Thoughts on house prices, credit growth, and excess volatility
AUGUST 27, 2012
Fed Reserve Bank of San Francisco on house prices, credit growth, and excess volatility
Readers who have not yet seen it may be interested in a report by the Fed Reserve Bank of San Francisco:
Some key quotes and thoughts as they pertain to the current situation in Canada:
“In a given area, past house price appreciation had a significant positive influence on subsequent loan approval rates(Goetzmann et al. 2012). Areas which experienced the largest run-ups in household leverage tended to experience the most severe recessions as measured by the subsequent fall in durables consumption or the subsequent rise in the unemployment rate (Mian and Sufi 2010).
Overall, the data suggests the presence of a self-reinforcing feedback loop in which an influx of new homebuyers with access to easy mortgage credit helped fuel an excessive run-up in house prices. The run-up, in turn, encouraged lenders to ease credit further on the assumption that house prices would continue to rise. Recession severity in a given area appears to reflect the degree to which prior growth in that area was driven by an unsustainable borrowing trend–one which came to an abrupt halt once house prices stopped rising (Mian and Sufi 2012).”
The simple reality is that bank lending is procyclical, loosening as asset prices rise and tightening as they fall, or have a high probability of falling. I've often said that the next decade will look nothing like the past, with one of the core areas of change being the availability of credit. Already we're seeing regulators lean on banks to tighten underwriting standards while in other areas, lenders are taking the initiative themselves.
One great example is BMO's recent decision to abandon it's condo deposit loan program which used to give interest-only loans for deposits on pre-construction condos. That program is now shelved while at the same time, they've tightened the availability of mortgages on Toronto condos where the LTV is between 65% and 80%. Expect this to be just the start. Now that low ratio bulk insurance is much more difficult to get, meaning banks cannot so easily insure away their risk on low ratio loans, you can't expect banks to readily lend at 80% LTV in areas like Vancouver or the Toronto condo market where even the banks themselves, for all their bullish bluster, acknowledge the distinct possibility of a +20% market correction.
And as the mortgage fraud scandal in Australia has continued to develop, we are again reminded that in instances where household credit significantly outpaces income growth, we almost always find a loosening of lending standards often accompanied by fraudulent practices.
Consider the Canadian situation:
While Canada has never rivaled the US in terms of exotic loan products, it's important to maintain perspective. What has unfolded in the US represents the greatest destruction of wealth in human history. We may not have traveled as far down that road as they have, but the fact that Canadian consumer and mortgage credit growth has massively outpaced income growth over the past decade, and we now have nearly as much of this credit outstanding relative to GDP as the US had at peak (93% of GDP vs 95%) certainly suggests that we ARE on that road. How comfortable should we be with a consumer debt/GDP ratio only marginally better than a country that blew itself up with excess consumer credit?
“At the time, many economists and policymakers argued that the strength of the U.S. economy was a fundamental factor supporting house prices. However, it is now clear that much of the strength of the economy during this time was linked to the housing boom itself. Consumers extracted equity from appreciating home values to pay for all kinds of goods and services while hundreds of thousands of jobs were created in residential construction, mortgage banking, and real estate.”
If this was true in the US, it most certainly is true in Canada where by every possibly measure, our economy is more levered to this current boom than was ever the case in the US.
Regarding home equity withdrawal, the US hit an estimated peak of 8-9% of aggregate personal disposable income from 2003 to 2006. This is precisely the rate of equity withdrawal currently occurring in Canada based on Bank of Canada estimates, though we’ve sustained that rate for far longer:
Chart sources: Calculated Risk blog, Bank of Canada
“Intuitively, a loan-to-income constraint represents a more prudent lending criterion than a loan-to-value constraint because income, unlike asset value, is less subject to distortions from bubble-like movements in asset prices…During the U.S. housing boom of the mid-2000s, loan-to-value measures did not signal any significant increase in household leverage because the value of housing assets rose together with liabilities. Only after the collapse of house prices did the loan-to-value measures provide an indication of excessive household leverage. But by then, the over-accumulation of household debt had already occurred.”
