What’s up, all? Since I haven’t been here, I’ve been a little of over there and a little of over there. Mostly dipping deep into social activism via the Occupy movement but also really giving myself a good education in the things that I never knew enough about and I knew I wouldn’t get the truth about in school. One of these things was finance, economics, banking–the kind of stuff that Gateman glosses over. My most recent exposure has been on this Canadian housing bubble we are all living in–the one that ‘will never recede’. Well, I just finished a paper a few days ago on this exact topic, because I felt like the PEOPLE needed to know the truth. And what would you believe, today there is an article in the Globe and Mail about how. ‘Skyrocketing house prices bound to come down, BMO head says’. Lol, you don’t say! Here is the paper I wrote with two friends in Econ 211, read it and you will know just why this Canadian housing bubble DOES have to come down and why the circumstances surrounding it make the story a lot more tenuous than just a ‘market correction’. Enjoy!
Kiss Your Borrowed Prosperity Goodbye by Anthony Mayfield, Nick Wogan and Mustafa Akhtar
Colleen Wallace, a 70 year-old resident of Chelsea, finds her savings flagging in the wake of lower than ever interest rates. It’s a savers dilemma. Canadians find themselves in a turmoil characterized by stagnant income, weak return on investments and increasing food and especially housing prices. Inflation at 2.3% in relation to interest rate at around 1% not only discourages savings but also renders a loss in net value. Life-long investments made to pay off mortgages are now rendered redundant as economists warn the housing boom has come to an end (Silcoff and Mckenna).
The Canadian housing market since 2001 has seen an increase in prices that has far outpaced inflation and economic growth in the country. This increasing of prices in relation to personal income has played a part in the creation of what some would consider a bubble in the Canadian housing market. The Economist magazine has used two functions to try and calculate the overvaluation, if any, of the housing prices in Canada and has found that the average of the two calculations gives an overvaluation of 25% . (The Economist, Part 2) Indeed, it has been estimated that a bursting of the bubble across Canada in a similar fashion to the Toronto Crash of 1989 would result in reduction of home prices by up to 40% in the worst scenario (MacDonald 4).
It would appear that the Canadian housing market is overvalued, with Bank of Canada Governor Mark Carney admitting that some housing is ‘probably overvalued’(Hodgson). The Canadian housing market, it can be argued, is due for a correction to the true market value. The most pressing question is how will this be achieved and how can a bursting of the bubble, characterized by a sudden, sharp decrease in prices similar to seen in Toronto in 1989 be avoided. In this paper we will argue that through slowly and steadily raising overnight rate of the Bank of Canada, a responsible deflation of the housing bubble can be achieved and the overvaluation of housing in Canada can be corrected. We will also argue that there is an increasing precedent to do this correctly and safely, as the household debts accumulated on the Canadian population has “left Canadians vulnerable to economic shocks” (Praet 1) and vulnerable to debt spirals triggered by a crash in the equity held in the home (CGA 35).
Housing bubbles emerge when housing prices increase more rapidly than inflation, household incomes and economic growth (MacDonald 3). Low mortgage rates, access to easy credit, net immigration and the stock of available housing contribute to the growth of a housing bubble (MacDonald 4). Factors such as low mortgage rates and access to easy credit help draw buyers into a market they might otherwise not be able to compete in. This increases demand and pushes the price of the housing to higher levels (MacDonald 4).
Currently, all-time record low mortgage rates are being offered by the Big Five Canadian banks of 2.9% which is based large part on the record low overnight rate set by the Bank of Canada at 1%. While this may give an artificial impression of housing affordability during which the rates remain at record low rates, this presumption of affordability could change rapidly and intensely if mortgage rates rise to historical averages, which are usually nearer to 4% (MacDonald 4). Mortgage rates play a large factor in whether or not potential buyers will purchase a house. If the interest rates are too high buyers will be pushed out of the market due to the burden of anticipated mortgage payment costs (MacDonald 4). Larger down payments and mortgage insurances also have the effect of discouraging borrowers from taking out a mortgage (MacDonald 4).
Asset price booms and their subsequent bubbles are discouraged by economist and central bankers. This is done because as evidenced by the recent housing crash of the US in 2008, a sudden crash in prices can have very grave implications for employment and the real economy when the bubble is burst (Meltzer 2003). Asset price bubbles also contribute to an artificially held belief by investors that they will always receive real returns on their investment, in this case with investment in housing (Selody and Wilkins 7). This can lead to speculative purchases of housing and an over-investment in the housing market. This was referred to in 1996 by Alan Greenspan, in reference to the asset bubble seen in the late 90s in the United States as “irrational exuberance” (qtd. in Selody and Wilkins 5).
This irrational exuberance can also stem from positive developments in the real economy that leads to “the underestimation of risk and over-extension of credit”, which is the cause of “over-investment in physical capital” (Meltzer 2003). This same phenomenon applies to real estate market as explained by Collyns and Senhadji (qtd. in Selody and Wilkins 5). This also directly affects inflation as housing prices are factored into the consumer price index from which inflation is calculated (Selody and Wilkins 5).
Canadians have been increasingly taking on debt to pay for increasing prices of living as real wages have stagnated since the 1980s (Yalnizyan 6), and has thus “force[d] households to substitute consumption from income with consumption from credit” (CGA 34). This particular type of credit, known as “revolving credit” has been called “alarming” by the CGA as it allows minimum payments without repaying principal, which could “effectively evolve into a debt spiral” (CGA 35). In fact, The Organisation for Economic Co-operation and Development (OECD) has found that Canada has the highest consumer debt to financial asset ratio among 10 OECD countries, including the US (McDonald 3). Currently Canadians owe $1.5 trillion in mortgage debt across Canada, which equals an average of $176,461 owed for every 2 child family (CTV). It can be argued that growing population and positive inflation create natural preconditions for debt. However, even when accounted for the aforementioned instruments, household debt still shows an upward trend (CGA 30). Subsequently, British Columbians on average carry an additional $35,588 in non-mortgage debt. These debts has been referred to by Governor Mark Carney as recently as March 9th, 2012 as the “the biggest domestic threat to the economy” (Isfeld). Indeed, what this all-time record levels of household debt means, is that the Canadian consumer is very vulnerable to a sudden lowering of house prices as indicative of a housing crash.
