How do we get from here to Armageddon?

This is essentially a rerun of this earlier post, which produced no answers I found convincing. It's provoked by Livio's recent post, which produced comments raising questions similar to one that I've been asking for many months now. The question is: what are the mechanics behind "there's a housing bubble in Vancouver" (it's always Vancouver) to "therefore, Canada is doomed to a US-style balance-sheet recession"? There are any number of pundits who are willing to make this jump in logic, but the intermediate steps are almost never enumerated.

I don't have any problem imagining that housing prices in Vancouver and elsewhere will fall when the Bank of Canada starts its next cycle of interest rate hikes. What I'm having problems seeing is why that means we will follow the path the US took.

Of course, before we get too concerned with the power of the Vancouver housing market over the Canadian economy, we have to answer the question: "What is so special about Vancouver?" After a sharp increase during the mid-2000s, Calgary prices peaked in mid-2007, and fell more than 15% before bottoming out in 2009. They have yet to recover their peak. Why is a fall in Vancouver housing prices a national crisis to be dreaded, while a fall in Calgary housing prices is not?

Anyway. Brad DeLong claims that

In order to have successfully predicted that we would be where [the US is] now, you would have to have predicted a large number of things:

1. That a global savings glut and a period of low interest rates would produce a housing boom.

2. That the housing boom would turn into a housing bubble.

3. That the housing bubble would lead to a collapse of mortgage underwriting standards.

4. That risk management practices on Wall Street would have been nonexistent.

5. That the Federal Reserve would not be able to construct its usual firewall between finance and the real economy.

He continues on, but says that the most imaginative got to point 5 at most. Canada is running a current account deficit these days, so point 1 can't be dismissed out of hand. Point 2 is a definitely a possibility - but if all the bubble stories are datelined Vancouver, then it's hard to see how much of an effect it will have on the rest of Canada.

Point 3 seems to be where we have to stop the analogy to Canada. After a brief flirtation with longer amortisation periods and zero down payments - which is as far as we got to reproducing the subprime excesses of the US - Canadian regulators have spent the last few years tightening mortgage requirements. Is there any sign that Canadian mortgage underwriters have adopted pre-crisis US-style practices? The Canadian business press has been very keen to match the horror stories coming out of the US, but no amount of digging seems to have produced anecdotes corresponding to the 'liar loans', 'teaser rates' and 'NINJA loans' that were the standard fare of the pre-crisis US financial press.

The CMHC's short-lived and long-dead experiments pale in comparison with such exotica. It's not at all clear to me that an eventual weakening in prices will bring about a massive entry of houses on the supply side of the market. Who would be selling those houses, and why? And if there is no sudden influx of houses on the market, why would prices crash? It seems more likely to me that house prices would stay stable or decline slowly as nominal incomes grew to levels compatible with existing home prices.

Point 4 also seems moot - Canadian mortgages haven't been securitised in the bewilderingly opaque way that pre-crisis US mortgages were. If there were to be a massive wave of Canadian mortgage defaults, there wouldn't be much mystery about who would be on the hook: it would be the CMHC, and, by extension, the federal government. I don't see why financial markets would seize up in a fit of counterparty confusion the way Wall Street did in the fall of 2008.

Moreover, the odds of a massive wave of Canadian mortgage defaults seem small. As everyone know by now, Canadian mortgages are generally recourse, so the incentives to walk away from homes that are underwater are greatly reduced. If Canadians refused to default in large numbers when mortgage rates went above 20% in the early 1980s, why would they do so if they go up a couple of points from where they are now?

I'd like to think that point 5 is also moot, to the extent that the Bank of Canada is - so far - more insulated from partisan politics than the Fed is. And of course, the Bank can also learn from the Fed's mistakes.

But I may be missing something in the roadmap that takes us from here to housing market Armageddon. If so, could someone tell me what it is?

Comments

[Frances Woolley]

"Why is a fall in Vancouver housing prices a national crisis to be dreaded, while a fall in Calgary housing prices is not?"

One point to mention is that the current (2011) Vancouver boom is being fuelled, in part, by restrictions on real estate transactions in Chinese cities. Vancouver might be pricy, but compared to Beijing, it's value city.

Vancouver housing prices touch on a whole lot of other sensitive issues - race, immigration, rising income inequality, etc - which is one reason people get so exercised about the topic.

I think also the absolute level of prices matter too. As the popular http://www.crackshackormansion.com/ crackshack or mansion on-line quiz demonstrates, it's hard to get much for under a million in Vancouver. There's basically much further to fall, with attendant consequences, even for recourse mortgages.

[Dan F]

Ask Garth Turner. He seems to be certain that the market is about to tank (and he has been absolutely certain of it for the past 5 years)

[Tuzanor]

Vancouver is such an enigma due to the lack of land due to mountains and oceans as well as the reasons Frances mentioned. It's always been "insanely" expensive as far back as I can remember, even the as far back as the 1980s. I think it needs to be treated as an outlier and even then, it's only for "single-detached houses" that the prices are in the millions of dollars. Its condo prices are not much more expensive that Toronto.

I think Stephen is right on the mark here. We may or may not have a bubble and a crash, but it will play out very differently here and probably won't affect the economy in the same way as our southern neighbours. Though a change of government may become more likely...

[Nick Rowe]

Random thoughts. Not really a clear scenario:

Vancouver may not be so special -- just at the more extreme end of the spectrum. Toronto may be overvalued too. Ottawa looks a bit overvalued as well, from my casual observation of price/rent ratios. The Armageddon scenario would have house prices fall across most of the country.

I read Garth Turner's blog a lot. Not a lot of solid data there, but the anecdotal evidence of frothy behaviour is definitely worrying. When people are thinking "Last chance to buy before we are forever priced out of the market" that sounds like a bubble.

A big fall in house prices matters (for construction, and for people who bought overvalued houses, etc.) even if it doesn't result in Armageddon.

IIRC, CMHC only insures mortgages with less than 20% equity. If house prices fall more than 20% (which they may, in some places) it will be the banks themselves on the hook for some of those underwater mortgages that are not CMHC-insured. Plus, the loss to the bank may be bigger than the amount the mortgage is underwater, because it's hard to get the owners evicted, plus the house will show badly if it's a bank repossession. (My current house was a bank repossession, and I had to buy it "sans aucune guarantee" from the vendor, all the light fixtures etc were stripped out, so most buyers wouldn't touch it, so I got it at maybe 20% below market for comparables.

From my vague memory of empirical studies, it's unemployment that is the biggest driver of mortgage default in Canada, historically, rather than higher interest rates. Any scenario of large-scale mortgage default would probably require a significant rise in unemployment.

External factors may be as important as Canadian factors. I'm still pessimistic on the Eurozone, and a financial collapse there would be big in global terms. I don't follow China closely, but it sounds like risks are rising there too. Though China is a very different case from Greece, because China does not have external debt, the internal problems within China *may* be more close to those of the Eurozone as a whole. And the US is still not recovering properly. Eurozone+China+US problems could make a big dent in the Canadian economy.

Big CMHC losses would mean a big rise in the Federal debt/GDP ratio, which might cause fiscal retrenchment.

OK. Here's my Armageddon scenario: Canadian house prices fall say 20% nationally, but much more in some areas, so the losses to CMHC and banks are bigger than an across-the-board 20% fall. Construction falls, and CMHC losses cause fiscal tightening, so AD falls. China+Eurozone+US problems cause AD to fall further. The BoC cuts to 0% again, but the global recession causes a drop in commodity prices that causes labour demand to fall unequally across the country. People cannot move, because they can't sell their underwater houses, so the unemployment is structural, as well as demand-deficient. High unemployment causes mortgage defaults. CMHC covers only some of the losses, and the banks get into trouble.

