Canada's Housing Bubble Essay
CANADIAN BUBBLE, EH?
How real is Canada's housing bubble anyway? More real than any other countries. That is due to the following facts that I will present below, but first it is better to start with a little history. In the year of 2008, as stated on Statistics Canada, the recovery of the recession was much quicker than in other recession period such as in 1981-1982 and 1990-1992. However, was it a real recovery or an illusion? In 2011, Globe and Mail published an article on why Canada’s recession was not as brutal. In summary, Philip Cross explored what factors caused the impulsive slide, and why the downturn was not nearly as severe as in previous recessions, here are some of his findings: * Jobs contracted at only half the rate at which output fell during this recession. * May, 2009, seems to be the low point for monthly GDP, “when widespread plant closures in the auto industry as two major firms went bankrupt depressed output, and the same month was the low in hours worked.” * …show more content…
The initial speed of descent in the last downturn exceeded that in the other two recessions. * Employment bounced back much more quickly than in previous recessions. * Full-time job cuts were heavier in prior recessions than the recent one. Full-time employment at the end of last year is still 64,000 below its pre-recession peak, which explains why total hours worked remain 0.7 per cent below their peak. * Exports plunged at a record rate. “The most striking feature of the 2008-2009 recession was the speed and severity of the contraction in exports,” the report said. * With the fall in exports came a collapse of business investment. Investment in plants and equipment plunged by about 20 per cent in the recession, matching a record plunge.
In prior recessions, it plummeted by nearly 6 per cent. This time round, it fell by only 2 per cent over two quarters and has already fully bounced back. He attributes this to several factors: Canadian households had strong balance sheets going into the downturn. Employment didn’t fall as much as in past contractions. Credit wasn’t as impaired as in other countries. “This reflects both a sounder financial system and the massive response from policy makers both to shore up capital and to lower interest rates.”
Everything seems legit, however Mr. Cross seems to have no idea, what happened to the banking system during that period and what actually was done in order to keep the “Big picture” as good as it seemed. It is commonly understood, that Canadian banking system is one of the strongest banking system in the world, but it seems that the system is no different than most of its counterparts and a Canadian economic crisis is just as inevitable. What Mr. Cross and some other analytics and reporters didn’t know while analyzing the crisis and the recovery, is that Canadian banks received a bailout in 2009 from the Fed, BoC, and CMHC. (CMHC stands for Canada Mortgage and Housing Corporation) In the analysis (article) published on Wednesday, January 2nd, 2013 by Chris Ferreira there are 6 key arguments about the Canadian Banking System’s unsound economics. One of which is just mentioned “bailout” of the banking system and the others are: * The key reason underlying this bailout was that Canadian banks are actually under-capitalized; * Canadian banks operate under a fractional reserve system, with 0% reserve requirement; * The Canadian Deposit Insurance Corporation does not hold enough cash on hand; * Canadian banks hold the majority of their balance sheets on non-productive assets; * The Bank of Canada has virtually no gold left to back their monetary system
“It is true, we have the only banks in western world that are not looking at bailouts or anything like that… and we haven’t got any TARP money.” – Stephen Harper, Prime Minister of Canada. However, it is NOT true, as it turns out after the release of a report with some estimates on the publicly available data from the Canadian Mortgage Housing. To prevent similar catastrophe as it happened in US, the US fed and the Bank of Canada offered short-term collateralized loans to Canadian banks, and the CMHC bought $69 billion worth of mortgages off Canadian Chartered Banks. Which is the same to what the US Fed has done with their quantitative programs. As it turned out, at its peak, Canadian Banks received more than $114 Billion, which is 7% of the ENTIRE Canadian economy in 2009. Directly from the CCPA report: "Canada's banks received $114 billion in cash and loan support between September 2008 and August 2010...”
