After Australia raised rates to 4% as expected, the other major commodity country, Canada, decided to leave rates unchanged at their record low of .25%, as expected. They also repeated that policy won’t change before the end of Q2 but they hinted that they could go up soon after as they said “core inflation has been slightly firmer than projected, the result of both transitory factors and the higher level of economic activity.” They also said “the level of economic activity in Canada has been slightly higher than the bank had projected” in its Jan report. Rates have been at record lows because of the BoC’s concern with economic growth in the US, Canada’s biggest trading partner, and due to the strength in the Canadian $ which today is rallying to a 6 week high vs the US$ but the time has passed for record low interest rates in Canada considering their more positive outlook and bubbly housing market.
As the world’s spotlight turns to the Vancouver Olympics, all eyes will be on Canada. Our nation suffered comparatively less than other G7 economies during the last recession, and our banking system has received praises for being good and boring (read the Sceptical Market Observer’s comment on this).
To be sure, our economy is adding jobs, our stock market has rallied sharply, our currency is close to reaching parity with the USD, commodity exports are up, everything looks great. A buddy of mine even told me that our currency is being bought by central banks around the world. Canada seems to be on a tear.
But things are far from perfect. For one, there is a housing bubble in the making that could last a lot longer than people think. Stephen Jarislowsky, one of Canada’s best known investors, says he believes government measures aimed at juicing the housing market has put the sector in a bubble:
“I am convinced there is a housing bubble in Canada,” Mr. Jarislowsky told Bloomberg News. “… I conclude that the prices of housing today in the U.S. are cheaper than they should be, and that the prices in Canada are far more expensive than they should be.”
Mr. Jarislowsky is not alone. Other economists have also fretted about a bubble given the stunning rebound in real estate after the slump, and projections for record sales and prices this year. Ottawa is now considering tightening some rules. Said Mr. Jarislowsky: “They have basically encouraged people to buy houses based on cheap mortgages. That has created the opposite effect of what was desirable.”
There has been much official chest swelling over Canada’s relatively strong performance during the financial crisis, but perhaps Canadians shouldn’t — if you’ll excuse the mixing of metaphors — be counting their chickens until they are sure that there are no black swans present. And in fact there does seem to be one dark, plump, bird looming around the back of economic barnyard: the Canada Mortgage and Housing Corporation. Or is that a turkey that should be renamed the Canada Moral Hazard Corporation?
The CMHC was never given a cutesy acronym like its U.S. equivalents, Fannie Mae and Freddie Mac. But why not “Morrie Haz,” acknowledging that it has always been an instrument of moral hazard, the situation where insurance makes the insured-against event more likely?
As we know, Fannie and Freddie — which were privately-owned but “government-sponsored,” which meant they inevitably got bailed out — were front and centre in the U.S. housing market meltdown, which in turn precipitated the global financial crisis.
There are increasing concerns that the Canadian housing market is headed the same way as that of the U.S., stoked by the same factors: artificially low central bank interest rates, and the government insurance/promotion of risky mortgages.
This policy double whammy explains the growing calls for somebody — banks? CMHC? Carney? Flaherty? Anybody else? — to tighten mortgage regulations. These requests appear puzzling until we realize the role of the CMHC in encouraging perverse behaviour.
In a free market, if banks felt a housing bubble building, they would simply tighten standards themselves, either by demanding higher credit qualifications, hoisting rates, or shortening amortization periods. Hoisting rates is out of the question, since rock bottom mortgage rates are now considered by the Bank of Canada to be essential to national economic recovery and protection of our export industries. That leaves Morrie Haz waiting there to insure mortgages, and gives the banks every incentive to hand out any loan that can get insurance. However, they obviously grasp that such cosmic policy fecklessness will ultimately come back to haunt them.
A couple of weeks ago, Peter Routledge of credit analyst Moody’s pointed out that the overheating of the housing market was goosing an unsustainable increase in household borrowing more generally. “As witnessed in the United States,” he wrote, “this movie does not end well.” Specifically, once the punchbowl of low interest rates disappears, households find themselves in trouble, and so do their bankers.
Mr. Routledge noted that Canadian banks likely wouldn’t wind up in the same depths as their U.S. counterparts, but that is only because their riskiest mortgages are backstopped by CMHC. But this makes the systemic threat to the Canadian economy greater.
The U.S. crisis was massive but did not fall entirely on Fannie and Freddie. It was shared with other financial institutions. Nevertheless Fannie and Freddie both failed and had to be taken into government “conservatorship.” Mr. Routledge suggests that the situation is more “secure” in Canada, but as a recent report from the Fraser Institute points out, what this really means that the Canadian system features “massive taxpayer exposure.”
Mr. Routledge suggested that CMHC should tighten its insurance criteria, and this week he was seconded by former Governor of the Bank of Canada David Dodge.
The Fraser study, by Neil Mohindra, confirms that the taxpayer risk from a housing collapse is greater in Canada than elsewhere. He notes that a stunning 90% of all insured residential mortgages in Canada are covered by the CMHC. This amounts to an estimated $480-billion for which Canadian taxpayers would be on the hook if the housing market tanked (although any loss would obviously only be a fraction of this amount).
