Drifting Towards Disaster: The Growing Risk of a Canadian Economic Crisis
A comforting narrative has emerged about Canada. It goes something like this: While the United States has been reckless in its lending, Canada is the smaller, prudent neighbour with a careful eye on the creditworthiness of borrowers. So as the U.S. housing bubble burst and financial crisis ensued, Canada remained a well-regulated rock.
And speaking of rocks, the great northern land just happens to have the commodities required for the massive industrialization of China and India (throw in Brazil and Russia for the sake of a good acronym). And for good measure, Canadian governments are models of fiscal probity compared to debt-addled Uncle Sam (true at the national level; just don’t look at the provinces).
Like most good investing stories, there is some truth associated with the above characterization. And left at the level of glib, almost lore-like proclamations, all is well. Look under the hood and the tout becomes more difficult to swallow.
For example, while subprime mortgages certainly exist in Canada, they do not seem to have proliferated like they did in the U.S. bubble. But it is still very possible to have a housing bubble even if most of the loans are plain vanilla and given to qualified borrowers.
Bubbles are primarily about valuation, not esoteric financial products, even if those are thrown into the mix. And the greater the role of debt in creating the bubble, the bigger the mess when the bubble bursts.
Just how out of whack are Canadian house valuations? Maclean’s magazine, citing the work of David Madani of Capital Economics and formerly of the Bank of Canada, recently wrote:
The elephants Madani sees include a sharp run-up in house prices compared to income: the average Canadian home now costs five times the average income, well above the multiple of three that is considered affordable. There’s also a sharp rise in home ownership rates, which at about 68 per cent of Canadians mirrors closely the 69 per cent at the top of the U.S. bubble. Madani also points to continued overbuilding and Canada’s still healthy construction industry. New building permits reached $6.8 billion in December, a 4.5-year high.
The biggest elephant of all is how much the boom has been fuelled by cheap and abundant credit thanks to a low interest rate policy pursued by the Bank of Canada, along with government-insured mortgages. “All the warning signs are there,” Madani says. “We just have to connect the dots.”
Madani, and others like Ben Rabidoux of The Economic Analyst, are right. People are simply ignoring the similarities between the U.S. and Canadian housing bubbles. It reflects the strange emergence of Canadian hubris and exceptionalism, recognized by Rabidoux in the Maclean’s article when he lamented that, “One of the really terrible narratives we’ve allowed to develop in the minds of Canadians is that somehow we are better than the U.S. and so that means we have nothing to be concerned about”.
But because Canada hasn’t had the flood of American-style teaser mortgages and NINJA loans, the consensus isn’t fazed that there has been a veritable explosion in total mortgage debt over the past decade.
To the extent that people do fret about the Canadian mortgage market, the focus seems misguided. The primary risk is not that interest rates rise.A much bigger problem for Canadian housing will be if prices start cratering.
When that happens, the classic mismatch of debt and collateral will become apparent. So long as collateral values, in this case the prices of homes, continue to rise, the debt behind the real estate is benign. But when the value of the house or condo falls below the mortgage value, insolvency is exposed. In a long-run sense, it was always there, but the good times masked it as prices soared to the sky.
Canadians are not simply taking out foolish mortgages. They are upping the bet by borrowing significant sums via home equity lines of credit. To do so at such lofty prices, as happened in the U.S., is directly betting that the bubble will not burst. HELOCs during a house price mania are a clear expression by the borrower of a belief that there is some permanence in their residential equity. Simply put, at current Canadian house price valuations it is a crazy bet to make.
It would be bad enough if Canada was on the brink of a housing crash given the record amount of household debt. But there’s a second bubble, commodity prices, waiting to burst that will merely compound the pain.
Time and again, Wall Street points to emerging markets like China and India as the source of high commodity prices. And there is a grain of truth in this. But the more important factor is financials flows into commodities. When the financial crisis ensued and resource prices crashed, it was widely recognized that there had indeed been a speculative bubble. It has returned, just as there has been a resurgence in risk-taking across multiple asset classes.
To the extent that China matters to commodity prices, the transmission mechanism may be more complex than the consensus realizes. Yes, a slowing economy will impact real-world consumption demand in China. Perhaps more importantly, though, a China slowdown will wreak havoc with the investment thesis behind many bullish commodity trades by hedge funds and other speculators. Perception in this case has likely been far more important than reality in setting prices.
Another twist in the commodity bubble is the apparent role played by financing games within China itself. Multiple press reports (see here and here) suggest that significant imports of commodities from copper to soybeans are not for consumption purposes, but rather as a mechanism for obtaining bank credit. It’s also worth mentioning the stories of Chinese citizens and corporations speculating on commodity prices themselves, as one particular Bloomberg article about a pig farmers stockpiling base metals aptly demonstrated.
Resource-laden Canada, riding high on the development of the oil sands and new mining ventures, to say nothing of the bountiful effect on Bay Street, will suffer greatly when commodities fall from grace. In turn, this will exacerbate the bursting of a real estate bubble that in some areas has been juiced by the presence anything from the oil sands to potash.
Twin bubbles bursting, each painful, together an absolute disaster. And to top it off, the manufacturing sector, which could in theory mitigate some of the damage, is being suffocated by a strong Canadian dollar that policymakers stubbornly refuse to weaken. When the housing and commodity bubbles burst, the loonie will get pummelled. But closed factories won’t re-open overnight. Reviving manufacturing will take many years and a large devaluation of the Canadian dollar.
Like most financial manias, the signs are there that Canada is heading for an economic cliff. Yet, human optimism being what it is, the good times so tempting to believe in, cognitive dissonance rules the roost. Until the chickens come home, that is. When that happens, Canada faces a most unfortunate day of reckoning.