What happens when governments own markets? When prices are backed by the state for political reasons? Where the state does everything it can to encourage people to make highly leveraged bets on the market – and steps in to intervene whenever something goes wrong? Where as a result investors, most of whom are complete amateurs, are convinced that prices can only go up? And where a decline in the market will affect not just asset prices, but the entire economy – because so many people are involved in the game?
Of course, all this goes against the spirit of free-market capitalism. You might think that it could only happen in a state-run economy, like China, with its persistent attempts to prop up the stock market. But it also applies in non-Communist countries – including Canada.
As shown by the Chinese stock market, the state can back up prices to a degree, but at some point
reality sets in
Some two years ago, I wrote in this column that Canadian house prices were completely out of whack with standard metrics. According to The Economist, prices at the time were overvalued by 78 percent in relation to rents (the highest in their survey of 18 countries), and 34 percent relative to income. Institutions such as the OECD and IMF were yelling warnings from (and to) the rooftops. I concluded that: “Canadian housing is in a bubble, caused in large part by the existence of extremely low interest rates… Instead of a crash, expect a gentle sag. At least until interest rates go up, as they eventually will.”
So far, according to the Teranet index, that prediction has proved accurate in three of the top-five housing markets, with Montreal, Ottawa, and Calgary peaking in mid-2014, even though the benchmark interest rate has actually halved to 0.5 percent. However, Toronto and Vancouver have continued to bloat. Earlier this year, the average price of a detached house surpassed a million dollars in Toronto, and twice that in Vancouver. This despite the fact that Canada’s economy was in a funk after the collapse in its main export, oil.
There are clearly a number of factors involved. For example, foreign ownership in these cities has probably helped drive up prices, though no one knows for sure because data on said foreign ownership is not available. But perhaps the main reason has less to do with the invisible hand of supply and demand, than with the visible, if heavily-camouflaged, hand of the state.
For many decades house prices in the US and Canada tracked quite closely, but they diverged significantly in the aftermath of the 2007 financial crisis – instead of crashing like over the border, Canadian prices dipped only slightly before resuming their glorious upwards march. This success was attributed to a robust banking system, coupled with a mythical cultural aversion to excessive debt. However there was more to the story than that.
As investment advisor Hilliard Macbeth notes in his timely book When the Bubble Bursts: Surviving the Canadian Real Estate Crash, the Canadian Government is heavily involved in the housing market because they provide subsidised mortgage insurance for banks. This is rather like allowing stock market investors to borrow from banks, and guaranteeing that if things go pear-shaped the state will step in. During the crisis, the government launched an Insured Mortgage Purchase Programme, which dramatically extended this insurance. At $69bn, its scale was in relative terms the same as the famous TARP in the US, but it received far less attention or debate. They also temporarily lengthened maximum mortgage periods to 40 years (though that has since been scaled back to 25) and changed the rules so that homebuyers could raid their tax-free pension accounts to make a down payment.
As in many other countries, interest rates were set to emergency levels. When the Bank of Canada cut its rate even further in 2015, this crashed the Canadian dollar, but allowed the house-buying spree to continue unabated, which was convenient for a fall election. Residential investment has ramped up so that it now accounts directly for about seven percent of GDP, more than the 6.3 percent reached at its peak in the US (which has now collapsed to about half that level). Cities such as Toronto and Montreal are awash in freshly completed condominiums looking for buyers. Construction is so important that any slowdown will hurt the economy, which will reduce housing demand, which in turn will reduce construction in a negative feedback loop.
Handle with care
So how long can the last remnants of this real estate boom continue? According to Hyman Minsky’s Financial Instability Hypothesis, a marker for the final stages of a credit cycle is the appearance of buyers who – like the NINJA borrowers with ‘no income, no job and no assets’ of the US sub-prime crisis – can’t service interest payments but rely on the borrowed asset increasing in value. In Canada, you can buy a home with only five percent down, but in 2015 more than a quarter of down payments from first-time buyers were themselves borrowed (not sure where they got the down payment for those loans). If buyers can’t afford the down payment, maybe they can’t afford the house.
An even stronger indicator, though, is total faith in the market. As Minsky put it, “Success breeds a disregard of the possibility of failure.” Or as one of Macbeth’s investment clients told him, “Real estate always goes up in value.” Risk seems lowest when everyone is in perfect agreement, which of course is when risk is highest.
As shown by the Chinese stock market, the state can back up prices to a degree, but at some point reality sets in. And with near-zero interest rates, and rates expected to rise in the US, there is little more that the government can do, short of actually buying all those condominiums themselves – it’s hard to arrest ‘malicious’ short-sellers, though they could crack down on renters.
This leaves them in a bit of a quandary. When speaking about Iraq, Colin Powell used to cite the Pottery Barn rule: “You break it, you own it.” The converse is that, if you own it, it’s your problem if you drop it. As the result of a long series of policy measures designed to keep homeowners happy, the state now owns the Canadian housing market. When the central bank eventually tries to raise interest rates, it will be hoping that it doesn’t shatter