The study suggests that the CMHC’s activities should be privatized, but that possibility appears a long way down the road, both for practical and political reasons. The biggest problem is that nobody is going to want to privatize a property which harbours a potential time bomb.
The whole thrust of CMHC insurance is to encourage banks to make riskier loans. Normal insurance provisions are based on actuarial principles. CMHC insurance is based — like the activities of Fannie and Freddie — on promoting home ownership. Mixing social and economic objectives usually ends in taxpayer tears.
There is no indication that the Canadian mortgage market has been subject to the lunacies of the U.S., where — for a while — anybody with a pulse could get a home loan. Still, high ratio mortgages — that is, ones with down payments as low as 5% — inevitably carry a hefty risk of default when a bubble bursts. That default then becomes the CMHC’s problem.
As such, notes Mr. Mohindra, Canada is not a model for anybody. Morrie Haz has always been an accident waiting to happen.
According to Moody’s Mr. Routledge, “If policymakers deploy the appropriate tools early rather than late in this period of household credit expansion, perhaps the Canadian movie will end differently.”
But Finance Minister Jim Flaherty knows that ending the party is not going to be popular, which is where inevitable political self-interest compounds those practical problems. Meanwhile CMHC isn’t just a provider of potentially reckless insurance and the depository of last resort for mortgage assets the banks don’t want. Yesterday a representative of Diane Finley, Minister of Human Resources and Skills Development, who is also responsible for CMHC (go figure), was in Montreal handing out stimulus slush under Canada’s Economic Action Plan.
Mr. Flaherty doesn’t want to see a bubble, much less a bomb. But when it comes to which movie we’re coming to the end of, maybe he should check out The Hurt Locker. Just in case.
Of course, lenders like ING, oppose any clampdown to rein in mortgage borrowing. Sound familiar? I agree with Stephen Jarislowsky and I also fear that this movie isn’t going to end well. Enjoy the Vancouver games, because I feel a post-Olympics winter chill headed our way.
David Rosenberg writes today that with the Greece issue on the backburner again, benign economic news from China and Australia, it appears that risk appetite is back on. The dollar and yen are selling off:
Global investor risk appetite is back on the front burner with the U.S. dollar and Yen selling off; oil, copper and gold rallying; bonds trading defensively (actually selling off noticeably in Europe); equities firming across the board with Asian markets up 1.8%, emerging markets up 1%, and the global MSCI index up 0.5% at the moment.
EU policymakers are meeting with an aim to backstop Greece’s financial problems — all we need are headlines like that to pop up every day so that investors can keep on breathing a sigh of relief. And, the data were also Goldilocks in nature. China’s inflation rate fell to 1.5% YoY in January from 1.9% and well below the 2.1% consensus estimate, and hence another reason to breathe a sigh of relief since this alleviates concerns over another round of policy tightening.
Then we had Australian employment come out and ratified the view that the global economy is humming along at a very nice clip — jobs rose 52,700 in January, which was more than triple what the consensus community had penned in and the unemployment rate dropped to 5.3% in January from 5.5% the prior month.
The concerns from yesterday over what Ben Bernanke had to say that at some point in the future the Fed will have to start snugging liquidity, and do so without initially touching the funds rate but rather widening the spread between it and the discount rate, conducting reverse repos and raising interest rates on commercial bank deficits at the Fed, has totally dissipated. Meanwhile, the problems in the U.S. housing market continue unabated with the number of foreclosure filings (RealtyTrac data) topping the 300k mark for the 11th month in a row in January (nice to see the Obama modification plan at work) — 315,716 to be exact, up 15% from a year earlier. Banks also repossessed more than 87,000 homes last month, down 5% from December but still up 31% from January 2009.
Moreover, for all those pundits believing that companies are about to embark on a capex cycle, they should consider that the data so far for Q4 show that the reporting S&P 500 companies have thus far boosted their cash holdings by 78% YoY, to $1.2 trillion, and have cut their spending budgets to $30 billion from $41.5 billion.
This article is a guest contribution from Barry Ritholtz, or the BigPicture.
Yesterday’s WSJ had an article about Canada’s Housing market. (Housing Rebound in Canada Spurs Talk of a New Bubble). The article noted that “Average home prices in Canada have risen 23% from their trough in January 2009. Home-sales volumes are up 70% over the same period . . . Canada’s housing recovery has been so rapid that some here are worrying about a bubble.”
But to call it a rebound misses the point. As the Cleveland Fed pointed out, Canada’s housing market never went bust — there was a sales dip, but nothing like the US. And prices have continued to go higher to the point where the Journal is now discussing them in terms of bubbliciousness.
Why is that?
There are a variety of reasons why Canada’s market held up better than that in the US, but I boil it down to the big four:
1) Lending Standards: Were increasingly non-existent in the US from 2001-07. On the other hand, Canada never had the non-bank lenders that abdicated these standards en masse. There was no “Lend-to-Securitize” business model in Canada.
2) Mortgage Insurance: Mortgage with less than 20% down payment are considered a high LTV ratio (This was 25% previously). Mortgage insurance is required. Over 80% of Canada’s homes have what was commonly known as PMI in the US.
3) Full Recourse Mortgages — you can walk away from the house, but not the mortgage debt. Makes quite a difference in the way borrowers behave.