Canadian Centre for Policy Alternatives published a report with above estimates. The CCPA study estimates that three of Canada's banks - CIBC, BMO, and Scotiabank - received bailouts that exceeded their market value at the time, which does tend to support the conclusion that they were under extreme financial stress.
Mortgages were the usual suspect in 2008 Canadian banking bail-out and so mortgages provided a canal for government assistance. The default risk on approximately 50% of Canadian mortgages is in practice back-stopped by the Canadian government via the Canadian Mortgage and Housing Corporation. Banks do pay to insure their mortgages with the CMHC but at what could be argued, are far below market rates given global real estate volatility and the escalation of pricing risks in the Canadian market. Of course, when the Big Five (5 largest Canadian banks) got into trouble the taxpayer CHMC, the Bank of Canada and surprisingly even the US Federal Reserve stepped into breach:
Clearly, banks received emergency funding about the size on a per capita basis of that received by the US banks to fill the liquidity gap that accrued during liquidity crisis in 2008-2010, so the need to sell performing but illiquid CMHC guaranteed mortgages. Canadian banks needed a bailout that amounted to approximately 7% of GDP when the large part of their asset base - Canadian mortgages - was not in any apparent distress.
Why Did the Canadian Banks needed to be Bailed Out? Canadian Banks practice a fractional reserve system which allows then to use the money that are created out of air, charge interest, and offload their risk to the taxpayers in the event of a CMHC insured mortgage default or a bank-run. Which brings us to the same point as Americans got – involving in reckless money borrowing and brings Canadians to a debt-level far beyond those of the Americans. That gives us a clearer picture on the situation in Canadian Economy, housing and banking system. Now, let’s see in more details what is going on with the housing bubble today.
In the US crisis of 2007-2008, the bubble popped; yet, in Canada, the bubble continues to grow. Low interest rate creates an environment when investments of firms are badly assigned due to an artificially low cost of credit and an unsustainable increase in money supply. Canadian debt/disposable income levels are approaching 160%, far above the US equivalent of 128% before the US debt crisis, says Chris Ferreira. CMHC fixed the down payment to 0% from March 2006 to October 2008 to create housing demand, then CMHC declared 5% minimum, however banks were offering a 5% cash back component to their mortgages, therefore it looks like we still have “NO Money down” situation. CMHC permits the minimum 5% down to come from sources like credit lines, as a result sub-prime mortgages still do exist in Canada. The scheme is simple: if debt level increases – trend continues, to increase debt level – either lower the interest rates or loose the rules. Interest rates are almost at the zero mart, therefore loosening the rules is the solution, and however that creates only an increase of non-qualified buyers thus increasing the price of housing.
What could be a solution for lowering prices? – Deflation. If some people would start to default, the money supply would begin to vanish, since they are created out of an air, resulting deflation. Deflation should be accepted, as it lowers the prices during the crisis. So-called mal-investment (a concept developed by the Austrian School of economic thought, that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply. – Wikipedia) would liquidate and the economy would restore itself to equilibrium. What happened in 2008 is a temporary solution by central bank, which brought the economy to a crucial point, so why Canadian banks and housing market will most likely collapse in near future? The answer is in financial instrument that is used by banks called mortgage-backed securities and the banking system as a whole. Basically, banks package and sell multiple mortgages together in order to get those loans off the books of banks. The CMHC actually holds over $300 billion worth of Canadian mortgage paper, along with insuring an additional $600 billion worth of mortgages and in the event of default, it’s the taxpayers that will pay the bill for those mortgages.
Canadian newspaper Mclean’s published an article “Time to panic about the housing market”, where former analyst for BoC David Madani said following: “Everybody points out the differences in the U.S., about financial regulations and subprime mortgages,” “But to me this is all a borderline attempt to misdirect the whole debate because we’re engaging in that type of discussion and only that discussion.
