JANUARY 02, 2011
Jay Bryan, perhaps the most ardent housing perma-bull in the mainstream media, is back at it again, this time suggesting that the notion of a Canadian housing bubble is 'hare-brained'. You can count this one among a number of poorly researched articles suggesting that since our bubble is not 'American' in nature, it means we have no problems to contend with. As I have long maintained, it is exceptionally dangerous to look south of the border at arguably the greatest wealth destruction in human history and somehow allow ourselves to become smug at the fact that our excesses did not equal theirs.
I've never suggested that our bubble experience will mirror theirs, but that doesn't mean we don't have our own structural issues to deal with. Please read this article before reading my response below.
As is increasingly true of most recent media stories about the glories of Canadian real estate, this one leans heavily on weak anecdotes and outright false statements. As such, I take great pleasure in dismantling this garbage.
If you gather that I may be perhaps more put off than usual, it's probably because Mr. Bryan's writing style reeks of arrogance and hubris in addition to providing incredibly misleading and dangerous information. We'll get to that in a moment. First word to Mr. Bryan:
"It's hard to find a reputable analyst who predicts anything other than mild fluctuations in housing over the coming year or two."
If you switched the word 'reputable' with 'bank-employed', I would totally agree with this statement. But that kind of changes the message, doesn't it? I'm not sure how Mr. Bryan defines 'reputable', but I'd suggest that the following list of famed economists and money managers who all see trouble in Canada's real estate market would put Mr. Bryan's list of 'reputable' analysts to shame:
Dean Baker- “It looks me like you have some real problems...Canada could see house prices collapse by 25 to 30 per cent if interest rates rise by about two percentage points”
Robert Shiller- “The Canadian housing market could face a similar housing bust to the United States, particularly in more bubbly markets as Vancouver and Calgary”
Paul Krugman- “Canada cannot be complacent in the face of disturbingly bleak global conditions, because Canadians spend too much relative to their household incomes and the country’s housing bubble has yet to burst.”
David Rosenberg- “…Housing values are anywhere between 15 per cent and 35 per cent above levels we would label as being consistent with the fundamentals. If being 15 per cent to 35 per cent overvalued isn’t a bubble, then it’s the next closest thing. We are talking about two to three standard deviation events here in terms of the parabolic move in Canadian home prices from their lows. So, if it walks like a duck …”
Mike Shedlock- “A Canadian housing crash is a given. The only thing that remains to be seen is how deep the crash is.”
Don Coxe- "Canada continues to experience a real estate bubble"
Stephen Jarislowsky- "In Canada the hardship still lies ahead. Our houses are still 20 to 30 per cent above normal levels...I think things are going to get a hell of a lot worse....I hope I’m wrong but I think Canada is on the edge of a lot of trouble.”
Note that unlike the bank-employed economists Mr. Bryan no doubt is referring to, none of these analysts are employed by an institution whose basic business model revolves around perpetual expansion of credit, something that tends to slow markedly during housing corrections. As I've noted before, both the profit engine and the unsecured debt exposure of the big banks call into question their ability to give a completely unbiased prediction. With that in mind, Mr. Bryan, let's hear your list. Who have you got? And remember, bank-employed analysts only get you half marks.
"There was never a solid basis for the scary speculation, but it just kept bubbling up. Serious Canadian media, including the Globe and Mail, made housing-bubble headlines into a staple. Below the headline, there was usually an acknowledgment that there was no evidence of anything more than a hot market, but the scary headlines didn't stop."
Oh my! What a ridiculous thing to say. 'No evidence of anything more than a hot market'? Seriously?
As I have always maintained, the rational way to gauge the potential overvaluation in real estate is not through anecdotes, as Mr. Bryan is evidently fond of, but rather through a long-term comparison of widely accepted measures of fundamental value. Without these anchor points we quickly resort to the unfounded drivel spewed by the likes of the author. Among the most widely accepted measures of value are the price/income ratio, the price/rent ratio, and long-term real (inflation adjusted) house price growth. Without recapping the entire primer hyperlinked above, let me simply provide a few graphs for your consideration:
As the most fundamental indicator of the sustainability of current house prices, the current price/income ratio has a lot to say. As we are well into uncharted territory for Canada, and now past the peak the US experienced during their own real estate bubble, this graph alone calls into question the author's assertion that there is 'no evidence' of a housing bubble. But let's not stop there.
There is currently a severe dislocation in the costs of home ownership versus the costs of renting the equivalent dwelling. Bringing this back in line with long-term trends will involve a massive increase in rents, a declining housing market, or a combination of both. You can probably guess what I'm betting on.
Yale professor Robert Shiller (co-creator of the famous Case Shiller house price index in the US and one of the disreputable analysts I cited above) famously calculated that house prices pace inflation over long time horizons. The obvious implication is that any time house prices rise significantly less than inflation over long periods of time, a mean reversion will result in house prices correcting to the upside. More importantly in the context of this discussion, periods of time that are marked by an increase in house prices relative to inflation are followed by periods of downward pressure. So what does that imply about the graph above?
Needless to say, the notion that there is absolutely no evidence that housing may be in bubble territory is either a blatant lie or a statement that exposes the ignorance of the author. Which one is it, Mr. Bryan?
"A bubble, unlike a normal price cycle, is a rare phenomenon that occurs when over-optimism and price excesses last so long and become so extreme that a large number of people begin to believe that prices can only go up, never down."