4) Single Regulator, Lack of Regulatory Capture: The hodge podge of Federal and State regulators encourages forum shopping; it also masks much of the massive lobbying effort by US banks and investment houses. Lobbying dollars don’t seem to be nearly as pernicous or corrupting Noprth of the border.
The Cleveland Fed also noted that subprime mortgages accounted for a fifth of all US mortgages originated between 2004–2006. In Canada, the subprime market share was roughly 5% percent in 2006—compared to 22% percent in the U.S. And the Canadian never expanded significantly into the wackier exotic mortgage products — IOs, Neg Ams, Piggy Backs, etc. (interest-only and negative-amortizations grew rapidly in the U.S. from 2003 to 2006).
In today’s Breakfast with Dave, Rosie discusses the Canadian housing market:
It sure looks that way. At a time when personal income is down around 1% in the last year, we have seen nationwide average home prices soar 21% and last month hit a record high, as did sales. In real terms, home price appreciation is back to where it was in 1989. Of course, back then, interest rates were far higher but then again, the economy was in the late stages of a phenomenal multi-year economic expansion, not making a transition from deep recession to nascent recovery.
While the Canadian economy is recovering, overall growth is still barely above zero as manufacturers grappled with excess inventories, a strong currency and a soft domestic demand picture south of the border. Employment conditions have improved, but are hardly that healthy, as we saw in the November jobs report where wages and the workweek were both down despite a constructive headline number (half of which were in the education sector, an inherently difficult area for statisticians to adequately seasonally adjust).
In answer to the question as to whether prices are in a bubble, all we will say is that when we ran some models showing Canadian home prices normalized by personal income or by residential rent, what we found is that housing values are anywhere between 15-35% above levels we would label as being consistent with the fundamentals. If being 15% to 35% overvalued isn’t a bubble, then it’s the next closest thing. We are talking about 2-3 standard deviation events here in terms of the parabolic move in Canadian home prices from their lows. So if it walks like a duck …
The following is a guest contribution by James MacGee of the Federal Reserve Bank of Cleveland.Mr. MacGee is an associate professor at the University of Western Ontario and a research associate at the Federal Reserve Bank of Cleveland.
by James MacGee
Housing markets in the United States and Canada are similar in many respects, but each has fared quite differently since the onset of the financial crisis. A comparison of the two markets suggests that relaxed lending standards likely played a critical role in the U.S. housing bust.
Despite their many points of similarity, housing markets in the United States and Canada have fared quite differently since the onset of the financial crisis. Unlike the U.S., Canada has not experienced a dramatic increase in mortgage defaults, nor has any Canadian bank required a government bailout. As a result, observers such as The Economist have pointed to Canada as “a country that got things right.”
The different housing market outcomes in Canada and the U.S. can tell us something about the underlying causes of the housing boom and subsequent bust. In particular, they can be used to evaluate the roles that low interest rates and relaxed lending standards played in the boom and bust.
Some observers blame monetary policy for lowering interest rates over 2002–2005, pushing up housing demand, increasing residential investment, and raising housing prices. In this view, the monetary-policy-induced housing boom thus set the stage for an inevitable housing bust.
Others contend that relaxed lending standards, highlighted by the rise in subprime lending, played a critical role. This loosening of standards led to an increase in housing demand, as mortgages were issued to households that were likely to have trouble making the mortgage payments. This extension of credit to risky borrowers helped fuel a housing boom and set the stage for the resulting surge in defaults, which were a big factor in the housing “bust.”
The Canada and U.S. housing market comparison suggests that relaxed lending standards likely played a critical role in the U.S. housing bust. Monetary policy was very similar in both countries from 2000 to 2008, but housing prices rose much faster in the U.S. than in Canada. This suggests that some other factor both drove the more rapid appreciation in U.S. prices and set the stage for the housing bust. A likely candidate is cross-country differences in the structure and regulation of subprime lending markets. That mortgage delinquencies began to climb before the recession in the U.S. but only began to rise recently in Canada (after the economic slowdown began), points to the significance of those structural and regulatory differences in explaining the U.S. housing crash.
Canadian and U.S. Housing Market Trends
Canada and the U.S. experienced significant increases in house prices and residential investment from 2000 to 2006, though prices in Canada appreciated more slowly. Figure 1 plots the S&P/Case-Shiller 20 city composite index and the (Canadian) Teranet-National Bank 6 city composite index. Both series are based on repeat sales, making these series a closer approximation to a “constant-quality” price index of nominal home prices than average house price sales. The Case-Shiller and Teranet series indicate that over 2000–2006, U.S. prices appreciated nearly twice as much as Canadian houses. However, Canadian house prices continued to appreciate until late 2008, and are now nearly 80 percent higher than in 2000.
1. Housing Prices
Sources: S&P/Case-Shiller (20-city) for U.S. house prices and Teranet (6-city) for Canadian.
The counterpart to rapid house price appreciation has been an increase in the ratio of mortgage debt to disposable income. While the comparison is complicated by different definitions of the household sector and debt categories in the Flow of Funds accounts, the trends are similar to those of house prices. Between 2000 and 2006, the ratio of mortgage debt to disposable income in the U.S. increased by roughly 50 percent, jumping from two-thirds to over 100 percent. In Canada, the increase was roughly half as large, with the debt-income ratio moving from 70 to 90 percent.