[Nick Rowe]

continued: Having learned the lesson from Ireland, the government decides that the banks, collectively, are too big to save. Financial system goes bang.

[Frances Woolley]

"From my vague memory of empirical studies, it's unemployment that is the biggest driver of mortgage default in Canada, historically, rather than higher interest rates. Any scenario of large-scale mortgage default would probably require a significant rise in unemployment."

That's another issue with the Vancouver housing market. In Ottawa, where there's a lot of government jobs, historically employment has been fairly stable in good times and bad. In Vancouver, where there is less government sector employment, and more of the economy is resource based, employment also tends to be more volatile. Increasing the risk of booms and busts.

Though with more retirees in Vancouver, more health sector employment, and the healthy marijuana industry (which I would guess would be pretty stable, or even counter-cyclical), that may have changed.

"I think it needs to be treated as an outlier and even then, it's only for "single-detached houses" that the prices are in the millions of dollars."

And right now, from what I hear, housing prices seem to be going crazy only for single detached homes in certain particularly desirable neighbourhoods.

[Wendy]

My take, living in Vancouver, is that Frances is correct. The economy is much more diversified than in the past; the largest driver is now probably the port (imports-exports), which is now operating above pre-recession levels. If you look at location quotients, Vancouver has 5 or 6 categories (using conf board categories) above 1. It's not just health and retirees.

And the crazy house price increases are limited to a few areas. Many of the suburbs continue to be soft for all product (that's a developer's perspective; we might also call them "balanced" in terms of supply and demand). Insatiable demand is mainly in the walkable, amenity rich, older neighbourhoods in Vancouver city itself. Also, it's not usually first-time buyers making the $1 - $2 million purchases--it's people with equity who have been in the housing market for a while (not necessarily retirees but young boomers and gen x).

[Andrew F]

I don't think a disaster scenario on the scale of what happened in the US is likely to happen in Canada in the near future. That is not to say that prices can't decline by 15 or 20% in the priciest markets, between tightening lending standards and rising interest rates sucking demand out of the market. There might be demographic factors playing a role in the future, too, as many retiring boomers have a substantial portion of their net worth tied up in real estate. I can see many of them downsizing to reduce carry costs and free up some of their capital (or perhaps even lower maintenance properties that allow them to travel) putting some pressure on detached dwellings.

[Livio Di Matteo]

In simplest terms, its all demand and supply factors and the size and timing of the shocks affecting demand and supply (employment drop, interest rate rise, tighter lending factors, demographic change, drying up of foreign money, drop in immigration, loss of confidence in rising house asset values, etc..) will determine whether or not prices fall 15-20-30 percent. That answer is of course both absolutely correct and absolutely useless. There is probably no formula set of factors affecting the housing market that can be used to predict a housing bust - otherwise we would not be having this discussion. Borrowing from the wise Aslan in Narnia, nothing happens exactly the same way twice. What you may need to watch out for this time is what I would term "contagion" effects. If prices drop dramatically in one major Canadian housing market due to its local conditions, could it start a panic in other markets out of a fear factor?

[Nick Rowe]

It will be interesting to watch Australia, where house prices have finally started to decline, after a very long period of increases. Canada =/ Australia, but we are perhaps a lot closer to Australia, especially recently, than to the US.

[name_withheld]

@Livio: We have already had a massive demand shock and mortgage credit tightening and neither derailed the march of prices in Vancouver (mostly because the latter didn't effect buyers in that market). The only local shock left is higher interest rates, but again, probably not high enough to crash the housing market.

Some modelling that i've done shows that after the malaise of the late 90s in the BC market, prices caught up to fundamentals in about 2005/06 (after being undervalued for 5-10 years) but have since outpaced those fundamentals by a wide margin. I expect the same situation to play out in coming years. My baseline is for a sharp decline in "average" prices as the distribution of sales normalizes away from the high-end followed by a few years of flat to negative (in real terms) price changes while fundamentals catch up.

[jesse]

We should remember that not all parts of the US experienced a housing "boom" or "bubble" (whatever the difference), so when we hear stories of housing meltdowns south of the line, it helps to remember it's not a ubiquitous malaise. I do think generally Dr. Gordon is correct that Canada's condition is not as acute as the US's was 6 years ago. That does not preclude a US-style meltdown from occurring in certain locales where prices are high and the economy is heavily geared towards real estate and construction. Even in the bubbliest of Canadian cities, while the journey may be different than the American experience, the end destination of prices and incomes ended up the same. From that point of view who cares how "subprime" Canada is? We got there in the end regardless!

One note about CMHC: if prices do start falling, we should remember that banks hold many non-high-ratio loans that will become high-ratio as prices fall. CMHC is the backstop for all these loans and could see its insurance under force balloon significantly if prices weaken for an extended period. While its reserves may look hunky-dory under OSFI guidelines, that can change relatively quickly.

[name_withheld]

Just saw this: http://www.cic.gc.ca/english/resources/manuals/bulletins/2011/ob320.asp

Going from around 5000 wealthy immigrants each year to somewhere less than 700 could be a pretty good catalyst for some Vancouver markets

[Bob Smith]

Nick,

You're right that high ratio mortgages (i.e mortages with a loan to value ratio greater than 80%) must be insured under the Bank Act (though, note, only at the time granted). But that's only a minimum, and it is apparently not uncommon for lenders to seek insurance on loans with a lower loan to value ratio (i.e 75% - once you get under 80%, the CHMC mortgage insurance becomes pretty cheap). But the key point is that insured mortgages account for something like 80% of Canadian residential mortgages (and those are the national numbers - I'd suggest to you that that number is probably materially higher for Vancouver. Think about t's a lot easier to come up with 20% of the 155k average home price in Moncton than it to come up with 20% of the $800K average home price in Vancouver). So right off the bat, the exposure of lenders to a residential mortgage bubble is (at most) 20% of their portfolio.

Moreover, of the uninsured mortgages, it's unlikely that most (or even many) of them only have 20% equity in their houses. After all, the 20% threshold is their initial equity, not the average equity of that group at any moment in time (in fact, 80% of all Canadian homeowners have more than . Someone who's 8 years into their uninsured mortgage in Vancouver (for example) probably has a a heck of a lot more than 20% equity in their property (both as a result of having paid down principal on their initial mortgage and on the growth in the value of their property over the last 8 years). True, there may be a subset of that population who has been extracting equity to finance their lifestyles (through HELOCs or through other forms of recourse borrowing), but I think it's safe to say that they're a minority (and I believe one of your colleagues here posted some numbers to that effect recently) and in any event, the banks aren't likely to let them take out enough equity to put their loan/value ratio over 75%.

Furthermore, query if you might not expect non-insured mortgage holders to be less inclined to walk away in a system with full recourse than their counterparts in the US. After all, you might expect that such people would be wealthier (excluding housing) on average (since they, unlike the rest of us, could come up with the aforementioned $200K average down-payment in Vancouver) then (a) they might be better situated to ride out a housing crash and (b) they don't have much incentive to walk away and trash the place since (unlike a NINJA borrower in California) the bank could come after them for any deficiebcy. Not that we can know one way or the other, but I'd be willing to bet that the former owner of your house (well, other than the bank) had an insured mortgage.

