NOVEMBER 04, 2012
Comments on CIBC's "no US-style crash for Canadian housing" report
I feel compelled to give my thoughts on a highly-publicized CIBC report out last week titled, “Should we worry about a US-style housing meltdown?”, written by Ben Tal. The full report can be read here.
It’s actually an excellent report that’s well worth the read. Today I’d like to highlight the parts I agree with, tomorrow the parts I disagree with, and then later, and most importantly, what I think is missing in this discussion of housing market risks.
What I agree with:
1) A US-style crash is not likely in Canada:
I agree completely that a US-style housing correction is not likely in Canada for a number of reasons, but primarily because I don’t believe that the flow of credit will virtually dry up here in Canada. I may be wrong, but at this point I can’t envision a scenario where credit evaporates almost overnight while confidence is shattered by the very real likelihood of a global financial system collapse as it was at the height of the US crisis.
I think that's a very real possibility in places like Australia where banks are heavily reliant on offshore funding, the flow of which is notoriously prone to reversal. We don't have nearly the same risk on that front here in Canada, though the dynamics by which credit constricts via pro-cyclical lending policies by the banks is a universal phenomenon observed in every housing boom and subsequent bust. I don't believe Canada is "different" on this front, but I also don't believe credit will collapse.
That said, it is an enormous jump in logic to go from “no US-style housing crash” to “we have nothing to be concerned about”. The reality is that the US housing crash represents the greatest destruction of wealth in history. House prices fell nearly 35% peak to trough by some measures. As I’ll explain later, we don’t need a “US-style” housing crash to inflict some very significant economic pain, particularly given how incredibly levered our economy and labor markets are to this current housing boom vis-a-vis the US at peak. A Canadian-style correction that fails to match the US experience in magnitude can nevertheless be an enormous macro event. And yet this seems to be glossed over in this type of analysis.
2) Subprime lending in Canada never rivaled US stupidity:
Tal notes that: “Any comparison to the US (mortgage) market of 2006 reflects a deep misunderstanding of the credit landscapes (in Canada and the US”). Once again, I agree. In fact, I expressed that sentiment nearly verbatim last year in an article titled, “Subprime lending in Canada: Wading through the rhetoric.”
That said, by no means do I believe Canadian lenders have avoided entirely the pitfalls of imprudent lending. In fact, it was likely the US crisis that saved Canada from experiencing a full-blown housing crisis as the first thing regulators did was eliminate some of the extreme US-styled subprime lending practices like 0 down, 40 year am, stated income lending, and I believe many of the practices we currently accept as “normal” will be looked upon in the future as being highly risky and without place in a “conservative banking system”. There is, after all, a reason that regulators have actively sought to curtail many Canadian lending practices via CMHC and OSFI regulatory changes. I'll have a LOT more to say on this tomorrow.
The bigger issue here is that most discussions of risks faced by Canadian housing begin and end with this fact. In the mind of some analysts, the fact that we haven’t experienced the full lending fiasco experienced south of the border means we have absolutely nothing to be concerned about. There is seldom any consideration given to other indicators that point to an asset bubble, most notably prices relative to rents, incomes, and per capita GDP, real house prices, and speculative behavior or how the rise in house prices, construction activity, and the consumer spending it fosters may artificially buoy the economy and labor market. We’ll look at this in detail later, but suffice to say that anyone hanging their expectations for a soft landing solely on the subprime story is choosing to look at only one side of a complex issue.
3) Recourse is not what it’s cracked up to be:
It is truly refreshing to hear a mainstream economist finally acknowledge what others, including myself, have been pounding the table about for years: Non-recourse states were the minority in the US, and the difference in price declines between recourse and non-recourse states were not significant.
There is a tremendous misunderstanding about recourse laws here in Canada, particularly as they pertain to bankruptcy. That is a separate post unto itself, but bottom line is that recourse laws vary from province to province, but mortgages are NOT the life sentence they are made out to be here in Canada. In most cases, lenders (or insurers like CMHC) can pursue debtors by garnishing wages for only a fixed period of time following bankruptcy (as low as 2 years in some provinces), and only if their income is above a certain level.
Also lost on most people is the fact that the ultimate element of recourse on the riskiest loans rests with the insurers….CMHC in particular….and NOT the banks. It strikes me as exceptionally unlikely that a crown corporation will be allowed to pursue “down on their luck” homeowners in the event of a widespread wave of defaults. That’s what we call political suicide….no government would allow that to happen, particularly given the rising scrutiny of CMHC practices.
Ultimately, you can't squeeze blood from a stone. Recourse only serves as a deterrent if there are assets to seize. In the case of delinquent debtors, that is not always the case. This is complicated further by the fact that certain investment vehicles offer full creditor protection, most notably segregated funds.
Bottom line: Tal nailed this one.
4) Mortgage deductibility was not a factor in the US bubble:
It’s amazing to hear most people point out that mortgage interest in the US is tax deductible, and so therefore this was primarily responsible for the US crash. Tal sets the record straight. I won’t repost his excellent commentary on this topic, and I have nothing to add to it. Read it for yourself. It's solid!
5) Low arrears rates do not necessarily indicate a stable mortgage market:
Once again, hearing this from another economist is a breath of fresh air. It’s driven me nuts that few economists could see that virtually no one would default on a mortgage if they had the capacity to refinance it or access home equity via a HELOC from which to pay the mortgage. Even OSFI, in announcing its B20 lending guidelines, acknowledged that the rise in HELOC debt masks potential borrower weakness as debt can be paid with additional debt.
It’s the ultimate example of finding out who is swimming naked when the tide goes out. Those who are making ends meet only by accessing additional credit via their growing home equity are quickly flushed out when equity levels decline and/or new regulation prohibits them from continuing that practice. It’s why delinquency rates are best thought of as lagging, not leading indicators of house prices, a topic I’ve addressed many times before.
I'll stop here for now. Tomorrow, I'll address a few of the important areas where I disagree with Tal's analysis.
As a reminder to folks in the Vancouver area, I will be in your neck of the woods later this month for a housing and investment seminar with David LePoidevin. Tickets are complimentary but are going fast.