The potential risks of increased household mortgage debt depend critically upon its distribution across borrowers. To see how the distribution of mortgage debt has changed we examine the distribution of the ratio of the outstanding loan to house value (the LTV) of borrowers. A high LTV implies that a small decline in the house price would leave the owner with negative equity. Negative equity is problematic as it removes the option for a homeowner who is unable to meet their mortgage payments to sell their home to repay the mortgage.
As figure 2 illustrates, Canada has significantly fewer households with LTV ratios above 80 percent than the U.S. Before the housing bust, roughly 21 percent of American households with mortgages had LTV ratios above 80 percent, versus 15 percent of Canadian households. Restricting attention to households with LTV above 90 percent the comparison is even more striking: roughly 12 percent in the U.S. versus just over 6 percent in Canada.
2. Distribution of Mortgages by Loan-to-Value Ratio (percent)
United States
Canada
LTV ratios
1999
2005
2007
2006
0–80
76.48
79.14
78.12
84.79
80–90
10.55
8.98
9.66
8.81
90–100
7.56
6.37
6.93
1.53
100+
5.41
5.51
5.28
4.87
Sources: Bank of Canada Financial System Review December 2007; American Housing Survey. The American Housing Survey reports the ratio of all outstanding mortgages (excluding home equity lines of credit) to the value of the house.
A surprising fact about these LTV ratios is how little the distribution of U.S. mortgages by loan-to-value changed during the housing boom. This is surprising given that the rapid house price appreciation acted to lower the LTV ratios of existing mortgages. Working in the opposite direction were two forces. First, some households undid the effect of higher house prices by extracting equity. Second, the rise in subprime and Alt-A mortgage originations from roughly 1.4 million in 2003 to 3 million in 2005 was accompanied by an increase in the median LTV of new subprime mortgages from 90 percent to 100 percent (as documented in Mayer, Pence, and Sherlund, 2009).
While broadly similar trends were occurring in house prices and mortgage debt in the U.S. and Canada, very different patterns of mortgage delinquencies and defaults were emerging. The best available comparison is for delinquencies on prime mortgages (which account for the bulk of mortgage credit) in the two countries (figure 3). Prior to 2006, delinquencies were comparable in both countries (and were slightly higher in Canada). While delinquencies increased more than four-fold in the U.S. after 2007, as of mid 2009 there has been little sign of an increase in mortgage delinquencies in Canada. A similar story holds in the subprime market. Researchers Mayer, Pence, and Sherlund reported that 8 percent of the U.S. subprime mortgages originated in 2007 had defaulted after 12 months, as opposed to 1.5 percent over 2000–2004. The available Canadian data also features an increase in subprime mortgage delinquencies, but the delinquency rate in 2007 was still under 2 percent, according to the Financial System Review in June 2008.
3. Mortgage Delinquency Rates (90+ days delinquent)
Sources: Mortgage Bankers Association. National Delinquency Survey.
Notes: The delinquency rate is the number of mortgages past due as a percent of the total number of mortgages at the end of the period. The delinquency rate does not include loans in the process of foreclosure.
These different patterns in delinquencies occurred during a period of similar macroeconomic performance. Unemployment rates were stable throughout 2007 and early 2008, at roughly 5 percent in the U.S. and 6 percent in Canada. The timing of the recent deterioration in labor markets has also been similar, with unemployment rates rising to 9.4 percent (U.S.) and 8.6 percent (Canada) by July 2009. What these data reveal is that mortgage delinquencies began to increase in the United States before the rise in unemployment, but in Canada they remained low and only began to increase after the rise in unemployment in 2008. That difference is a key clue to determining what caused the housing bust.
Monetary Policy and the U.S. Housing Bust
The low interest rate policy of the Federal Reserve over 2001–2005 is often cited as a key factor in the U.S. housing bust. The main narrative is that by lowering short-term interest rates, the Federal Reserve pushed down (longer-maturity) mortgage interest rates. This policy increased demand for housing, leading to upward pressure on housing prices, which encouraged builders to ramp up construction of new homes. This led to an “oversupply” of new homes, which triggered the housing bust.
The claim that interest rates were too low over 2001–2005 is motivated by a couple of observations. First, the federal funds rate was low by historical standards: declining from over 6 percent in early 2001 to 1 percent in 2003 and remaining low until 2005 (see figure 4). Second, interest rates over this period were much lower than those predicted by the Taylor rule for monetary policy (which relates the Federal Reserve target rate to inflation and GDP) over 2002 to 2006.
The Bank of Canada also made dramatic reductions in its target interest rate over 2001–2002. One might argue that Canadian monetary policy was not quite as “loose” as that in the U.S. as it maintained a higher overnight rate over 2002 to 2004. But a case can be made that Canadian and American monetary policy were very similar, at least in terms of the housing market. Ahrend, Cournede and Price (2008) estimate deviations from the Taylor rule for Canada and the U.S. over 2001–2006 and find that the cumulative deviations were nearly identical.
4. Central Bank Target Rates
Source: Mortgage Bankers Association. National Delinquency Survey.