Also, why would CHMC losses cause fiscal tightening? Yes, CMHC debts are also guaranteed by the Crown. But, unlike our Irish friends, the government of Canada can print money to repay its debt obligations and/or honour its guarantee. Rather than fiscal tightening, I'd have thought that the more likely outcome would be a defacto exercise in quantitative easing (as the government buys up its own government guaranteed bonds).

In any event, we've seen this game before. In the earlier late 1980's/early 1990's, the Toronto housing market dropped 25% and the Vancouver market fell 15%. Similarly, in the early 1980's Vancouver housing prices plummeted 36% in a year. All without triggering an apocalypse. "This time is different" doesn't make more sense for the bears than it does for the bulls.

[rp1]

DeLong's claim is disingenuous. Many people: Steve Keen, Peter Schiff, Dean Baker, Michael Shedlock predicted the US housing bust. They did not need to predict that the bubble would happen, or explain why it happened. They merely had to observe the bubble as it happened, and draw the conclusion that economic activity based on speculation and rising debt was not sustainable. When that activity vanishes you can expect a fall in GDP, and unless the debt is discharged, a balance-sheet recession could occur.

There is a practical limit to how much one can borrow, because lenders have a spread. As this limit is approached, the gains from speculation will decrease. Then you have a "Wile E. Coyote" moment where everyone realizes they won't get rich, that having debt costs money, and they are overpaying for shelter. They may even ponder how the next 30 to 35 years must now be spent working to claw their way out of debt at interest rates that can never go lower. There is very little potential for wind at the back, unlike the last 30 years when interest rates were falling.

And please don't say there is no speculation here. In major urban centres, mortgage interest + condo fees + property taxes exceed rent, sometimes by a factor of two. Those are all sunk costs. Someone buying at those prices is not seeking shelter.

Anyways, my answer is that the current valuations are sustained by the widespread expectation of gains, and if those gains fail to materialize a substantial number of people will cut their positions to try to preserve capital. I know too many people holding investment properties at extremely low and even negative yields. Granted, in 2008 the Bank of Canada saved those people by cutting interest rates to zero and ramming a big dose of inflation down the throats of anyone saving money and refusing to pay the prices. I don't think they can do that again.

[Bob Smith]

Dammnit, it was Nick who posted Will Dunnings' reports on the state of affairs of the Canadian mortgage/HELOC market (http://www.caamp.org/meloncms/media/Spring%20Survey%20ReportWEB.pdf). While I'm sure the BC numbers would be different, the fact that the average home equity ratio is north of 50% is no doubt comforting, both to Canada's banks and to CMHC. Certainly, based on the subjective measure of homeowner "comfort", BC homeowners don't appear overly concerned (though, I suppose, neither did the people buying 4 or 5 houses in California in the mid-2000s, all on credit).

[Mik]

Really good post. The way some people speak of the housing market, you could be excused for thinking the very definition of a housing bubble is a financial crisis of epic proportions.

Points 3 and 4 are quite critical for Armageddon, and you correctly point out they are simply not applicable to Canada. I believe we have our house in order. As Nick points out, a housing bust could go very bad when supplemented with international disasters beyond our control.

I don't see Armageddon but I do see the following. House values fall by a substantial percentage. People experience a decline in their net worth. Assuming housing makes up a sufficiently large proportion of net worth, this could work as a negative shock to consumption. C falls and depending on what is happening elsewhere we could slip in to recession. Not good but not quite the doomsday scenario some would have you believe.

[Stephen Gordon]

Some really good comments; thanks.

One thing I've learned is to never, EVER ask Nick for a worst-case scenario.

[name_withheld]

Correction to my post - its 700 applications (last year there were 3200) and the goal is to reduce backlog (so mabye 2500 apps or more still to be processed?). If so, there may not be much of an immediate impact.

[CBBB]

Why simply focus on Vancouver? The GTA also seems pretty overvalued.

[Nick Rowe]

Bob Smith: good response to my comment. As you can perhaps tell, my heart's not really into the worst case scenario!

name_withheld is onto some important stuff there, with the immigration numbers.

[name_withheld]

@Nick: I'm not sure how important these changes will be after doing further research. The cap on wealthy immigrants is only on new applications so its just thinning of the backlog. Total immigration (at least in the short-term) under the program may be unaffected.

[JP Koning]

Stephen, I’ll play around with your points 1-5 to come up with some sort of bearish scenario. I won’t go as far as Armageddon – that’s for punters. At the same time, this scenario involves something more than "soft landing".

Regarding point 1, the Canadian version of the “global savings glut” has manifested itself in massive inflows of foreign capital into Canada over the last number of years, much of which has targeted CMBs issued by the Canada Housing Trust. These inflows have helped the CHT to become the single largest purchaser of Canadian mortgage debt.

These inflows, combined with low rates, have led to a boom.

With regard to point 2, I’m agnostic as to whether the boom has become a bubble; bubble is too imprecise a word.

On point 3, that the acceleration in the housing market has corresponded with reduced mortgage standards is evident, though to some degree this has changed since the CMHC began tightening rules in 2008. But even then, we don’t really know if the CMHC closely enforces its policies or just gives them lip service. It is an opaque institution. Nor is the CMHC the sole financial innovator in the mortgage market. For example, you might be interested in the following mortgage:

https://www.cibc.com/ca/mortgages/article-tools/up-to-7prct-csh-bck.html

It allows investors to avoid the 5% down payment requirement... by lending the investor the 5% and an extra 2% on top. Voila, 102% mortgage! Cash back mortgages are a relatively new phenomenon on the Canadian market.

With regard to point 4, the key here is the risk management practices adopted not by Bay Street, but the CMHC, since the riskier end of the market is entirely insured. I try to be agnostic on this because, as I already pointed out, the CMHC is opaque, and so is the CHT, so I lack the data to properly evaluate. But the fact that neither is regulated by OSFI, or anyone else for that matter, does remind me of the lack of regulation of Fannie and Freddie. No oversight and lack of accountability tend to be bad signs. Regarding counterparty risk... note that even with CMHC-guaranteed MBS, not all high ratio counterparty risk is transferred to the government – certain residual risks remain with the private sector. That’s why all financial institutions are now being required to bring the mortgages they securitize back on to their balance sheets.

Point 5, if I understand properly, speaks to the ability of authorities to prevent the financial economy from hurting the real economy. If there were to be a bear market in Canadian housing, there would surely be a wealth effect, since housing has been the household's go-to asset since 2001. AA downturn would also be felt in government finances via increased stresses at the CMHC and CHT, compounded by foreign capital outflows. This would have real effects as the government raises taxes or commits to austerity, or uses the BoC to monetize the bad debt with all the concomitant negative effects of inflation that the population would have to endure.

[R Burbach]

I wonder if we are headed to a HELOC crisis in Canada rather than a mortgage crisis. Higher unemployment levels and underemployment leads to more tapping into those lines without any insurance net. My understanding is that the risk managers at Canadian banks are much more concerned about their HELOC exposure than their mortgage exposure.

[Hesam]

Nick Rowe: Big CMHC losses would mean a big rise in the Federal debt/GDP ratio, which might cause fiscal retrenchment.

Now wait a minute. There should be an upper bound for CMHC losses and I don't think that will cause any big fiscal problems for the federal government. Lets assume that the Mayans were right and the supposed Armageddon will happen in fall of 2012. The federal deficit projected for Apr. 2012 - Mar. 2013 is less than 20 billion dollars. Canada's nominal GDP at the time should be about 1.8 trillion dollars. So if the CHMC costs 70 billion dollars (this I think is wildly unrealistic; it is more than 1/5 of CHMC's current total assets) the deficit would go up to about 5% of GDP which is perfectly manageable.