It ignores the big elephants in the room.” The elephants Madani sees include a sharp run-up in house prices compared to income: the average Canadian home now costs five times the average income, well above the multiple of three that is considered affordable. There’s also a sharp rise in home ownership rates, which at about 68 per cent of Canadians mirrors closely the 69 per cent at the top of the U.S. bubble. Madani also points to continued overbuilding and Canada’s still healthy construction industry. New building permits reached $6.8 billion in December, a 4.5-year
high.
The biggest elephant of all is how much the boom has been fuelled by cheap and abundant credit thanks to a low interest rate policy pursued by the Bank of Canada, along with government-insured mortgages. “All the warning signs are there,” Madani says. “We just have to connect the dots.”
As well known, banks operate under a fractional reserve banking system, which means that banks keep only a part of their deposits while lending out the rest to other clients. Banks believes that people will not withdraw their money from banking system all together. Canadian banking system is no different, except for the part, that unlike most banks that stick to a 10% reserve requirement, Canadian banks have 0% requirement. That, of course, creates an opportunity to create money out of the air without any limit. What else is created while creating money out of the air? – Debt. It happens because this system constantly creates credit and therefore debt. When the mortgage is approved to the client, a sum of money is digitally created on a promise that it will be paid back with interest. Yet, it did not come from the reserves. Credit growth on that scale leads to a necessity of an expansion, if credit does not expand the economy falls and returns to its equilibrium. It is very similar to a well-known Ponzi scheme, which is destined to collapse because the earnings, if any, are less than the payments to investors.
There is also another problem in the whole system, it is government. Government decides where investments should be directed, instead of leaving this to the free market. For example, if real estate in the US and Canada is subsidize investments which most likely is a cause for distortions in the free market. The CHMC is offering mortgages at 5% down payment, first time home buyers credit and other motivations that have created unnatural huge demand, but real estate does not provide any net value to an economy. Investments should have been focused on small and medium businesses, but banks focused on real estate. Which caused, at the end as we see, the suffer of the businesses as it is almost impossible to access the money that are required for their growth, which causes the lowering in the supply of goods and which consequently keeps prices high.
How real is Canada's housing bubble anyway? More real than any other countries. That is due to the following facts that I will present below, but first it is better to start with a little history. In the year of 2008, as stated on Statistics Canada, the recovery of the recession was much quicker than in other recession period such as in 1981-1982 and 1990-1992. However, was it a real recovery or an illusion? In 2011, Globe and Mail published an article on why Canada’s recession was not as brutal. In summary, Philip Cross explored what factors caused the impulsive slide, and why the downturn was not nearly as severe as in previous recessions, here are some of his findings: * Jobs contracted at only half the rate at which output fell during this recession. * May, 2009, seems to be the low point for monthly GDP, “when widespread plant closures in the auto industry as two major firms went bankrupt depressed output, and the same month was the low in hours worked.” * …show more content…
The initial speed of descent in the last downturn exceeded that in the other two recessions. * Employment bounced back much more quickly than in previous recessions. * Full-time job cuts were heavier in prior recessions than the recent one. Full-time employment at the end of last year is still 64,000 below its pre-recession peak, which explains why total hours worked remain 0.7 per cent below their peak. * Exports plunged at a record rate. “The most striking feature of the 2008-2009 recession was the speed and severity of the contraction in exports,” the report said. * With the fall in exports came a collapse of business investment. Investment in plants and equipment plunged by about 20 per cent in the recession, matching a record plunge.
In prior recessions, it plummeted by nearly 6 per cent. This time round, it fell by only 2 per cent over two quarters and has already fully bounced back. He attributes this to several factors: Canadian households had strong balance sheets going into the downturn. Employment didn’t fall as much as in past contractions. Credit wasn’t as impaired as in other countries. “This reflects both a sounder financial system and the massive response from policy makers both to shore up capital and to lower interest rates.”