In addition, mortgage interest rates—the main direct channel through which monetary policy impacts the housing market—tracked each other closely in the two countries. Unlike the U.S., where the mainstay of the mortgage market is the 30-year fixed mortgage, the most common mortgage product in Canada is a five-year fixed rate mortgage (with a 25-year amortization period). As figure 5 illustrates, the two benchmark mortgage interest rates move closely with one another until after the beginning of the U.S. housing market crisis, when U.S. rates fall significantly below Canadian rates.
5. Benchmark Mortgage Interest Rates
Source: International Monetary Fund,International Financial Statistics, COFER data.
The similarity of the impact of monetary policy and the absence of a housing market bust in Canada suggest that some other factor must have been present in the U.S. to generate the boom and bust. This is not to suggest that “loose” monetary policy did not put upward pressure on housing prices—indeed, both Canada and the U.S. experienced substantial levels of house price appreciation. However, the Canada-U.S comparison suggests that some other factor drove both the more rapid house appreciation and set the groundwork for a U.S. housing bust.
Relaxed Lending Standards: Different Subprime Lending Booms
The other leading explanation of the housing boom and bust relies critically on relaxed lending standards. This story is linked to the dramatic rise in subprime lending and high levels of loan securitization, which some commentators have argued reduced the incentives for mortgage originators to maintain underwriting standards. This is one area where there was a significant difference between the two countries, both in the size and nature of the subprime market and in the fraction of mortgages securitized.
The subprime markets in the U.S. and Canada include households with tarnished credit histories as well as borrowers with difficult-to-document income sources. Subprime lending has grown rapidly in both countries, though the magnitude has been far more striking in the U.S. While subprime mortgages accounted for less than 5 percent of mortgage originations in the U.S. in 1994, a fifth of all mortgages originated between 2004–2006 were subprime, according to data reported by James Barth in 2009.
But while subprime lending also increased in Canada, the subprime market remains much smaller than in the U.S. The most cited estimate is that subprime lenders had a market share of roughly 5 percent in 2006—compared to 22 percent in the U.S. (Mortgage Architects, 2007). Moreover, the Canadian subprime market never expanded significantly into newer products, such as interest-only or negative-amortization mortgages, whose popularity grew rapidly in the U.S. from 2003 to 2006. Instead, the Canadian subprime market mainly offered products popularized in the U.S. during the 1990s, such as longer amortization periods for loans (from 25 to 40 years), and mainly targeted near-prime borrowers.
Securitization has also been less common in Canada than in the United States, with roughly 25 percent of Canadian mortgages securitized in 2007 versus nearly 60 percent in the U.S. The Canadian securitization market has grown rapidly over the past decade, rising from roughly 5 percent of mortgages in 1998 to over 25 percent in 2008. However, in many ways, the Canadian market resembles the early stages of the U.S. mortgage securitization market, as most securitized mortgages in Canada are backed by an explicit government guarantee. This government guarantee requires limits on borrowers’ debt-service ratios and amortization periods, which makes it more difficult for lenders to offer some types of subprime loans.
The different magnitude of the subprime lending boom in the two countries is consistent with differences outlined above between the Canadian and U.S. housing markets over the past 10 years. The rapid growth of the subprime market provided an additional boost to demand in the U.S. that is consistent with the more rapid house price appreciation in the U.S. than in Canada.
The subprime story is also consistent with the different pattern of mortgage delinquencies in Canada and the U.S. In the U.S., mortgage delinquencies for both prime and nonprime mortgages began to rise before the recession began and unemployment rates began to climb. In contrast, mortgage delinquencies in Canada have only recently begun to increase—after unemployment rates started rising and the Canadian and world economies slowed sharply in the fall of 2008.
Finally, the relaxed lending story is consistent with the fact that the U.S. experienced a housing bust over 2007–2009 while Canada did not. While the expansion of subprime lending provided a temporary boost to housing price growth rates, when prices stopped rising, the inability of some borrowers to refinance homes they could not afford led to a spike of delinquencies. The resulting increase in liquidation and foreclosure sales put additional downward pressure on house prices, which in turn pushed more borrowers into default. This “negative feedback” cycle helped push a correction in the housing market into a housing bust.
One possible critique of this argument is that while Canada has not yet experienced a housing bust, it is likely to experience one in the next year. Indeed, a recent Merrill-Lynch-Canada report noted that Canadian house prices over the past decade closely resemble U.S. house prices with a two-year lag (see figure 1). Based on this, they concluded that Canada was also likely to experience a large decline in house prices over the coming year. Canada’s smaller subprime market share and fewer households with high LTV ratios, however, suggest that the country is less likely to see the rapid increase in defaults that helped trigger the bust in U.S. housing prices. So far the incoming data suggest that the Canadian housing market is likely to experience a housing market slowdown rather than a bust.
Why Was the Subprime Market in Canada Smaller?
Given the key role played by the “subprime” market, the question is why the Canadian subprime market was both smaller and levels of securitization were lower than in the U.S. While it is difficult to disentangle the reasons why Canada avoided the subprime boom, some factors can be identified that may have contributed to the differences in the Canadian and U.S. subprime markets.