[Andrew F]

^ Like Nick said, his heart wasn't really in it.

[Determinant]

Nick's a macroeconomist; thinking up systematic doomsday scenarios is why he gets up in the morning.

[wjk]

Vancouver is the poster child of Canadian excess. The site 'crack shack or mansion' comparing $5k Detroit homes to identical looking $1M Vancouver homes says it all.

#3 - collapse of mortgage underwriting standards - happened in the form of CMHC insuring virtually anyone remotely credit worthy for as much debt as they could possibly handle. Also, many of the poor underwriting standards in the US didn't come to light until their bubble started to collapse. Let's see how things look in Canada when our bubble starts to deflate.

#4 - non-existent risk management practices - also largely not needed in Canada since CMHC assumes most of the risk.

[Too Much Fed]

From:

http://globaleconomicanalysis.blogspot.com/2010/12/canadian-borrowing-gone-mad-look-at.html

Are these addendum comments correct?

"Addendum:

I said Bank of Canada in a couple of places where I should have said CMHC.

Here are a couple of corrections from Canadian readers.

"RP" Writes ....
Quick corrections here Mish. Mortgages in Canada are guaranteed by the CMHC, which is a crown corporation equivalent to Fannie Mae. Anything less than 20% down requires this insurance, so that's the source of the Canadian banks' "health". The loose lending standards were set by the current "Conservative" government, a few months after they came in office. We had 0 down, 40 year mortgages insured by the government for a couple of years. Now it's officially 5% down and 35 years, but every bank will lend you the downpayment. The government also insures mortgages for rental properties.

Similarly, "MS" writes ....
Hey Mish,

One inaccuracy that should be corrected. It's the CMHC (Canada Mortgage and Housing Corporation) that serves as the equivalent to Fannie and Freddie, not the BoC. The CMHC insures mortgages for below market rates, and the major banks pass along their loans to them.

The Conservative government ordered the CMHC (a crown corporation) to insure some $300 Billion in additional mortgages during the crisis - nearly double their previous holdings. It is this that has buoyed the Canadian R/E market since then. Banks don't worry about credit worthiness, because the CMHC will take it anyway in order to meet their quota.

"Moi" Writes ....
Mish you are one of the few Americans that seem to "Get It". So many of the other US financial writers talk glowingly about how sound Canada is financially and how the Canadian banks did not take part in the risky lending practices that the US banks have taken part in. This is complete and utter BS!! The Canadian banks are doing the same sort of zero down or variable rate mortgages it's just they have none of the risk to worry about. 600 Billion dollars worth of that mortgage risk is held by the government of Canada thanks to the Canada Mortgage and Housing Corporation (CMHC). There are cash back mortgages every where in this country. In other words come up with your measly 5% down payment and the bank will give you 5% back. So here in Canada we proudly brag about how we do not have zero down mortgages, we just call them by a different name. Also, if you do not have 5% to put down no problem. All of the banks will loan you money to by an RRSP (IRA), you can than cash that RRSP to be paid back later and use that as your 5% down payment. Voila, zero down mortgages.

The Canadian Association of Accredited Mortgage Professionals came out last month with their "Good News" annual report last month. Just like the Real Estate Industry, all news is good news. Take a look at the numbers. At these absolutely rock bottom interest rates:

100,000 mortgage holders would be in trouble with any rate move.
350,000 mortgage holders would be in trouble if rates only go up less than 1 percent.
250,000 mortgage holders would be in trouble if rates went up between 1 and 1.5 percent.

So, if interest rates which are at Century lows went up a measly 1.5 percent, 700,000 mortgage holders in Canada would be in trouble. What if they went up 2 or 3%? It would be mortgage Armageddon in Canada. This is how precarious our housing market. The following link gives you just one tiny example of why Canadian housing is a house of cards that could topple at the slightest touch.
http://whispersfromtheedgeoftherainforest.blogspot.com/2010/05/pardon.html

http://www.theglobeandmail.com/report-on-business/canadian-mortgage-debt-tops-1-trillion-for-first-time/article1789172/

5% or more cash back mortgage:

http://www.tdcanadatrust.com/mortgages/5_cashback.jsp
http://www.rbcroyalbank.com/products/mortgages/cash-back-mortgage.html"

[Jim Rootham]

I just read "The Big Short" by Michael Lewis. It's about the people who identified the sub prime mortgage crisis ahead of time and made a lot of money off the crash. It's not true that the poor underwriting standards did not come to light ahead of time, it's just that the warnings were ignored.

[Too Much Fed]

"Canada is running a current account deficit these days, so point 1 can't be dismissed out of hand."

What would the current account deficit look like if commodity prices and/or commodity quantities fell?

[Too Much Fed]

You'll need to look at:

1) the effective margin rate (effective down payment %)

2) how interest rates affect the monthly mortgage payment

3) more than 1 property

4) the assumptions of the people who went into debt, especially the future wage assumptions that might not be true

In other words, some personal finance budgeting.

[Declan]

Nick's doomsday scenario seems like a pretty reasonable worst-case (and as an aside, he is right about bank's taking losses more quickly than you would think on a housing price decline). I think if housing crashed, you'd have a monetary issue just with all the money being removed from / not added to circulation. I'd suspect that far from Canadian institutions responding better to a debt-deflation than the U.S. is doing, the more conservative Canadian approach to money matters would lead us more to U.K. style austerity madness.

Admittedly, I live in Vancouver, but I still wonder if you added up all the residential construction workers, the real estate brokers, the lawyers, the marketers, the home renovators, furniture stores, etc. what percentage of the economy it would add up to.

Also, with respect to Nick's comment above that, "we are perhaps a lot closer to Australia, especially recently, than to the US." the key metric to watch in my opinion is chart 12 from Carney's presentation in Vancouver, which measures the responsiveness of housing supply to prices. Unlike in Australia, in Canada we responded to higher prices with a construction boom, which is the reason price/rent ratios are so much further out of whack in Canada vs. in Australia. Part of the problem in Australia is that they are simply not building enough houses, but I haven't seen any evidence of this problem in Canada. Still, this chart suggests we don't react as strongly as the Americans, so that may help us avoid the same magnitude of 'over-construction' they saw. (Over-construction in quotes since if they can afford to build those houses, they can afford to live in them, it's just the macro stuff that has gone wrong).

As a final note, the denial about potential price declines in Canada reminds of studies done on the U.S. market before it collapsed.

Nick says that, "If house prices fall more than 20% (which they may, in some places)" and Andrew says, "That is not to say that prices can't decline by 15 or 20% in the priciest markets"

I think that prices can fall a lot further than people seem to think because much of the current support for prices is purely psychological, and that's not really the most stable form of price support. Price support in terms of investments in housing actually being cash flow positive is a long way down in a lot of markets, especially when you consider the potential vicious cycle of a housing led downturn causing reduced household formation rates.

[Jim Rootham]

The issue is not whether or not prices can fall, but what the consequences of a fall are. As far as I can tell, Canada is not repeating the fraudulent practices of the US. So no financial institutions meltdown. Yup, the housing part of the economy (agents, builders, etc.) will take a hit, and AD along with that, but the data cited above basically says it won't be big enough to move Canada into a recession that the BoC can't get us out of.

You have to remember the US financial armageddon what predicated on fraudulent practices.

[Andrew F]

You can have real estate crashes without fraudulent borrowing/lending.

Canada is indeed in a better situation than the US because of exchange rate flexibility.

[Bob Smith]

"What would the current account deficit look like if commodity prices and/or commodity quantities fell?