Everything seems legit, however Mr. Cross seems to have no idea, what happened to the banking system during that period and what actually was done in order to keep the “Big picture” as good as it seemed. It is commonly understood, that Canadian banking system is one of the strongest banking system in the world, but it seems that the system is no different than most of its counterparts and a Canadian economic crisis is just as inevitable. What Mr. Cross and some other analytics and reporters didn’t know while analyzing the crisis and the recovery, is that Canadian banks received a bailout in 2009 from the Fed, BoC, and CMHC. (CMHC stands for Canada Mortgage and Housing Corporation) In the analysis (article) published on Wednesday, January 2nd, 2013 by Chris Ferreira there are 6 key arguments about the Canadian Banking System’s unsound economics. One of which is just mentioned “bailout” of the banking system and the others are: * The key reason underlying this bailout was that Canadian banks are actually under-capitalized; * Canadian banks operate under a fractional reserve system, with 0% reserve requirement; * The Canadian Deposit Insurance Corporation does not hold enough cash on hand; * Canadian banks hold the majority of their balance sheets on non-productive assets; * The Bank of Canada has virtually no gold left to back their monetary system
“It is true, we have the only banks in western world that are not looking at bailouts or anything like that… and we haven’t got any TARP money.” – Stephen Harper, Prime Minister of Canada. However, it is NOT true, as it turns out after the release of a report with some estimates on the publicly available data from the Canadian Mortgage Housing. To prevent similar catastrophe as it happened in US, the US fed and the Bank of Canada offered short-term collateralized loans to Canadian banks, and the CMHC bought $69 billion worth of mortgages off Canadian Chartered Banks. Which is the same to what the US Fed has done with their quantitative programs. As it turned out, at its peak, Canadian Banks received more than $114 Billion, which is 7% of the ENTIRE Canadian economy in 2009. Directly from the CCPA report: "Canada's banks received $114 billion in cash and loan support between September 2008 and August 2010...”
Canadian Centre for Policy Alternatives published a report with above estimates. The CCPA study estimates that three of Canada's banks - CIBC, BMO, and Scotiabank - received bailouts that exceeded their market value at the time, which does tend to support the conclusion that they were under extreme financial stress.
Mortgages were the usual suspect in 2008 Canadian banking bail-out and so mortgages provided a canal for government assistance. The default risk on approximately 50% of Canadian mortgages is in practice back-stopped by the Canadian government via the Canadian Mortgage and Housing Corporation. Banks do pay to insure their mortgages with the CMHC but at what could be argued, are far below market rates given global real estate volatility and the escalation of pricing risks in the Canadian market. Of course, when the Big Five (5 largest Canadian banks) got into trouble the taxpayer CHMC, the Bank of Canada and surprisingly even the US Federal Reserve stepped into breach:
Clearly, banks received emergency funding about the size on a per capita basis of that received by the US banks to fill the liquidity gap that accrued during liquidity crisis in 2008-2010, so the need to sell performing but illiquid CMHC guaranteed mortgages. Canadian banks needed a bailout that amounted to approximately 7% of GDP when the large part of their asset base - Canadian mortgages - was not in any apparent distress.
Why Did the Canadian Banks needed to be Bailed Out? Canadian Banks practice a fractional reserve system which allows then to use the money that are created out of air, charge interest, and offload their risk to the taxpayers in the event of a CMHC insured mortgage default or a bank-run. Which brings us to the same point as Americans got – involving in reckless money borrowing and brings Canadians to a debt-level far beyond those of the Americans. That gives us a clearer picture on the situation in Canadian Economy, housing and banking system. Now, let’s see in more details what is going on with the housing bubble today.