Unfortunately the horses have long left the barn in Canada. House prices relative to incomes are at all-time highs in every major city in the country, and implementing a loan-to-income constraint at this point would be disastrous:
Cheers
Ben
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18 Comments
Debt carrying-cost ratios are nowhere near worrying right now, but that could change with rising rates. Increasingly it seems like the only hope is for the Bank of Canada (and the wider bond market) to hold rates low long enough for credit tightening and jawboning to get debt ratios down.
Its a delicate balance. We need job and wage growth to help out household balance sheets, but that would likely lead to inflationary pressures, which of course would necessitate higher rates.
Interest costs as a % of PDI are certainly below long-term norms, but total payments remain near all-time highs. And keep in mind that interest-only HELOCs will eventually have to be repaid, all of which means more money diverted away from consumption and towards debt repayment. No matter how you look at it, a consumer deleveraging will at some point become a necessity, which will certainly weigh on economic growth.
Hence the BoC's exhortations to businesses to start spending in order to fill in the gap left by consumers.
The bulls will never get it Ben. It's the debt load, not the debt servicing that matters. http://i49.tinypic.com/2cy1hma.png
But debt ratios aren't going down, and won't go down until well after a crash occurs. Our policy makers are talking and tweaking but they have not addressed the problem at all. I can get a subprime loan right now. I do not think they will address it. We have become like China, with households subsidizing ever growing malinvestment. What is Canada's pitch to its young people? Join the ant tribe?
http://www.thedailybeast.com/newsweek/2010/06/19/smart-young-and-broke.html
Bank of Canada .... abandon its [not it's]. The injection of the apostrophe into the possessive 'its' has gotten us all confused. But back to housing. It's nuts.
Something and or anything please prick this damn bubble!
Thanks Ben. Great analysis, as always.
Can you please write an article about the MLS Housing Price Index? Garth Turner wrote about it a while ago, but as usual only substantiated it anecdotally. I'd be curious to see your analysis of what it is and how it is misleading, as you did with RBC's housing affordability measure.
By the way, did you see the latest RBC affordability report? http://www.rbc.com/economics/market/pdf/house.pdf. Vancouver is apparently up 2.2% despite recent price drops. Ha!
The methodology for the HPI is clearly spelled out. Why don't you just read it and decide for yourself.
Instead of posting such a silly comment, please provide the exact formula and actual references. The homepriceindex.ca website has very few details. The following sentence leads me to believe that the formula is probably a lot more complex than you think and does not represent selling prices:
The MLS® HPI is based on the value homebuyers assign to various housing attributes, which tend to evolve gradually over time.
@Pierre
How about you spend the 5 seconds to click on Resources -> Methodology on the homepriceindex.ca site? Here let me help you with that: http://homepriceindex.ca/docs/mls_home_price_index_methodology_en.pdf#Vi...
Hi Ben,
Thank you so much for such well written, fact based articles.
As much as me and my husband would like to buy a house, it's articles like this that help us remmain patient and intensly curious about what will happen to our friends the "jones" when the spending catches up to them.
I would really appreicate any articles about Alberta(paticularly Edmonton), as i am so sick about hearing how it's diffrent here and how the oilpatch will keep as all flush with money! (which is a load of crap as we carry more perosnal debt here than most canadians)
They're called fundementals for reason people!
Cheers.
Ben,
Thanks for the new articles. I would describe them as "robust" and they are appreciated.
Trader
Does anyone have a rough idea on when the "distinct possibility of a +20% market correction" might occur?
If people knew the answer to this question, a lot of people would be selling their homes... It'll take a couple years at least... Even longer for some markets
Can someone help me understand this from Bens debate on GM? "Around the world, the trend is almost universal: assets and debt rise more quickly than income.". Shouldnt we expect growth in RE prices vs growth in incomes to be similar.... not yearly 8% vs 2% consistently for 12 years? Great job Ben BTW.
Provincial Budget cuts of $1.4 billion to be made, is the announcement in BC today.
Cuts to services means more hazards in real state infra-structure.
Will real estate values be set by phone apps in the future?
Blur all the coloured charts and graphs together. I see a dinosaur eating its tail.
mhanson.com has been down for the weekend. What's up?