Perhaps the simplest story is that Canada was “lucky” to be a late adopter of U.S. innovations rather than an innovator in mortgage finance. While the subprime share of the Canadian market was small, it was growing rapidly prior to the onset of the U.S. subprime crisis. In response to the U.S. crisis, some subprime lenders exited the Canadian market due to difficulties in securing funding. In addition, the Canadian government moved in July 2008 to tighten the standards for mortgage insurance required for high LTV loans originated by federally regulated financial institutions. This further limited the ability of Canadian banks to directly offer subprime-type products to borrowers.
There are also several institutional details that played a role. The Canadian market lacks a counterpart to Freddie Mac and Fannie Mae, both of which played a significant role in the growth of securitization in the U.S. In addition, bank capital regulation in Canada treats off-balance sheet vehicles more strictly than the U.S., and the stricter treatment reduces the incentive for Canadian banks to move mortgage loans to off-balance sheet vehicles. Finally, as noted above, the fact that the government-mandated mortgage insurance for high LTV loans issued by Canadian banks effectively made it impossible for banks to offer certain subprime products. This likely slowed the growth of the subprime market in Canada, as nonbank intermediaries had to organically grow origination networks.
A Challenge for Policymakers
The Canada-U.S. comparison suggests the low interest rate policy of the central banks in both countries contributed to the housing boom over 2001–2006 and that a relaxation of lending standards in the U.S. was the critical factor in setting the stage for the housing bust. A caveat worth emphasizing, however, is that the Canada-U.S. comparison tells us little about what would have happened if U.S. monetary policy had been tighter earlier. Tighter monetary policy in the early part of the decade may have helped to limit the subprime boom by slowing the rate of house price appreciation over 2002–2006. The Canada-U.S. comparison does, however, highlight the practical challenge facing policymakers in assessing whether a rapid run-up in asset prices is a bubble or a “sustainable” movement in market prices.
Recommended Reading
“Monetary Policy, Market Excesses and Financial Turmoil”, by Rudiger Ahrend, Boris Cournede, and Robert Price (2008). OECD Economics Department Working Paper No. 597.
The Rise and Fall of the U.S. Mortgage and Credit Markets, by James R. Barth (2009). Milken Press.
“Rebuilding the Banks,” The Economist, May 16, 2009.
“The American Mortgage Market in Historical and International Context,” by Richard Green and Susan Wachter (2005). Journal of Economic Perspective, 19(4), 93–114.
“The Rise in Mortgage Defaults,” by Christopher Mayer, Karen Pence, and Shane Sherlund (2009). Journal of Economic Perspectives, 23(1), 27–50.
“Comparing the Canadian and U.S. Subprime and Alternative Mortgage Markets: Why the U.S. Subprime Fallout Is a U.S.-only Phenomenon,” Mortgage Architects (2007). <http://files.newswire.ca/40/MASubprime.pdf, accessed: June 15, 2009.>
Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, by John B. Taylor (2009). Hoover Institutions Press.
“Structure of the Canadian Housing Market and Finance System,” by Virginia Traclet ( 2005). Background paper prepared for CGFS Working Group on Housing Finance in the Global Financial Market.
“The Tipping Point?” by David D. Wolf and Carolyn Kwan (2008). Merrill Lynch Canada, Economic Commentary.
Gold is getting a great deal of sponsorship, in general, but it is even more notable, when some of that sponsorship is coming from the likes of this era’s new contrarians. John Paulson, who personally made $4-billion betting against subprime mortgages in 2007, has shifted his focus to gold during the last 9 months, and now he is ramping it up yet another notch. On another note we’ve also covered in the recent past, David Einhorn’s now well-known accumulation of gold bullion, as well as S&P500 Puts.
John Paulson, who scored about $20 billion of profits between 2007 and early 2009 wagering against the housing market and financial companies, is launching a hedge fund dedicated to buying up shares of gold miners and other bullion-related investments, according to investors.
He is starting a new fund with his own money:
Mr. Paulson told his investors he personally would invest between $200 million and $250 million in the new fund, which he said will begin on Jan. 1, according to an investor at the meeting.
His theory on gold differs, in that Paulson seems to have recognized quite rapidly that central banks’ appetite has shifted in favour of the shiny stuff, and that their appetite is not strictly based on concerns of inflation. If you read between the lines, Paulson is suggesting that will be the gravy (when it indeed happens), and the real impetus is the constrained supply:
He noted that central banks around the globe have gone from sellers of gold to buyers, and that the global supply of gold is constrained.
While harmful inflation isn’t on the horizon, he said, Mr. Paulson argued that there is a risk of a burst of inflation down the road. That’s because in the past there’s been a lag between a surge in money supply and higher inflation. Gold often does well when inflation rises.
Mr. Paulson told investors that the Federal Reserve will prove reluctant to raise interest rates, given the weakness in the economy, which also could pave the way for higher inflation, at least at some point, another reason for his growing conviction about gold.
This is an interesting development for the stocks of gold producers. At the very least Paulson and other investors who are devoted to this theme will add key support to the market’s appetite for gold equities and bullion.
The following article is a guest contribution from RGE Monitor, and Nouriel Roubini’s Project Syndicate, August 16, 2009.*
Where is the US and global economy headed? Last year, there were two sides to the debate. One camp argued that the recession in the US would be V-shaped—short and shallow. It would last only eight months, like the two previous recessions of 1990-1991 and 2001, and the world would decouple from the US contraction.
