Posted by A few weeks ago, I wrote a little piece about the Chinese property bubble and how so many Canadians seem to be an expert on the subject after watching some report on the Canadian Brainwashing Corporation or 60 Minutes. Let me be very clear. There is a property bubble in China but its not the one that most people are worried about. Most people seem to think that China is overbuilding and there are huge empty ghost cities that could house millions. While partially true, this isn’t the real problem because those ghost cities will eventually get filled. You see, China is still on the path of urbanisation to the extent that 20-30 million people annually are moving to the cities from the farms. The last time I wrote on the subject over six years ago when I retired, I calculated that there was probably at least 20 years more of this trend to go before any slowdown so we still far from the end. It is difficult for Canadians to understand this concept fully. The numbers are just so mind-boggling huge that it escapes their comprehension. In simple terms, China is building infrastructure like roads, sewage, electricity, and housing the size of Australia’s entire existing infrastructure stock just about every year. If you’re an American, think about building a new Texas every year or if you’re European, the Benelux. And China has been doing this year in and year out for the past 30 years. China’s problem isn’t so much over building per se, its building in spots people don’t really want to be; because everyone wants to be in Beijing, Shanghai and Shenzhen… not Zhengzhou. Where? Oh you know, the capital of Henan Province… the city with nearly 10 million people (three times larger than Toronto, Canada’s largest city) that snobby Beijingers like to refer to as a bunch of crooked country hicks. Sadly, this is true just about everywhere in the world, not just China. Everybody wants to live in Manhattan but most end up joining the bridge and tunnel crowd in New Jersey or Long Island.
China’s real property problem is actually the prices. For a country with a fraction of the per capita income of the west, property prices, especially in those big cities that everyone wants to live in, are generally much higher than in the west. This is also not a purely Chinese phenomenon. When I took the senior executives of China’s largest fund management company to India back in 2008, they were shocked to find that property prices in downtown Mumbai were three times more expensive than in already pricey Beijing. In America, think about how nobody except tech billionaire and their millionaire stock-optioned employees can afford to live in San Francisco. This unaffordability of housing poses a huge threat, not only to social stability but to the entire banking and financial system because excessive borrowing and leverage can cause systemic risk as we saw in Japan after 1990, Sweden in 1992, most of Asia post the 1997 financial crisis, and the USA following the sub-prime collapse in 2007.
What is surprising is that so many Canadians can lecture me about their “sophisticated” understanding of the housing bubble in China and not recognize the one in their own back yard. Even worse, the one in China clearly has a great deal to do with the one in Canada, and for those Canadians who like to tell me China is doomed, it is unbelievable they can’t see if that is true, then they are as well. Vancouver (or Hongcouver as I like to call it) has long puzzled me because I have no clue what actually drives the economy there other than a little of trade, mining, forestry, fishing, tech, entertainment and smattering of other small industries. Cities tend to have a few big core strengths to justify their existence. Calgary has oil and gas; New York has Wall Street. Just over 100 miles south of Vancouver and across the border lies the city of Seattle. Despite being similar in size and geographical location, the two cities could not be more different and are a testament to the contrast between the two countries. Think Seattle and we can come up quickly with a plethora of huge multinational corporations: Boeing, Microsoft, Starbucks, Amazon and Costco to name a few (yes, I know Boeing technically moved their headquarters to Chicago a few years back). Think Vancouver and… crickets… no wait… Lululemon!
Which leads to me the conclusion that Vancouver’s number one industry asides from see-through yoga pants, has to be suckering well heeled Chinese immigrants to pour money into the big black hole of a property bubble. I would have said marijuana, but locals insist that pot exports are down dramatically due to home grown sources and legalisation in the United States. Do not kid yourself; property bubbles drive all sorts of other economic activity from the Ferrari dealership to restaurants and retailers not to mention the construction industry, banking and all the vulture real estate agents. Collapsing property bubbles have a massive opposite effect, especially on the financial system. Thus, Canada is faced with a similar dilemma as China. While high property prices cause social unrest as young people are unable to buy a home, the economic and social implications of falling property prices are far worse. With home ownership rates of 70% in Canada and huge debt loads, we are doubly worse off because any fall in property prices will have a huge knock on effect on consumption.
While Canadians were admonishing America after 2007 for their profligate sub-prime lending, NINJA loans and CDO’s, we were slowly and quietly planting the seeds of our own destruction. Canada now leads the industrialised world in household debt levels and has long passed the levels in the USA where the sub-prime crisis hit. British Columbia’s Liberal government (i.e. Vancouver) caved in to racist populism by suddenly putting a 15% tax on non-resident (i.e. Chinese) buyers of property last August after hearing that about one in 10 transactions were from foreigners. Of course, it has to be those evil foreigners who are causing all our problems. It can’t be us. Everybody knows that Canadians are so nice and low key and polite. While undoubtedly foreign buying in Vancouver and Toronto (well, more Toronto now as post tax, transactions in Vancouver have plummeted and valuations cooled) is significant, it ignores the fact that the other nine in 10 transactions were locals. In other words, all those people who say it doesn’t matter if property prices fall because those rich Chinese pay in cash are full of shit. It will have a huge impact on 70% of Canadians who own their homes and an even larger effect on anyone who has taken out a lot of debt to buy housing in recent years at a high valuation.
