while not yet at US levels, are growing concerns.
3. Much of the latter growth in the Canadian economy immediately prior to October of 2008 was in regions of historically low growth such as Saskatchewan (from which Toro draws his example of bubble housing price growth) but these are agricultural and commodity rich areas which, arguable, previously had especially low real estate values and now have a strong economic foundation to sustain recent rises in housing values.
4. Both the banking and mortgage insurance systems are sound and resistant to lending to weak borrowers.
5. Canadian residential mortgages are not the foundation of a secularized debt instrument or derivative industry to a significant let alone destabilizing degree.

In summary, Toro is correct to observe that Canadian housing prices have not corrected to the extent witnessed in the US and are on the rise again and that historically low interest rates will continue for the foreseeable future for reasons that don’t necessarily reflect the needs of the Canadian housing market. That said, for the reasons set out above, the jury is still out on the question of a housing bubble growing in Canada in the foreseeable future.

Nov 01 05:30 PM

[brent lane:]

Firstly, the "Saskatoon bubble" was primarily caused by a sudden and unexpected influx of tech companies arriving more or less simultaneously (mostly encouraged by large provincial gov't subsidies and grants). A sudden wave of new, high-salaried consumers allowed demand to outstrip supply for a short time. That situation is even now reversing itself and the local market is coming back into balance.
If you don't believe that the Saskatoon situation is an aberration, look at Regina - no such bubble there. Better yet, look at Windsor, which is about the same size as S'toon. A prolonged and steep slide has pushed real estate prices to lows not seen in fifty years. Conditions are not yet like they are 700 yards across the river in Detroit, but lordy, they're getting there. So where's that old "Windsor bubble"?
Secondly, when interest rates hit at an all-time low (0.25% and destined to stay there), international capital flows OUT of a country, not in. Saskatoon real estate prices did NOT rise because international financiers bought bundles of a hundred thousand local mortgages at a time without looking at them, as happened in California, Michigan, Nevada and other US disaster zones.
Thirdly, the lending policies of Canadian banks are, by law, much more conservative than the predatory, mendacious and fiscally irresponsible tactics of the shylocks in the US. So I'm really not sure why you consider so many existing Cdn. mortgages "sub-prime". These people still have jobs and continue to pay down not only their debt, but their principal. Look at the receivership ratio for Cdn. mortgageholders vs. US. The difference is practically exponential. Cdn. banks are also much better capitalized, and are not allowed to spend much on dangerous toys that they don't understand, like derivatives of derivatives, or derivatives cubed.
Fourthly, it is true that the federal government (read "the taxpayer") essentially backstops all the mortgages on CMHC's books. But CMHC, like the banks, is also a conservative lender (I've been self-employed for 30 years, but CMHC wouldn't even look at me.)
AND the government is in an excellent position to do this. Several years of budget surpluses have allowed us to pay off a substantial portion of our debt. Compare this to the US and its ever-steepening debt curve.
Also, so far we have avoided the grotesque excesses of the US's make-work-&-restart the-economy policy. Now THAT'S a hail-Mary play if I've ever seen one. The bottom line here is that while we are proceeding with a fair number of large projects, we are not mortgaging our entire infrastructure to the Chinese or Saudis. Nor will we be stuck with mountains of debt that we cannot service and facilities (like millions of miles of new highways) that we cannot afford to maintain.
It's true that some localized Cdn. real estate markets may currently be overvalued and facing a correction - Vancouver, say, or the Okanagan. But most of these areas are also highly desired by both immigrants and wealthy non-citizens looking for a second home or a safe, enjoyable recreational or income property. As long as Canadian crime statistics are less than a quarter of American, and as long as the flow of people desiring Canadian citizenship continues, real estate prices in these areas are not destined to collapse suddenly, which is the basic definition of a "bubble"

Nov 01 07:50 PM

[Moochacha:]

The concept of a housing bubble is a bit foreign to Canadians to begin with. How can there be a housing bubble when many people don\t own there own home, and people who have a home are losing them? Irresponsible lending?

In the U.S. where foreclosures are rising, the real reason that many of these are taking place is because people signed up for ARM's (adjustable rate mortgages that really didnt benefit them, but were extremely beneficial to companies such as Countrywide, who were able to securitize them and make a killing. The states where the housing crisis is the worst is exactly where these so called subprime mortgage companies operated.

People applying for mortgages to these companies were often
simply misinformed that they would get 1/4 percent savings if they chose this mortgage over the regular mortgage according to there accounts. This was an arbitrage play by these subprime vultures who profitted when they were able to securitize these mortgages, and package them with higher rated mortgages. With all the investig tions by congress etc they dropped the ball on this. I am not sure but I think there may be some court cases regarding this.