Others, including me, argued that given the excesses of private sector leverage (in households, financial institutions and corporate firms), this would be a U-shaped recession—long and deep. It would last about 24 months, and the world would not decouple from the US contraction.
Today, 20 months into the US recession—a recession that became global in the summer of 2008 with a massive recoupling—the V-shaped decoupling view is out the window. This is the worst US and global recession in 60 years. If the US recession were—as is most likely—to be over at the end of the year, it will have been three times as long and about fives times as deep—in terms of the cumulative decline in output—as the previous two.
Today’s consensus among economists is that the recession is already over, that the US and global economy will rapidly return to growth and that there is no risk of a relapse. Unfortunately, this new consensus could be as wrong now as the defenders of the V-shaped scenario were for the past three years.
Data from the US—rising unemployment, falling household consumption, still declining industrial production and a weak housing market—suggests that the US recession is not over yet. A similar analysis of many other advanced economies suggests that, as in the US, the bottom is quite close, but it has not yet been reached. Most emerging economies may be returning to growth, but they are performing well below their potential.
Moreover, for a number of reasons, growth in the advanced economies is likely to remain anaemic and well below trend for at least a couple of years.
The first reason is likely to create a long-term drag on growth: Households need to deleverage and save more, which will constrain consumption for years.
Second, the financial system— both banks and non-bank institutions—is severely damaged. Lack of robust credit growth will hamper private consumption and investment spending.
Third, the corporate sector faces a glut of capacity, and a weak recovery of profitability is likely if growth is anaemic and deflationary pressures still persist. As a result, businesses are not likely to increase capital spending.
Fourth, the releveraging of the public sector through large fiscal deficits and debt accumulation risks crowding out a recovery in private sector spending. The effects of the policy stimulus, moreover, will fizzle out by early next year, requiring greater private demand to support continued growth.
Domestic private demand, especially consumption, is now weak or falling in over-spending countries (the US, UK, Spain, Ireland, Australia and New Zealand, etc.), while not increasing fast enough in over-saving countries (China, other Asian countries, Germany and Japan, etc.) to compensate for the reduction in these countries’ net exports. Thus, there is a global slackening of aggregate demand relative to the glut of supply capacity, which will impede a robust global economic recovery.
There are also now two reasons to fear a double-dip recession. First, the exit strategy from monetary and fiscal easing could be botched, because policymakers are damned if they do and damned if they don’t. If they take their fiscal deficits (and a potential monetization of these deficits) seriously and raise taxes, reduce spending and mop up excess liquidity, they could undermine the already weak recovery.
But if they maintain large budget deficits and continue to monetize them, at some point—after the current deflationary forces become more subdued—bond markets will revolt. At this point, inflationary expectations will increase, long-term government bond yields will rise and recovery will be crowded out.
A second reason to fear a double-dip recession concerns the fact that oil, energy and food prices may be rising faster than economic fundamentals warrant, and could be driven higher by the wall of liquidity chasing assets, as well as by speculative demand. Last year, oil at $145 a barrel was a tipping point for the global economy, as it created a major income shock for the US, Europe, Japan, China, India and other oil-importing economies. The global economy, barely rising from its knees, could not withstand the contractionary shock if similar speculative forces were to drive oil rapidly towards $100 a barrel.
So, the end of this severe global recession will be closer at the end of this year than it is now, the recovery will be anaemic rather than robust in advanced economies, and there is a rising risk of a double-dip recession. The recent market rallies in stocks, commodities and credit may have gotten ahead of the improvement in the real economy. If so, a correction cannot be too far behind.
Chairman Bernanke’s testimony and Wall Street Journal article outlined the Fed’s exit plan and addresses his critics with regard to a lack of transparency about the exit strategy. There is no doubt the Fed will be able and has the tools to unwind the massive monetary stimulus in place at the present time.
More importantly, the question is if the Fed can identify the appropriate “time” and “magnitude” of monetary policy tightening. There is no precise checklist to guide a central bank about when and by how much to tighten monetary policy. The Fed’s steps will entail judgments as the economy stabilizes and moves along a new growth path.
Going back in time, there are two cases that come to mind. First, is the case of 1937 when unsuitable and hasty monetary and fiscal policy changes halted the recovery of the economy and reversed course such that the economy recorded the second leg of the downturn during 1937-38 (see chart 2). The main lesson from this experience is to avoid the mistakes of this period. The Fed raised the reserve requirements in July 1936 to reduce excess reserves banks were holding which it viewed as a threat to price stability. During this time period, banks were overwhelmed with fear about financial panics and wanted to hold excess reserves. When the Fed raised reserve requirements and excess reserves of banks were reduced, they stopped lending. This, in turn, led to another period of economic decline.
The second case is the more recent episode when the Fed held the federal funds rate at 1.00% from June 2003 to June 2004 in order to prevent a deflationary situation from taking hold. This stance of the Fed has come under severe scrutiny and has been identified as an incorrect policy posture in terms of the duration of an easy policy which eventually led to the housing market boom.
Based on the 1936/37 experience, the Fed will err on the side of delaying tightening, while the 2003/2004 episode suggests that the Fed will have to weigh the risks of maintaining easy monetary policy for an extended period. Both these historical episodes indicate the Fed is not infallible and suggests that the timing and magnitude of monetary policy changes is a tight rope walk. Therefore, it appears that the Fed will have to be not only deft but also lucky to be successful in the management of monetary policy in the months ahead. It is well-known, that the Fed has not been preemptive and has applied monetary policy brakes too late and too strong in the post-war period, with the exception of the 1995 soft-landing event.