This time its different. We’re not Americans with their crazy CDO’s squared. Our banks are more conservative and well capitalised. How many times have I heard these arguments before? Oh that’s right. When I was studying at the Stockholm School of Economics in 1993 right after the property collapse in Sweden in 1992. When I was working in Hong Kong in 1997 on the eve of the British handover and the Asian financial crisis. While I was an investment banker in 2007 flying into New York just in time to watch Lehman Brothers implode the next morning. My all time favourite is economists that predict that the bubble will gently deflate with prices flat or slowly declining while transactions remain stable. That’s what most of the Canadian economists seem to be forecasting right now. The only problem with this theory is… I’ve never seen it happen anywhere in the world. The next time your kid blows soap bubbles in the yard, I dare you to try to slowly deflate one. They’re called bubbles for a reason. The either grow bigger or they pop; they never slowly deflate. Otherwise we would call them housing balloons.
Buyers with a down payment of less than 20% (high-ratio mortgages) have to buy mortgage insurance. Mortgage insurance in Canada is backed by the federal government through the Canada Mortgage and Housing Corp (CMHC) and two private insurers, Genworth Financial Mortgage Insurance Company Canada and Canada Guaranty Mortgage Insurance Company. The federal government backs the insurance offered by the two private-sector firms, subject to a 10-per-cent deductible which means essentially the taxpayer is the default insurer for all mortgages in Canada. CMHC has a portfolio of some $540bn and the mortgage backed securities (MBS) market is about $440bn of this. Genworth has another $223bn while there is no data from Guaranty Mortgage but I would guess it isn’t that large. So out of a $1.4bn somewhere just over half is insured by the government. Is any of this sounding like Fannie Mae and Freddie Mac to you?
The Canadian government implemented new mortgage rules in October to address the property bubble. Change one is to expand the mortgage rate stress to all insured mortgages including low-ratio mortgages to ensure that the buyer could still afford the mortgage if rates were to rise to the Bank of Canada’s five-year fixed posted mortgage rate. Other stress tests include the buyer will be spending no more than 39% of income on home carrying costs like mortgage payments, heat and taxes. Total debt service including all other debt payments cannot exceed 44% of income. To me, this is a pretty lame attempt to clamp down as the test is hardly stressful. You want a real stress test, see if your client can tolerate 10% mortgage rates that we had for two decades from the mid 70s to mid 90s let alone the mortgage rates of 20% in 1982.
Change two, the government will only provide insurance for low-ratio mortgages that are less than 25 years in duration, with a purchase price less than $1 million, with the buyer having a credit score of 600 and only for owner occupied property. Essentially, this will limit the government’s exposure to property in Vancouver (average home prices of $1.4m) and to a lesser extent Toronto. It may marginally increase the cost of borrowing as these mortgages will no longer be insured.
Change three. Currently any capital gain from selling your primary residence is tax-free but now any sale will continue to be tax free but sale of primary residence must be reported to the Canada Revenue Agency. Essentially, this is not a change but is aimed at preventing foreign buyers from claiming a primary residence tax exemption which they never were eligible for in the first place. No real impact.
Change four: The government is launching consultations on lender risk sharing with the end goal of reducing the governments exposure to home lending as it is currently acting as the de facto insurer for 100% of all insured mortgages in Canada. Over time, this may put some more pricing discipline into the market as the banks could care less as long as you tick off the right boxes, they can offload all the risks to the feds and make money. Does this sound anything like the MBS and CDO market games that Wall Street was playing with the bond rating services and Fannie Mae? In any case, its pointless as the bubble is already huge and this does nothing to curb it; it only seeks to limit any further increase in direct exposure by the government to the bubble.
And by clamping down on the regulated mortgage market, the government may be inadvertently fueling the growth of the shadow banking system resulting in a rise in the same sort of sub-prime loans that we saw in the United States. Regulated lenders in Canada are not allowed to lend more than 65% of the value of a home to borrowers with bad credit or more than 80% to even good credit without government backed insurance. Enter the shadowy finance world of the NINJA (No Income, No Job, No Assets) where loans are “bundled” with a primary mortgage and a second loan from unregulated groups called Mortgage Investment Corporations (MICs). The share of unregulated lenders has shot to 12.5% of Canada’s C$1.6 trillion mortgage market in 2015, up from 6.6% in 2007. The Bank of Canada estimated that unregulated lenders have about C$125 billion in assets, including auto loans and other products as well as mortgages. The vast majority of that total is held by companies not listed on public exchanges – meaning little hard data is available on their lending. The bank report acknowledged that significant gaps remained in data about the shadow banking sector.
We have a dangerous housing bubble in Canada and it is not one we can extricate ourselves from easily given how dependent the economy is on this bubble at this point in time. The oil and gas industry is in the toilet still and manufacturing just isn’t what it used to be. So are we doomed? Probably. Will it be in 2017? Maybe. But I doubt it. It’s just as plausible (and I think more likely) that the bubble just gets a little bigger this year given interest rates are still low and the Canadian dollar is weak. Don’t forget everyone was screaming about this five years ago (see graphic above). Like I wrote previously, forecasting the end of a property bubble, like predicting tipping points for climate change, is a mugs game. Eventually, you will be right but anyone who put off buying a home in Vancouver in 2012 because all the pundits were screaming that it was all going to come to an end soon is probably regretting that decision right now. Especially if he is still stuck renting a shit hole in Surrey as a result and commuting an hour and a half to work every morning.