Hard to tell isn't it? The dollar would probably plunge and we'd be back to the late 1990's/early 2000's when we rant hefty current account surpluses.

[Bob Smith]

"Canada is indeed in a better situation than the US because of exchange rate flexibility."

Am I missing something or doesn't the US also have a flexible exchange rate? In fact, the US goes one better than a flexible exchange rate. They have a flexible exchange rate and a currency that (for the foreseeable future) is more or less universally accepted AND they have a license to print that currency.

[Andrew F]

The US unfortunately has less exchange rate flexibility, partially due to their status as a reserve currency, and partially due to the dozens of countries that peg their currencies against the US dollar, most notably China. No one maintains a CAD peg.

[Normand Leblanc]

It seems to be a constant to read that here in Canada, we do not have NINJA, ARM, subprime, etc like in the US.

If we assume that the average Canadian is as rich (or poor) as the average American then, how is it possible that our loans are of better quality given the fact that, as a whole, the canadians are as much in debt as our cousins?

BTW...great post!

[Jim Rootham]

Partly due to a different income distribution, Canada is more equal than the US.

[Patrick]

Normand:

Nick has pointed out many times that average debt or gross debt is meaningless. It's the distribution of creditors and debtors that matters. FWIW, this is a toy I used to explain it to a friend recently, and it seemed to work (I hope it's right!):

Assume a world with four people. Two are creditors, two are debtors - call them C's and D's

C0 has income of $1 dollar and savings of $1. C1 has income of $100 dollars and savings of $100.

D0 has income of $1 dollar, D1 has income of $100 dollars.

Now imagine two possible arrangements of this world. In the first configuration imagine half the population is smoking crack, and the other half are Puritans. C1 lends $100 to D0 at a very high interest rate, and C0 lends $1 to D1 at near the risk free rate.

In another arrangement of the world, everyone is normal and well adjusted. C1 lends $100 dollars to D1 and C0 lends $1 dollar to D1 both at more or less a the same interest rate - a few points above the CB's overnight rate.

In both cases gross debt is $101 and net debt is $0, but they're hardly equivalent worlds.

[Nick Rowe]

Normand: good question. My answer is "low interest rates". Remember, there are always lots of people who have no or little debt, but are a very good credit risk. If the demand for loans for e.g. investment is low, then equilibrium interest rates will be low. And some people will be induced to borrow by those low interest rates.

[Nick Rowe]

Patrick: we were posting at the same time.

Our 2 answers are complementary. If we start in your world 1, and then C1 stops smoking crack, so C1 decides to stop lending $100 to people like D0. This creates an excess supply of savings, so the equilibrium interest rate will fall, and D1 will be induced to want to borrow $100 rather than $1.

[JP Koning]

Both gross debt and the distribution of debt matter. Everyone wants to be an extremist.

Average credit is important because mortgage debt and housing prices are reflexive. A mispricing of credit puts upward pressure on houses, and upward pressure on houses forces people to get more credit etc etc.

The distribution of credit is important because it gives insights into the fragile points in the reflexive process. It is the weakest hands, once there are enough of them, that will upend the process.

[Ian Lee]

Too much Fed:
100,000 mortgage holders would be in trouble with any rate move.
350,000 mortgage holders would be in trouble if rates only go up less than 1 percent.
250,000 mortgage holders would be in trouble if rates went up between 1 and 1.5 percent.
So, if interest rates which are at Century lows went up a measly 1.5 percent, 700,000 mortgage holders in Canada would be in trouble. What if they went up 2 or 3%? It would be mortgage Armageddon in Canada. This is how precarious our housing market. The following link gives you just one tiny example of why Canadian housing is a house of cards that could topple at the slightest touch. http://whispersfromtheedgeoftherainforest.blogspot.com/2010/05/pardon.html
*********************************************************
Allow me to provide the following empirical data. In the 1981 Great Recession interest rates increased from 10% to just over 20% under Fed Chair Paul Volker while unemployment went to the highest levels in Canada since the Depression.

Yet national mortgage delinquency rates in Canada went from .5% to 1% of mortgage receivables, notwithstanding the highest mortgage interest rates in our history and the highest unemployment rates since the Depression.

Garth Turner and the other gloomsayers simply fail to understand that Canadian homeowners view mortgage debt very differently from credit card debt or consumer debt. Consumers will readily and easily default on credit card debt, utilities payments and consumer loan payments but will almost never default on mortgage payments.
I was Mortgage Manager of BMO Ottawa Main, 4th largest branch in the country in those days. I saw unemployed customers with no income make their payment - on time - every month (bless all those mothers and fathers, brothers and sisters across the land). By the end of the Great Recession, with 1/4 Billion in mortgages outstanding in this branch we foreclosed on exactly ZERO homes with interest rates over 20%.

This will be criticized as "anecdotal" - except that the national mortgage delinquency stats corroborate this for 1980, 1981, 1982 ...

Can housing markets decline in value? Absolutely - as others have noted - in the past in Toronto, Vancouver and in other regional markets they have stagnated for years e.g. Ottawa.

The Canadian banks possess rich data sets for decades that reveal an absolute inverse correlation between equity and delinquency. The more "skin in the game", the lower the probability of delinquency and default.

Watered down mortgage underwriting standards imposed by US Congress in the 1996 CRA caused the US housing bubble and then housing collapse while large scale securitization (motivated by commercial banks unloading their "hot potatoes" of Congress mandated junk mortgages to investment banks who richly deserved being stung) produced opaqueness such that no bank knew the exposure of any other bank to subprime mortgages. See the just published book, Reckless Endangerment by NY Times business reporter Gretchen Morgenson that meticulously documents the role played by Congress, Fanny and Freddie in watering down the underwriting standards.
Also see finance prof Calomiris at Columbia and Stan Leibowitz aT U Texas for their separate empirical analysis of the housing bubble and collapse.

[Whitfit]

On a related topic, could part of the rise in housing asset prices have to do with the excess supply of savings, because people are afraid to invest in financial assets, that they view as riskier right now?

I was put on to this idea by Krugman's thoughts here:

http://krugman.blogs.nytimes.com/2009/05/02/liquidity-preference-loanable-funds-and-niall-ferguson-wonkish/

[Nick Rowe]

Ian: your comparison to 1981 is persuasive. One small doubt though.

When bankers decide whether to lend an individual money, they look at 3 things: income; assets; and "character" (as revealed by previous history of paying debts). Right? Is "character"(/culture?) the same now as it was 30 years ago? People follow norms, to some extent. What is seen as legitimate depends on what other people are doing. Regardless of underlying differences with the US, Canadians have seen a lot of Americans default on their mortgages. "Hey, it must be OK, because all the Americans are doing it."?

[name_withheld]

@Ian - I was enjoying your comment until you blamed the housing bubble in the US on the CRA. That right-wing meme has been thoroughly debunked and yet continues to walk the earth as a zombie lie. Here is just one of many takedowns: http://bigpicture.typepad.com/comments/2008/10/misunderstandin.html

[Ian Lee]

You raise a critically important issue that is debated often in business OB and IB research and courses (and in sociology) concerning culture: is it enduring and relatively permanent or does it change slowly over time due to exogenous influences (have the Germans always been "German" or the Greeks always "Greek"?).

I can state that in the 1970s (when I was in banking) there were significant differences "culturally" between American banking and Canadian banking (as late as the mid 1970s, Canadian banks continued to "import" British trained bankers to Canada - not American trained bankers - at BMO Main Office about 40% of the 35 member management team were Brit imports).