Another area of concern is consumer credit, which makes critical part of household debt. Increasing household debt is an alarming trend, with Canadians now reaching a level of 155% debt to income ratio. The increased indebtedness means that “the household sector is more exposed to interest rate risk, particularly where variable rate mortgages are prevalent, and to shocks to household income and house prices” (Debelle 21). Debelle goes on to argue that the biggest of these shocks is unemployment. This could lead to default, distressed selling and thus a downward spiral in housing prices. High indebtedness could also compromise labour mobility, worsening unemployment (21). It is especially concerning because unlike mortgage, consumer debt is not backed by appreciable assets.
One explanation to why bubbles persist is the presence of rational arbitrageurs who try to “ride the bubble as long as they can” (Selody and Wilkins 5). Asset bubbles have been argued by central bankers to be a product of a combination of extraneous and incalculable elements of consumer behaviour. This line of argument argues that because the cause is exogenous, monetary policy will be rendered impotent. This reasoning explains Bernanke and Greenspan’s argument that “instruments of monetary policy are too blunt to be used” (Selody and Wilkins 5).Contrary to this, however, empirical data shows a strong correlation between excessive credit growth and asset-price bubbles (Selody and Wilkins 6).
Vancouver has had two housing bubbles, meaning large overvaluations of property, in the past. One of which was in 1981 which faced rapid devaluations and a second in 1994 which gradually declined (MacDonald 4). However, most Canadian housing markets have been historically stable from 1980 to 2001 (McDonald 4).This is because traditionally Canada has had consistent and effective impediments to taking on mortgages. This ultimately ended in 2001, when a loosening of mortgage restrictions finally culminated in a zero-down, forty year mortgages being issued by the end of 2006 (MacDonald 6). In 1994, Vancouver’s bubble had a slow housing deflation that could more accurately be called a market correction. This is largely favoured over a scenario such as the Toronto housing bubble which had a deeper and longer crash in 1989, or an even worse scenario such as the sudden and steep decline in prices seen in the US in 2008. In Vancouver during the 1994 deflation, housing prices decreased by 16% over a four year period. (MacDonald 18) . This is juxtaposed with the 1989 crash of the Toronto housing market, which saw condominium prices drop 39% and all other housing lose 27% of their value in a shorter period of time (MacDonald 16).
Using the trends of these two housing bubbles, the Vancouver bubble of 1994 and the Toronto bubble of 1989, the Canadian Centre for Policy Alternatives has calculated what the housing bubbles in several major Canadian cities could look like in the two aforementioned scenarios. The worst hit city in both scenarios is Edmonton, but the forecasts harbor major differences. In a scenario with a housing correction through deflation, rather than a true ‘bursting’ of the bubble, housing prices in Edmonton would drop a calculated 29%, from $333,000 to $235,000 over a three and a half year period (Macdonald 8). Vancouver’s housing prices would decline from $658,000 to $524,000 in the same period, a drop of 20% (MacDonald 9). In this same scenario, using the trends from the Toronto crash of 1989, Edmonton would suffer the worst again, this time a 40% decrease in housing value from $330,000 to $203,000 over a period of five years (MacDonald 9). Vancouver’s prices would drop a calculated 31%, from $658,000 to $454,000. (MacDonald 9).
For Canadians taxpayers, there are large stakes in seeing that the housing bubble is dealt with in a way that does not precipitate an event in which the Canadian Mortgage and Housing Corporation (CMHC) has to pay for the insurance of a large number of failed mortgages. We have already seen a $75 billion dollar purchase of mortgages from major Canadian banks by the CMHC in 2007 (http://www.fin.gc.ca/n08/08-090-eng.asp), which ultimately is paid for by the Canadian taxpayer. Professionals estimate 375,000 mortgages holders in Canada are already challenged by their current payments and may not be able to handle higher rates (MacDonald 3). This is of particular concern, as a high proportion of Canadian mortgages are insured by the government through the CMHC (MacDonald 6).
In conclusion, the housing market in Canada and its larger macroeconomic implications is a critical topic to say at the least. As can be drawn from the argument above, a housing crash remains a likely possibility, especially if prudent steps and measures are not taken to discourage such an event. Such a situation would have dire consequences not only for households in terms of foreclosures and the extreme likelihood of having to pay into the CMHC for failed mortgages, but also for the economy as a whole. A raising of interest rates that occur too quickly could have catastrophic events by pushing many households into a debt spiral which will ultimately end in foreclosure. However, not acting and allowing interest rates to remain at historic lows will only accentuate the problem and make the inevitable correction more painful in the long run. Another major concern is the adverse blow to consumer and investor confidence that will implacably result in undesirable long term macroeconomic implications. For the details raised throughout this paper, it is imperative for The Bank of Canada to take corrective measures in time before the situation exacerbates and evolves into a vicious trap.
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Debelle, Guy. “Macroeconomic Implications of Rising Household Debt.” IDEAS: Economics and Finance Research. Web. 15 Mar. 2012. .
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Praet, Nicolas. “Canadian Debt Still Rising, but at Slower Pace: Equifax.” Www.canada.com. Www.canada.com, 10 Jan. 2012. Web. 14 Mar. 2012. .
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