I agree with this statement but not with what's being implied. Current sentiment towards real estate is exceptionally bullish, with well over 90% of the population seeing real estate as an excellent investment regardless of current prices. Coupled with the highest home ownership rate in history, this certainly suggests that a massive swath of the population is engaged in the very euphoria that Mr. Bryan asserts (and I agree) is indicative of a speculative bubble.
"This kind of speculative bubble was allowed to form in the U.S. housing market through a combination of monetary policy that was too easy for too long and shockingly irresponsible regulation of banks, which enabled people to get mortgages they could never repay and allowed banks to package these bad mortgages into toxic securities that eventually shook the foundations of the banking industry in the U.S."
"In Canada, nothing remotely like this happened."
Let's start with what is true about this statement. Certainly we never experienced the same level of reckless lending that occurred in the US in the run up to their collapse, but by no means were our lending requirements prudent.
Before discussing that in more detail, let me quickly debunk one of the major lies contained in this quote. Mr. Bryan suggests that while the US got into trouble by bundling mortgages into securities, 'nothing remotely like this happened' in Canada. That's a lie. The securitization process is currently consuming more than 100% of new mortgage. These mortgages are packaged and sold as 'mortgage backed securities' such as the Canada Mortgage Bond.
You can see from the chart below, courtesy of the Bank of Canada, that total outstanding mortgage credit grew by $65.4 billion between 2008 and 2009. But the growth of mortgage backed securities totaled $84.6 billion, or some 129% of new mortgages. This was only possible as the big banks reduced their mortgage exposure, possibly seeing the writing on the wall. The notion that we don't have an exceptionally active securitization process taking place in Canada is complete nonsense.
About those prudent lending standards by our Canadian banks. I've written about this many times before, but let me quickly recap some of the key points in this discussion:
- Since 2005, CMHC has loosened mortgage insurance requirements from a maximum amortization length of 25 years to the current 35 year max, with a brief experiment with 40 year, zero down payments.
- 20 percent down payments were the minimum requirement for most of CMHC's 60 year history. By contrast, they currently insure 5% down mortgages. While 'technically' zero down payment loans do not exist in Canada, there are many ways around this, such as the 7% cash back offer from CIBC or the 5% cash back offers from most big banks. Borrow the down payment from a credit card, line of credit, or friend and then pay back once the funds are released. Voila! You own a home with zero equity. We can debate just how prudent these new lending requirements are, but the fact that we have seen a major loosening of lending standards over the past half decade is indisputable.
- In an effort to prop up the real estate market in 2008 (when affordability nose-dived and the economy soured), the Harper government directed the CMHC to approve as many high-risk borrowers as possible and to keep credit flowing. The approval rate for these risky loans went from 33% in 2007 to 42% in 2008.
With regards to Mr. Bryan's assertion that Canada has not allowed 'people to get mortgages they could never repay', let's once again consider the data. Virtually all mortgages in Canada come up for renewal every 5 years, which is very different from the American system where the vast majority of mortgages are for 30 year terms at extremely low fixed rates relative to ours. When fixed rate mortgages in Canada renew, they do so at the new market rate. Let’s connect two dots: 1) 5 year fixed rate mortgages in Canada are still hovering near historic lows with only one direction to head. 2) A recent CAAMP report indicated that 16% of Canadians with a mortgage could not manage an extra $300 increase in mortgage payments. In addition, 11% of households would run into financial trouble if mortgage rates rose only 1.5%.
If we have even a moderate increase in interest rates over the next few years, we'll very quickly see just how many mortgages were given to people who 'could never repay'.
Finally, I want to address the very dangerous and blatantly false assertion by Mr. Bryan:
"...Unlike stocks or commodities, homes are an asset that's resistant to big drops in value."
This is exceptionally misleading and dangerous information for several reasons. First of all, the notion that homes are resistant to big drops in value is ridiculous. Our own Canadian experience certainly shows this. In the six months between Fall 2008 and mid Spring 2009, house prices in Canada shed some 20% of their value before emergency low interest rates and government stimulus managed to stem the tide by dragging demand forward.
Countries like Ireland, The UK, Spain, Italy, Greece, France, and the US all experienced significant declines over the same time period. Some, like the UK, are now dropping again now that stimulus measures are running out and the pool of potential buyers has dwindled.
Now I know that "it's different here", and we could never see the sort of declines experience in the US, but let's just take a moment and gaze at the carnage south of the border, particularly the change from the peak.
Mr. Bryan's assertion that real estate is inherently stable is reminiscent of Ben Bernanke's famous interview in which he brushed off the possibility of a housing bubble in the US because house prices had never declined on a nation-wide basis.
The reality, as is now being discovered by millions of home owners all over the Western world, is that real estate is inherently volatile simply because of the leveraged nature of most real estate purchases. The vast majority of stock and mutual fund purchases are made with savings. This is not the case with real estate.
Consider the example of a first time home buyer who purchases a home with a 10% down payment. If the home is worth 200K, they start out with $20,000 (10%) in equity. Well, not quite as they would have to pay 5% to sell it, plus legal fees and the substantial costs of breaking the mortgage...but I digress. If the real estate market declines by 10%, they've lost 10% of their investment, right? Wrong! They've lost 100% of their investment as they now have zero equity remaining, but still lots of debt which is now impossible to escape from without ponying up additional cash to cover the transaction fees associated with selling.
This is what people like Mr. Bryan forget. Leverage = risk. The notion that real estate is inherently stable is questionable at best, but is outright false when one considers the leverage carried by the average new home owner.
This is dangerous, misleading information. Mr. Bryan owes it to himself and his readers to become much more familiar with the issues he claims to be an expert on before writing 'thin gruel' like this ridiculous article.