We characterized American bankers as "go-go bankers (remember go-go dancers in miniskirts in the late 1960s on CJOH-TV), because they lent against projected cash flows, whereas we characterized ourselves as "prudent balance sheet lenders", as we would only lend against balance sheet assets - an inherent conservative bias against any start up as it had no balance sheet or against any firm with no substantial assets on the balance sheet.

On the mortgage side, in those days, we aggressively investigated the source of the down payment as we would not approve the mortgage if we determined that the down payment for the home purchase was borrowed. And the DP minimum was 10% and the amortization max was 25 years and mtg insurance was required above 75% - not 80% loan to value per the Bank Act in those days. And home ownership was around 60% of Cdns.

The first breach of these enduring rules was by the Trudeau Govt in 1974 when they announced the new AHOP home ownership program of 5% DP and 30 year amortizations for young boomers attempting to enter the housing market.

However, to return to your question and the overarching issue, in my judgment, the most astute analyst today in Canada concerning all aspects and variables that affect housing and financing of housding market, is Ben Tal, Deputy Chief Economist at CIBC, who has published several excellent empirical analyses on the Cdn housing market between 2009 and today.

His latest is: http://research.cibcwm.com/res/Eco/EcoResearch.html

He argues it requires two conditions for a crash which would rapidly return the housing market to equilibrium:

1. sharp rapid increase in mortgage rates in very short time period
2. a high risk mortgage market (i.e. weak underwriting standards)

However, his most deadly metric is:

"Digging deeper and looking at the households with both low equity positions and high debt-service ratios, we found that this fragile segment of the market accounts for only 3.2% of total mortgages. Shock the system with a 300-basis-point rate hike and that number would rise to a still-tempered 4.5%. Historically, even in that group, the default rate has been well below 1%."

Everyone should also remember another telling metric: over 50% of all Canadian homeowners are mortgage free while another 25% have equity greater than 50%.

Somewhere around 5% of homeowners are potentially in trouble and they are overwhelmingly young couples just getting established - the good news is they have mothers, fathers, brothers and sisters, who will help them out when they get into a jam (or they can sell their house). And $1 trillion of Cdns total indebtedness of $1.5 Trillion (against $7.5 trillion in gross assets), is mortgage debt.

It was ever thus.

[Ian Lee]

@Ian - I was enjoying your comment until you blamed the housing bubble in the US on the CRA. That right-wing meme has been thoroughly debunked and yet continues to walk the earth as a zombie lie. Here is just one of many takedowns: http://bigpicture.typepad.com/comments/2008/10/misunderstandin.html

Please believe me when I tell you I have read the purported debunking e.g. Krugman. Note that in the various "debunkings", there is no reference to empirical research by finance Prof Charles Calomiris, Kaufman professor of Financial Institutions (e.g. testimony before the US House Cmte) nor Prof Liebowitz: Anatomy of a train wreck or New evidence on the foreclosure crisis.

It is fascinating as the "debunking" has been done by people who have not completed any empirical research on this topic.

On an anecdotal level, a friend of mine was a finance prof at UW Seattle and on the side was a director of Seattle based bank that was in the mortgage business. Prior to my presentation to the Financial Armageddon "conference" at Carleton in Fall 2009 (where Nick Rowe presented as well), I asked my American friend, "what the hell were you guys doing in approving all that garbage i.e. sub prime mortgages. His answer was that they were warned by the regulators to ensure that a certain percentage went to low income citizens (per the CRA).
In fact, it was my friend who provided me the insight that the American commercial banks substantially increased their securitization of mortgages after the CRA was passed to "get rid of these hot potatoes" - because they knew the subprime mortgages being approved was junk. Unless you believe that a person who spent years as a Mortgage Manager suddenly overnight forgot how to distinguish between strong and weak mortgage applications.

Please read the Forward to Gretchen Morgenson:
More Americans should own their own homes, for reasons that are economic and tangible, and reasons that are emotional and intangible, but go to the heart of what it means to harbor, to nourish, to expand the American Dream. —William Jefferson Clinton, 42 president of the United States, November 1994
The president of the United States was preaching to the choir when he made that proclamation in 1994, just two years into his first term. Facing an enthusiastic crowd at the National Association of Realtors' annual meeting in Washington, D.C., Clinton launched the National Partners in Homeownership, a private-public cooperative with one goal: raising the numbers of homeowners across America.
Determined to reverse what some in Washington saw as a troubling decline of homeownership during the previous decade, Clinton urged private enterprise to join with public agencies to ensure that by the year 2000, some 70 percent of the populace would own their own homes.
An owner in every home. It was the prosperous, 1990s version of the Depression-era "A Chicken in Every Pot."
With homeownership standing at around 64 percent, Clinton's program was ambitious. But it was hardly groundbreaking. The U.S. government had often used housing to achieve its public policy goals. Abraham Lincoln's Homestead Act of 1862 gave away public land in the nation's western precincts to individuals committed to developing it. And even earlier, during the Revolutionary War, government land grants were a popular way for an impoverished America to pay soldiers who fought the British.
Throughout the American experience, a respect, indeed a reverence, for homeownership has been central. The Constitution, as first written, limited the right to vote to white males who owned property, for example. Many colonists came to America because their prospects of becoming landowners were far better in the New World than they were in seventeenth- and eighteenth-century Europe.
Still, Clinton's homeownership plan differed from its predecessors. The strategy was not a reaction to an economic calamity, as was the case during the Great Depression. Back then, the government created the Home Owners' Loan Corporation, which acquired and refinanced one million delinquent mortgages between 1933 and 1936.
On the contrary, the homeownership strategy of 1994 came about as the economy was rebounding from the recession of 1990 and '91 and about to enter a long period of enviable growth. It also followed an extended era of prosperity for consumer-oriented banks during most of the 1980s when these institutions began extending credit to consumers in a more "democratic" manner for the first time.
Rather than pursue its homeownership program alone, as it had done in earlier efforts, the government enlisted help in 1995 from a wide swath of American industry. Banks, home builders, securities firms, Realtors—all were asked to pull together in a partnership made up of 65 top national organizations and 131 smaller groups.
The partnership would achieve its goals by "making homeownership more affordable, expanding creative financing, simplifying the home buying process, reducing transaction costs, changing conventional methods of design and building less expensive houses, among other means."
Amid the hoopla surrounding the partnership announcement, little attention was paid to its unique and most troubling aspect: It was unheard of for regulators to team up this closely with those they were charged with policing.
And nothing was mentioned about the strategy's ultimate consequence—the distortion of the definition of homeownership—gutting its role as the mechanism for most families to fund their retirement years or pass on wealth to their children or grandchildren.
Instead, in just a few short years, all of the venerable rules governing the relationship between borrower and lender went out the window, starting with the elimination of the requirements that a borrower put down a substantial amount of cash in a property, verify his income, and demonstrate an ability to service his debts.

[name_withheld]

I'll outsource to some people who have done a lot of empiricial research into the CRA's role in the housing crisis:

Barry Ritholtz (Big Picture) http://www.ritholtz.com/blog/2009/06/cra-thought-experiment

Federal Reserve Governor Randall Krozner: http://www.federalreserve.gov/newsevents/speech/kroszner20081203a.htm

SF Fed Economists: http://www.richmondfed.org/conferences_and_events/research/2008/pdf/lending_in_low_and_moderate_income_neighborhoods.pdf

If you read the above (particularly the Fed pieces) and are still convinced the CRA is to blame, then there is no hope for you.

[Nick Rowe]

This is from Ian Lee. (He tried to post, but it refused to accept it. That happens to me sometimes. I log out, then log back in again.)

