NOVEMBER 20, 2010
Thanks to John in Ottawa for this very insightful comment:
Canada is a vast country and the “correction” will be different in one market to the next. Markets that are two to three standard deviations from the historic trend line should expect prices to revert to the mean. That is going to feel like a collapse to those affected.
It is important that we not lose sight of Canadian’s debt to GDP ratio. It is on par with that of the US at the peak of their housing bubble. Americans were using their homes as ATMs, through the so-called “wealth effect.” With stagnant incomes and so much to buy, credit card debt was being consolidated into mortgages at a stunning rate.
Americans had a huge incentive to consolidate into mortgage debt due to mortgage interest tax deductibility, something we don’t have. That does not mean that the same thing isn’t happening here. Last year 20% of Canadian mortgage holders refinanced or took out HELOCS, to the tune of $42,000 on average, and the majority used the money to “pay down debt.” Taking on debt to pay down debt is just another term for consolidation.
While house prices are rising, it may seem safe to indulge in credit card debt with the assurance that the credit cards, with their 18% to 24% interest charges can be dealt with through the house ATM. But there is a trap. What happens when the credit cards have been maxed out again, but the ATM is closed because house values have peaked, even if the peak looks, for a time, like a plateau?
Clearly, the spending stops! Consumption stops and saving becomes paramount. To an economist, saving and paying down debt are the same thing. In the US, the savings rate went from negative to positive in a hurry. Debt has been shrinking dramatically in the US in the Finance, Business, and Household sectors at a dramatic rate. The only thing propping up the US economy is the offsetting increase in Government spending (through debt financing). Negative real interest rates and record low mortgage rates in the US have not enticed the private sector to borrow and consume.
It has been shown that the rate of change in savings/consumption has a dramatic impact on aggregate demand, that is as the private sector’s psychology changes from taking on more debt to saving, or debt reduction, aggregate demand plunges. In the US, it plunged further and any time in recorded history, including the Great Depression. Nothing the Government or the Fed has done has managed to do more than put a bandage on this gushing wound.
As aggregate demand plunges, unemployment surges. The unemployment depth and breath has increased dramatically in the US in recent recessions. The current unemployment recession is the longest and most dramatic since the Great Depression. For many Americans, it is a Great Depression.
It is difficult, actually impossible, for me to believe that Canadian’s can somehow manage to bridge a deep drop in aggregate demand, similar to the drop in the US, and somehow simply maintain, or plateau, our housing prices. The inability to go the the home ATM will dramatically affect the psychology of the wealth effect and Canadians, like our American cousins, will begin to save. The construction industry will come to a screaming halt and unemployment will rise further.
Considering interest rates, we don’t have all the tools available to us that the US has available to them. We are not the reserve currency. We don’t have China and the Middle East (Saudi Arabia) covering our backs, let alone the Federal Reserve. The US government can take on virtually unlimited debt and engage in quantitative easing to control bond rates (with varying degrees of success). We can’t. Being the reserve currency has its privileges.
We have to consider ourselves more in terms of European nations. Our debt levels, in their various forms, are not dissimilar to those of Ireland and Spain. The Bank of Canada is unlikely, in my view, to raise rates again soon. However, we do not have the luxury of assuming that bond vigilantes will not turn their sights on us. But Ireland has the German tax payers to bail them out. Who bails us out. At the slightest sign of weakness, Canada’s long term borrowing costs, which directly affect five year mortgage rates (think five year ARM), could increase dramatically, far beyond the 2.5% threshold that Canadians are considered able to endure. Just this week the TD bank raised it’s mortgage rate by 25 basis points in reaction to the short term rise in US interest rates.
QE II is designed to reduce long term interest rates. The TD bank knows this and is clever enough to know that the recent rise in rates is most likely simply a very short term artifact of front running the Fed and won’t last. Is the TD bank feeling a bit sensitive, perhaps a bit exposed?
This is a rather long comment and I apologize for that. I thank those who took the time to read it through. The bottom line is simple. Yes, our banks may be on a fairly solid footing, but Canadians aren’t. We are exposed to a very high debt load, a continuing world wide financial crisis, a capricious commodities market, and, in many markets, a dramatic housing bubble.
Our federal government does not have the fiscal and policy tools to continuously bail us all out in a manner similar to the US. Can you imagine Harper extending unemployment benefits to 99 weeks or the Bank of Canada buying up $125B of mortgages? No other country’s tax payers will bail us out except through the IMF with the resulting forfeiture of fiscal sovereignty. Canadians will begin to save (pay down debt) again and GDP will plunge. If you, personally, want a “soft landing” you had better make sure you have a good parachute.