In the US crisis of 2007-2008, the bubble popped; yet, in Canada, the bubble continues to grow. Low interest rate creates an environment when investments of firms are badly assigned due to an artificially low cost of credit and an unsustainable increase in money supply. Canadian debt/disposable income levels are approaching 160%, far above the US equivalent of 128% before the US debt crisis, says Chris Ferreira. CMHC fixed the down payment to 0% from March 2006 to October 2008 to create housing demand, then CMHC declared 5% minimum, however banks were offering a 5% cash back component to their mortgages, therefore it looks like we still have “NO Money down” situation. CMHC permits the minimum 5% down to come from sources like credit lines, as a result sub-prime mortgages still do exist in Canada. The scheme is simple: if debt level increases – trend continues, to increase debt level – either lower the interest rates or loose the rules. Interest rates are almost at the zero mart, therefore loosening the rules is the solution, and however that creates only an increase of non-qualified buyers thus increasing the price of housing.
What could be a solution for lowering prices? – Deflation. If some people would start to default, the money supply would begin to vanish, since they are created out of an air, resulting deflation. Deflation should be accepted, as it lowers the prices during the crisis. So-called mal-investment (a concept developed by the Austrian School of economic thought, that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply. – Wikipedia) would liquidate and the economy would restore itself to equilibrium. What happened in 2008 is a temporary solution by central bank, which brought the economy to a crucial point, so why Canadian banks and housing market will most likely collapse in near future? The answer is in financial instrument that is used by banks called mortgage-backed securities and the banking system as a whole. Basically, banks package and sell multiple mortgages together in order to get those loans off the books of banks. The CMHC actually holds over $300 billion worth of Canadian mortgage paper, along with insuring an additional $600 billion worth of mortgages and in the event of default, it’s the taxpayers that will pay the bill for those mortgages.
Canadian newspaper Mclean’s published an article “Time to panic about the housing market”, where former analyst for BoC David Madani said following: “Everybody points out the differences in the U.S., about financial regulations and subprime mortgages,” “But to me this is all a borderline attempt to misdirect the whole debate because we’re engaging in that type of discussion and only that discussion.
It ignores the big elephants in the room.” The elephants Madani sees include a sharp run-up in house prices compared to income: the average Canadian home now costs five times the average income, well above the multiple of three that is considered affordable. There’s also a sharp rise in home ownership rates, which at about 68 per cent of Canadians mirrors closely the 69 per cent at the top of the U.S. bubble. Madani also points to continued overbuilding and Canada’s still healthy construction industry. New building permits reached $6.8 billion in December, a 4.5-year
high.
The biggest elephant of all is how much the boom has been fuelled by cheap and abundant credit thanks to a low interest rate policy pursued by the Bank of Canada, along with government-insured mortgages. “All the warning signs are there,” Madani says. “We just have to connect the dots.”
As well known, banks operate under a fractional reserve banking system, which means that banks keep only a part of their deposits while lending out the rest to other clients. Banks believes that people will not withdraw their money from banking system all together. Canadian banking system is no different, except for the part, that unlike most banks that stick to a 10% reserve requirement, Canadian banks have 0% requirement. That, of course, creates an opportunity to create money out of the air without any limit. What else is created while creating money out of the air? – Debt. It happens because this system constantly creates credit and therefore debt. When the mortgage is approved to the client, a sum of money is digitally created on a promise that it will be paid back with interest. Yet, it did not come from the reserves. Credit growth on that scale leads to a necessity of an expansion, if credit does not expand the economy falls and returns to its equilibrium. It is very similar to a well-known Ponzi scheme, which is destined to collapse because the earnings, if any, are less than the payments to investors.
There is also another problem in the whole system, it is government. Government decides where investments should be directed, instead of leaving this to the free market. For example, if real estate in the US and Canada is subsidize investments which most likely is a cause for distortions in the free market. The CHMC is offering mortgages at 5% down payment, first time home buyers credit and other motivations that have created unnatural huge demand, but real estate does not provide any net value to an economy. Investments should have been focused on small and medium businesses, but banks focused on real estate. Which caused, at the end as we see, the suffer of the businesses as it is almost impossible to access the money that are required for their growth, which causes the lowering in the supply of goods and which consequently keeps prices high.