Agreed, there have been several Fed publications arguing as you, Ritholz and Krugman argued, that the CRA did not cause or motivate or ensure that any sub prime mortgages were approved due to the CRA.

So lets return to first principles & the CRA itself & then move forward with some questions - not answers.

Philadelphia Fed, 2008: "Enacted by Congress in 1977, the CRA requires bank regulators to encourage insured depository institutions, to help meet the credit needs of their entire community, including low- and moderate-income areas. The CRA requires federally regulated and insured financial institutions to show they are lending and investing throughout their assessment areas, which are defined by the banks as areas in which they accept deposits and make a majority of their loans.[3] One of the main principles behind the CRA is that banks and thrifts benefit from the deposits of low- and moderate-income households; in return, they should open access to credit in these communities.

From the Dallas Fed, 2009: "By opening access, the CRA enables creditworthy low- and moderate-income individuals to become part of the financial mainstream. Since its passage, the CRA has leveraged an estimated $4.5 trillion in these communities and helped to create jobs, develop small businesses and make mortgages accessible.[4]

Ian's synthesis: The CRA was first passed (without regulatory teeth) in the Carter Administration in 1977, in an attempt to stop banks from "redlining". It was amended - with regulatory teeth - in 1996 during the Clinton Administration.

What banks? Commercial banks (not investment banks) as the 6,000 commercial banks across the US grant mortgage loans, consumer loans and small business loans.

Banks try - using databases, credit scoring, job checks, credit checks etc. - to lend money to people who will repay the loan. Inter alia, practices of redlining developed of refusing to lend to people from poor communities e.g. high percentage of renters, low average income, seasonal and high employment et al.

(I redlined all the time when I was in the bank. We would not lend to people on welfare or those living in subsidized housing projects or in Vanier which in the 1970s was known for drugs and other high risk activities).

The not CRA critics fully acknowledge that yes, the CRA was designed to stop these bad, horrible practices (of using risk metrics and proxies to minimize losses).

BUT critics implicitly argue the CRA was an abject failure - because it did not cause or influence any bank anywhere in the US to make any mortgage loans to any low income borrower in low income neighborhoods - the express intent of the CRA.

Stop for a moment. For the better part of 100 years, American commercial banks approved billions of dollars of mortgages using due diligence & credit underwriting standards developed during that hundred years.

Yet, sometime in the late 1990s - after the passage of the CRA with teeth, several thousand banks across the US suddenly threw out all due diligence and standard underwriting policies and procedures of a hundred years.

And for the first time, commercial banks started to securitize a majority of the mortgage volumes booked - up dramatically from less than 1/3 before 1996 to over 2/3s in the early nought decade. BUT it was not - repeat not - because of the CRA. Not at all. So what caused this change?

1. George W Bush and 2. greedy corrupt banks

In the late 1960s, I used to watch a TV show - Rowan and Martin's Laugh in - with Goldie Hawn and Flip Wilson. Wilson had a character called Geraldine Jones who whenever she was caught doing something bad, said in a high pitched falsetto voice, "the devil made me do it".

In our bucolic innocent past pre 2001 George W Bush, banks were not self interested i.e. "greedy". Greed was a new phenomenon brought by the "devil" himself - George W Bush. This is the "religious" nonsense of the left that is just as fatuous as creationism and similar nostrums on the right.

When a critic provides a credible empirically grounded hypothesis to refute the very substantial empirical research of Calomiris and Leibowitz and the "right wing meme" i.e. the New York Times and Getchen Morgenson - I will pay very close attention. To this point, I have not reviewed a more robust hypothesis - other than the negative "it was not the CRA".

The above is from Ian Lee.

[name_withheld]

Last post, because we are already at the point of talking past each other - but even Gretchen Morgenson and Josh Rosner don't blame the CRA: http://economistsview.typepad.com/economistsview/2011/07/we-do-not-blame-cra.html

[Jim Rootham]

Man, where to start with this one?

First the guy cops to prejudice in lending.

Next he invents a completely fictitious argument to attack. Can he name anybody who made that argument? Conceivable, but nobody I know.

The history of the subprime disaster is very clear. One key was the originate and sell model for mortgage lenders. Once mortgage lenders could sell all of their mortgages they no longer had any constraints on making loans to unqualified buyers. The other key was the ratings failures on Collaterized Debt Obligations. By combining bad debt in opaque ways the merchant banks scammed the agencies, which led to them being able to scam their customers. Ultimately they scammed themselves.

The reason it happened when it did had more to do with financial inventions than the CRA.

At peak 25% of US mortgages were subprime. Did the US banking system really redline 25% of the country?

[ian lee]

Last post, because we are already at the point of talking past each other - but even Gretchen Morgenson and Josh Rosner don't blame the CRA: http://economistsview.typepad.com/economistsview/2011/07/we-do-not-blame-cra.html

Possibly so. Thanks for the reference, as I had not read this piece.

So - now to clarify what I am arguing.

1. Agreed - the Dems did not cause the subprime crisis - for EVERY President since Roosevelt - Dem and Republican - in the annual state of the union address, said to the effect, "it is the right of every American to own a home".

2. the CRA was merely a symbol and a symptom of interference by the US Congress - by both parties - in the housing market. While we should all want vigorous regulatory supervision of all financial institutions - including shadow banking and not just banks - it is massive overreach for govt to contemplate second guessing lending or investment decisions down to a zip code or postal code.

And this brings me to Jim's response who was shocked (like Captain Renault in Casablanca to discover gambling in Rick's casino) to discover that banks "discriminate - with prejudice" against high risk customers.

Yes - and auto insurance firms charge high insurance premiums to young men and life insurance firms will not insure a pre existing condition and if you declare bankruptcy, it is very difficult to obtain credit ... Indeed! As they say in Quebec, "mais voyons en donc!"

Bank managers are promoted - for a number of reasons - including importantly, achieving or exceeding loan growth targets but also achieving delinquency targets. Decisions to reject applicants due to low credit score or low income including welfare income or inadequate assets (assured living in subsidized housing), are based on explicit policies and implicit understandings(i.e. what Polanyi called tacit knowledge) concerning risk characteristics.

The CRA was passed and then amended and as several Fed "branch" research depts noted, the CRA ie Congress, attempted to pressure or require lenders to provide lending monies to lower income people in lower income communities.

And, we do know that large numbers of subprime mortgages were approved from late 1990s to 2008(data in my presentation) and later defaulted.

The fed and others reject that the CRA achieved what it was supposed to achieve. Fair enough.
However, a sub prime crisis did unfold with large numbers of banks throwing their due diligence and underwriting standards out the window.

What hypothesis can logically and empirically explain this?

Jim suggested “innovation” i.e. of securitization. Given that securitization was "innovated" decades before the meltdown in 2008. Indeed, Fanny was created in 1938 to promote and develop a secondary market in mortgages - a precursor to securitization. (at BMO in late 1970s, we sold privately placed securitization bundles of about 10% of our mortgages written annually to pension and life insurance firms).

And we know that American commercial banks granted mortgages for about a century without the subprime problem - in other words they possessed the competencies to approve sound mortgages that did not default.

My hypothesis was a change in public policy - manifested inter alia but not limited exclusively to - the CRA.
This “govt policy intervention” hypothesis – that the US Congress intervened on bi-partisan level to push or require banks to lend to low income people in poor areas - advocated by Prof Leibowitz and Prof Calomiris amongst others, was rejected.

Suggest a more compelling hypothesis supported empirically.

[ian lee]

Jim - one more quick point on the innovation hypothesis, as I have come across this explanation on several occasions in the last 3 years, to explain the collapse in underwriting standards and thus the sub prime crisis.