Noteworthy excerpt’s from Bernanke’s testimony:
The Economy:“The U.S. economy contracted sharply in the fourth quarter of last year and the first quarter of this year. More recently, the pace of decline appears to have slowed significantly, and final demand and production have shown tentative signs of stabilization. The labor market, however, has continued to weaken. Consumer price inflation, which fell to low levels late last year, remained subdued in the first six months of 2009.”
Risk –“Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending. The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook.”
Inflation: “All participants expect that inflation will be somewhat lower this year than in recent years, and most expect it to remain subdued over the next two years.”
Monetary Policy: “The FOMC anticipates that economic conditions are likely to warrant maintaining the federal funds rate at exceptionally low levels for an extended period.
In light of the substantial economic slack and limited inflation pressures, monetary policy remains focused on fostering economic recovery. Accordingly, as I mentioned earlier, the FOMC believes that a highly accommodative stance of monetary policy will be appropriate for an extended period.”
The options the Fed has in its arsenal to tighten monetary policy are discussed in Bernanke’s article in the Wall Street Journal (Bernanke Op-ed in WSJ: The Fed’s Exit Strategy - WSJ.com). To be sure, the Fed is not limited to these alternatives only.
*Asha Bangalore is vice president and economist at The Northern Trust Company, Chicago. Prior to joining the bank in 1994, she was consultant to savings and loan institutions and commercial banks at Financial & Economic Strategies Corporation, Chicago.
Robert Shiller was among the very few to warn of a housing bust before it happened. Now he says that although the housing market could be approaching a bottom, prices might remain in the “doldrums” for years to come as the US remains in a “liquidity trap” comparable to the one it faced during the Great Depression.
Though stock market prices are valued fairly, Shiller said, equities remained a “risky” investment because the US had not turned the corner on its fiscal crisis. He warned that stock prices “could fall dramatically”.
How does an excess supply get remedied? By allowing prices to fall and by cutting production. This remedy applies to everything from hogs to houses. It is well documented that the prices of houses have plummeted. What may be less well known is that newly-started production of single-family homes has come back into equilibrium with the sales of new single-family homes - at least through April. Chart 1 documents that starts of single-family homes ran at a seasonally-adjusted annual rate of 368,000 in April, a touch above sales of new single-family homes at a seasonally-adjusted annual rate of 352,000.
Chart 2 shows that in recent months the ratio of single-family house starts to sales of new single family home sales is at it lowest level in 47 years. This is not to gloss over the fact that there still is a large supply overhang of new homes for sale that either have been completed or are under construction (see Chart 3).
But again, markets work. The housing market is moving toward a new equilibrium with production being curtailed and prices falling.
*Paul Kasriel is Senior Vice President and Director of Economic Research at The Northern Trust Company. The accuracy of the Economic Research Department’s forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul’s 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst.
This post is a guest contribution by Rebecca Wilder*, author of the of the News N Economics blog.
This week’s economic reports show a global economy hanging in the balance: signs of stabilization present, but the lagged economic reports still show no decided turning points. Exports are crashing - China and Canada, who depend on exports to fuel economic growth, are seeing export income fall at an increasing annual pace. Canada’s housing market is suffering, but it’s decline is not even comparable to its southern neighbor. Unemployment rates surge as resource utilization falls precipitously, and taking prices down to negative territory. However, the recent uptick in oil - uptick! more like a rocket-powered boost - will relieve the drag on headline prices.
Exports continue to disappoint in China, Canada and the US. Foreign demand for economic growth is out for the count. From the WSJ:
“Although recent economic data offer increasing evidence of a recovering Chinese economy, the external environment remains weak, spelling ever more dependence on domestic demand for growth,” Morgan Stanley economists said in a note after the data were issued Friday, predicting Beijing won’t shift its monetary policy stance in the near term”.
Canada’s housing market is taking a serious tumble. However, one cannot compare this housing market recessionary response to the meltdown in the U.S. The Canada Housing and Mortgage Corporation, a bottom may be forming:
Housing starts are expected to improve throughout 2009 and over the next several years to gradually become more closely aligned to demographic demand, which is currently estimated at about 175,000 units per year.
And reality rears its ugly head as unemployment rates surge in the US, Canada, and Australia.
Inflation is (almost) negative across the board - Germany posts 0.0% annual inflation in May.
The weak global economy will keep inflation low, but the surge in oil - already over 15% since the May average - will relieve the drag on headline inflation!
Industrial production may have found its bottom in the UK, but not in Germany! Germany, the Eurozone’s biggest economy, helped to push the Eurozone’s industrial production down 21.6% in April.
Overall, signs of a bottom are certainly forming; however, we wait for a turning point to show up in most of the lagged reports (1-3 months).
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WSJ What's News Late Edition, March 12,2010by The Wall Street Journal 12 Mar 2010 at 4:47pm
Stocks maintain a narrow range on mixed economic data but move higher for the week; retail sales posts an unexpected gain in February; and Toyota faces a lawsuit in California.
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