The subprime mortgage companies have not gained ground in Canada because these subprime companies and the infrastructure of the derivitive markets are not fostered by the banking system in the US.

Affordable housing through economic stimulus is taking a bum rap for the excesses of greedy bankers in my opinion.

Nov 02 12:08 AM

[Andrew Butter:]

Seeing as you obviously know what you are talking about you might have the data to work out of Canadian Housing is in a bubble.

Basically as a rough guide all you need to do is plot nominal GDP per house against the house price index, the difference between the best-fit regression line that (a) goes through zero and (b) takes you up to the start of a bubble (end of a slump - you have to eyeball that) gives you a measure of the level of mispricing (you need at least 20 years data).

See: www.marketoracle.co.uk...

Long Term interest rates play a small part but that's slightly complicated because it's an "S" curve, although to get a general fix on where you are you don't need that.

That model; works perfectly for USA, UK, Hong Kong and Dubai (interestingly if you index nominal GDP and the house prices the same way the model variables are exactly the same, I imagine they will be the same for Canada).

Alternatively if you send me the data I'll pop it in my model and tell you what I think the answer is ([e-mail]).

Nov 02 02:22 AM

[bob adamson:]

Toronto Resident -

Attached is a link to a weekend article in the Globe and Mail which partially refutes what I wrote earlier and partially supports what you wrote.

theglobeandmail.co.../

The better view might therefore be that it is premature (for some of the reasons I've stated) to believe a bubble is upon us but that (for some of the reasons you set out) we need to watch future trends closely.

bob adamson


On Nov 01 04:52 PM Toronto Resident wrote:

> This article seems to focus on why Canada's housing bubble has grown
> on a slightly different path than the others, vs. why it will pop
> very very soon.
>
> The 3 biggest factors in the Real Estate market today:
> 1) near-zero federal prime interest rates
> 2) the CMHC (Canada's Fannie/Freddie)
> 3) lack of supply (listings in some areas are 50% less than last
> year)
>
> The majority of all new home buyers in Canada are now sub-prime.
> Our definition of "sub-prime" is 5% down / 35-year amortization (after
> 0% / 40-yr were eliminated in late 2008). The Canadian Mortgage and
> Housing Corporation (CMHC) insures 100% of these mortgages. This
> has transformed the CMHC into the largest insurer of sub-prime mortgages
> IN THE WORLD with about $500B CDN on the books as of today. Even
> better, our dim-witted Finance Minister (Jim Flaherty) even buys
> these risky mortgages from the bank monopolies to clear the risk
> off of their balance sheets. This all happens while our Prime Minister
> (Stephen Harper) and his cabinet all deny that a housing bubble exists
> whenever the question comes up.
>
> Any buyer can also get a 2.25% variable mortgage, or sub-4% fixed
> rate mortgage... both right near all-time lows. Pushed by these artificial
> rates, Price-to-Income ratios have grown PAST where the US was at
> the peak of the bubble (over 5-to-1 for the country as a whole I
> believe, and 7-to-1 in places like Vancouver).
>
> All of this is happening while unemployment grows (we have lost all
> of our manufacturing jobs too), and taxes rise (new property tax
> increases and sales tax increases have shown up in the last couple
> of years).
>
> Put all of this together, and the whole thing is a disaster waiting
> to happen. Our mathematically-challenged Finance Minister bet the
> farm on the housing bubble, thinking that this would somehow grow
> the country out of recession.
>
> The Canadian media is just starting to catch on - if not for H1N1,
> the average person in this country might start to clue in to the
> insanity.
>
> This will not end well.

Nov 02 04:45 PM

[The Dark Years:]

One of the things that drove the bubble in the US was favorable tax policies. The 1997 Clinton Administration introduction of a 250k/500k exemption from long term profit on sale of your personal residence that certainly helped. With rapid price increases a family could gain quick wealth every two years by buying and selling (and of course moving) into a new home. Those who could took their gain and turned the previous residence into a rental and then began taking deductions for depreciation, taxes, association dues, mortgage interest and repairs. The gain got them into another residence and their fortunes seemed to take off. My point is that the favorable effect of these tax breaks helped fuel our bubble, but I doubt that is the case in Canada since presumably Canada does not offer such incentives. As I understand it taxes are significantly higher in Canada and less complicated as there are fewer loopholes and credits. Canadians pay high taxes but receive more from their government in the form of quality medical services which has some off setting benefit in dollars available to buy housing with. What all this leads to is the conclusion that it is very difficult to make like kind comparisons.

Nov 03 10:19 AM