When we securitized a percentage of our mortgages annually (we knew far in advance that it would occur as it was a policy) we were often nervous, as we thought, "what if one of the mortgages is a lemon that goes delinquent - they i.e. Sun life, will think we are trying to stiff them:". IF you want repeat business, you are not going to stiff your customer.

Securitization should - ceteris paribus - ensure HIGHER underwriting standards - not lower credit standards because when the customer eg investment bank or pension fund discovers that you sold them garbage, there will be serious push back and a loss of a customer. That is a negative outcome for a career banker.

What is the logical relationship between financial innovation producing securitization and lower underwriting standards?

What explains the abandonment of years of practice, experience and knowledge by several hundred thousand career mortgage managers across the US?

And given that the Fed acknowledged the express intent of the CRA in several research publications, if indeed it was a complete failure across the US in achieving what the CRA was supposed to do, why was the act a failure? i.e. why did the bank inspectors not enforce what they were required to enforce in the 1996 CRA? Who was guarding the guards?

These are the questions that are not being asked or addressed.

[Determinant]

Ian:

Did you give equal consideration to prepayment risk? My virtue of exercising the prepayment option on a mortgage deprives the bank of interest. In basic finance books this is explicitly stated as a characteristic risk of mortgage securities vs. government bonds.

[Patrick]

Ian: I don't know anything about CRA specifically. Based solely on what you've claimed above - that 'CRA with teeth' forced banks to lend to people they wouldn't otherwise have lent to - then I would expect that there are documented cases of regulators taking action or sanctioning banks in some way. Did this in fact happen? Are their documented cases of litigation (for example)?

Off the cuff, I'd say the causation ran the other way: bankers wanted something, anything to wrap in glossy prospectus and stamp AAA on, and any regulator who dared get in the way was run out of town (see Born, Brooksley).

[Ian Lee]

Determinant - prepayment risk was and is always there, which is why banks in my time in banking (70s and early 80s) charged a 6 month prepayment penalty (which was only waived if the mortgage was being renewed for a larger amount or due to foreclosure because under the relevant legialtion, once in foreclosure, a lender cannot recover prepayment penalty).

Based on anecdotal evidence today, it is my understanding that the Cdn banks today are charging larger amounts of prepayment penalties to compensate for the lost income when the mortgage is prepaid (the prepayment risk you noted). But that risk has always been present - typically excercized by professionals who move from one city to another necessitating the sale of the home.

Patrick - you ask good questions.

Leibowitz in his most recent research found: "The analysis [of McDash analytics with over 30 million mortgages] indicates that, by far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home. The accompanying figure shows how important negative equity or a low Loan-To-Value ratio is in explaining foreclosures (homes in foreclosure during December of 2008 generally entered foreclosure in the second half of 2008). A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures".

"To be sure, many other variables -- such as FICO scores (a measure of creditworthiness), income levels, unemployment rates and whether the house was purchased for speculation -- are related to foreclosures. But liar loans and loans with initial teaser rates had virtually no impact on foreclosures, in spite of the dubious nature of these financial instruments".

Source: "New Evidence on the Foreclosure Crisis: Zero money down, not subprime loans, led to the mortgage meltdown", July 3, 2009, WSJ

Re your comment: "I'd say the causation ran the other way: bankers wanted something, anything to wrap in glossy prospectus and stamp AAA on it".

Yet, although securitization had been around for decades, the motive you hypothesize did not occur previous to the late 1990s. Moreover, as I noted above, why would any business manager in any credible (not fly by night) business want to shaft his customers, thereby ensuring zero repeat business thereby contradicting the self-interest argument.

The causal question remains: if the collapse of mortgage underwriting standards was not caused by a change in US Govt policy manifested in the CRA (and related policies of HUD, Fanny et al), what caused the change in behaviour of century old mortgage underwriting practices? What was the causal factor that caused the 180 degree in underwriting in the late 1990s?

A really clever research project would be to examine the mortgages written from say 1998-2008 by US commercial banks and divide them into two populations: the 2/3 that were securitzed and the 1/3 that were retained on the books. Was there a differnece in eg down payment, credit history, mortgage default rates?

Another research set - to try to answer Patrick - would be to examine the bank inspector reports from before 1996 to after 1996 to see if references in these bank inspection reports were made to the duty imposed on banks (per the CRA) to lend to low income people in low income neighborhoods. If so, how was it measured? using census income data by zip code? and waht were the thrreats - if any - recommended or imposed by the bank inspectors.

Last point - the Dallas Fed in 2009 said:

"By opening access, the CRA enables creditworthy low- and moderate-income individuals to become part of the financial mainstream. Since its passage, the CRA has leveraged an estimated $4.5 trillion in these communities and helped to create jobs, develop small businesses and make mortgages accessible.[4]

Did not the Fed, Krugman, Ritholtz et al agree that mortgages were NOT granted because of the CRA - what then is the "$4.5 trillion in these communities ... to make mortgages accessible"?

[Nick Rowe]

Ian: CRA is not something I have researched in any depth. Not my country, and not my area. My sense is that CRA was bad policy, but I think that things would have unfolded in much the same way even without the CRA. Other countries (England, Ireland, etc.) had similar problems but no CRA. Thoughts?

[Ian Lee]

Nick - yes, I agree completely.

It brings me back to an earlier comments I made. The CRA is merely a symbol or an expression of the intent of policy makers to attempt to micromanage lending down to a zip code, without understanding the multiple variables that factor into a business loan or mortgage credit decision. I am not trying to suggest that the credit decision is mysterious and unfathomable. Rather, it is analogous to the grading system in university Appeal Committees (I sat for the last 3 years on the Grad Appeal Cmte - which acts prudently concerning second guessing the professor being appealed, for that professor possesses vastly more contextual knowledge concerning the student from his/her class behaviour).
If the US Congress had been worried about racism as the underlying social ill, they could rely on the Civil Rights Act and the plethora of anti racism statutes passed, to punish behaviour of this type.

But to return to your larger point, yes, any country can have a similar mortgage finance crisis without a CRA. All a country need do is reduce the minimum required down payment to obtain a mortgage - for as Stan Liebowitz showed in his empirical research and I know from banking data and my own previous banking experience, the single most important predictor of mortgage default is low or no equity.

Last year, I testified before the House of Commons Finance Cmte and urged them to recommend increasing the minimum down payment for a high ratio mortgage to 10% and to recommend reducing the amortization from 35 years to 30 years maximum. I was also invited to one of the Finance Minister's pre budget consultations and I recommended the same policies.

Needless to say, the housing development industry and the real estate brokers vehemently disagreed, for it would significantly reduce sales they argued. I cheerfully agreed that it would indeed decrease sales, as it would increase the "barriers to entry", i.e. the threshold to owning a home.

Ironically, anti-poverty groups agreed with the developers and brokers as increasing the DP would involve, they argued, "discrimination against low income people". To which I responded, the only person who has the "right to own a home" is the person with the required down payment who can afford the monthly PIT payment AND monthly utilities AND ongoing maintenance of said home. Yes, indeed, it is true that not everyone can afford to own a home. But then not everyone can afford to own a Porsche or a Volvo - like me (as I am a poor professor!).

But this brings us to the front door of the CRA or equivalent statutes of social engineering that try to gerrymander the financial rules.

I wished instead, these advocates would lobby for a National Securities Regulator or to bring provincially regulated pensions under the exclusive regulatory supervision of the Govt of Canada so that capital markets, deposit taking institutions, pensions and all shadow banking would be regulated by one federal authority.