How Canada’s big banks pumped up the housing bubble
MacLean's
Kevin Carmichael
10 March 2017
Royal Bank of Canada Chief Executive David McKay flattered some Bay
Street reporters with rare interviews the other day, having just
conducted another clinic in money making by guiding his 148-year-old
institution to a record quarterly profit of $3 billion. What better
time for a banker to subject herself or himself to scrutiny than amidst
a flurry of zeroes?
Judging by the headlines, the scribes were either underwhelmed or
uninterested by what McKay had to say about banking. He made news by
talking about Toronto real estate. Not so long ago, Royal’s chief
executive was fairly sanguine about Canada’s big-city housing bubble.
“We feel good about housing,” McKay said in 2015, even as institutions
such as the International Monetary Fund and the Bank of Canada warned
of trouble. He now sounds uneasy. He flagged for the Financial Post a
“somewhat dangerous mix of catalysts” that are pushing prices higher,
including the rich international buyers that Vancouver chased away last
year with a 15 per cent tax to deflate its housing bubble. “You’re
seeing 20 per cent house-price growth in a market where you shouldn’t
see that much,” McKay said of hometown. “That’s concerning. That’s not
sustainable. Therefore, I do believe we are now at a point where we
need to consider similar types of measures that we saw in Vancouver.”
McKay told the Globe and Mail almost exactly the same thing, so we
should assume the intervention was planned. It surely annoyed the
Toronto Real Estate Board, which on March 3 reported that the average
selling price of a detached home in the Greater Toronto Area was $1.2
million in February, a 32.5 per cent increase from a year earlier. The
board’s president, Larry Cerqua, went on at length in a press release
about how the incredible price increases have little to do with global
plutocrats seeking havens, and almost everything to do with limited
supply and strong demand, especially from first-time home seekers. “To
date, the provincial government and municipal governments have resisted
the implementation of a foreign buyer tax in the absence of empirical
evidence,” Cerqua said (though on Thursday Ontario indicated it might
consider a foreign buyers tax after all). Citing a recent survey of his
members that suggested international buyers accounted for only 5 per
cent of demand, Cerqua added that, “the solution to strong rates of
price growth and related affordability concerns lies not with taxing
foreign buyers more, but rather with addressing the supply of homes
available for sale, or lack thereof.”
It might be fun to hold Cerqua to account; but honestly, there would be
little sport in it. So let’s stick with McKay, given the leaders of
Canada’s banking oligopoly so rarely expose themselves to scrutiny by
the broader public. The Big Six are the beating heart of a financial
system that favours real estate over more productive investment, such
as lending to entrepreneurs. They pushed the cheap, post-crisis
mortgages that have turned Canada into one of the most indebted
countries in the world. There have been no shortage of studies making
this point. Just this week the Basel, Switzerland-based Bank for
International Settlements, or BIS, updated a series of numbers it
considers indicative of financial stress. The BIS tracks four “early
warning” indicators of stress in domestic banking systems, and Canada
was the only country that triggered red lights in three of the four.
Private credit in Canada is 17.4 per cent larger than economic output,
second only to China, where debt is 26.3 per cent greater than gross
domestic product. (The BIS starts to worry when the credit-to-GDP gap
exceeds 10 per cent.) Canada’s property prices are 11.6 per cent
greater than what the BIS calculates as trend, one of the widest gaps
in the world. The calculations also raise questions about whether
Canada could manage a sudden increase in interest rates of just 2.5
percentage points. That’s an unlikely scenario, but the BIS likes to
run the numbers to gauge a country’s ability to make its debt payments.
Only Canada, China, and Turkey tripped the alarm.
In a rational world, the banks could be counted on to help contain the
housing mania that has put Canada in this perilous situation. Before
the early 1950s, Canada’s biggest lenders had little interest in real
estate, according to Charles Calomiris and Stephen Haber, the authors
of Fragile by Design, a highly praised international history of the
interplay between politics and banking. That changed after William Lyon
Mackenzie King created the Canada Mortgage and Housing Corp. at the end
of the Second World War to backstop the construction of new homes for
returning soldiers. Nothing stirs a banker like risk-free lending. By
1954, the banks had convinced the government to change their charters
so they could join the post-War building boom. In 1992, they were
cleared to buy the trusts that were the initial beneficiaries of CMHC’s
backstop, triggering the consolidation that cemented today’s oligopoly.
In November 2015, the average monthly holdings of mortgages at Canada’s
chartered banks exceeded $1 trillion for the first time. The figure
continues to climb, reaching $1.07 trillion in December, according to
the Bank of Canada’s most recent statistics. That’s more than double
what the chartered banks commit to business lending.
Indeed, the banks are clearly aware of the optics of this imbalance—on
Thursday every major financial institution in the land pooled together
to announce a $500 million fund to extend loans to entrepreneurs,
because banks lending to new businesses is now apparently something
worthy of special announcement.
Royal’s stock price is about 36 per cent higher than it was a year ago,
so the chief executive is doing something right. But let’s not make him
a hero for taking on the likes of Cerqua. Besides international buyers,
McKay’s list of “dangerous catalysts” includes ultra-low interest
rates, limited supply, and speculators. He appears to have omitted at
least one big one: himself, and his counterparts at the other big
banks. By attempting to shift the spotlight to international buyers,
McKay diverts attention from Bay Street’s role in inflating the bubble.
The banks have been loading up on mortgages, secure in the knowledge
that the publicly owned CMHC will cover most of any losses. Too
cynical? Let’s ask McKay. You many recall hearing something about the
“short Canada” investment strategy a couple of years ago. Some American
investors observed what was going on in Canada and were reminded of
their recent recent housing meltdown. They took a look at the banks’
bloated mortgage portfolios and decided they could make money on bets
that institutions such as Royal and Toronto-Dominion Bank were headed
for trouble. And for a while the share prices of the banks suffered. In
2015, McKay went to New York with a message for Wall Street. He told an
audience of finance professionals that the speculators who thought his
bank would be severely hurt by a wave of defaults were missing
something about the way finance works north of the border. “What we
keep trying to educate is our first loss is covered by government
guaranteed insurance,” he said.
That comment is one of the clearest articulations you will ever read of
what economists call “moral hazard,” a situation where one party takes
part in a risky transaction because he or she knows his or her losses
will be covered by someone else. A subtle version of moral hazard was
at work ahead of the financial crisis. The U.S. government insisted
that it wouldn’t bail out the banks, but no one believed it, so outfits
such as Lehman Brothers Holdings Inc. carried on as if they had little
to lose. Canada is different in that the moral hazard is codified in
the laws and standards that guide CMHC. We just don’t talk about it
nearly as much as we should.
I am resisting calling McKay a hypocrite because I’m unsure he is one.
His job is to make money for his shareholders, which he does
exceedingly well, and he is only playing by the rules as they exist. So
far, that system has avoided the periodic financial meltdowns that
plague the United States. Meanwhile, CMHC has made hundreds of millions
of dollars from its insurance products, and most of that money ends up
in the federal treasury.
But if McKay and his counterparts in the oligopoly aren’t hypocrites,
they certainly are barriers to change. They have done little on their
own to deflate the housing bubble, and instead call on the government
to regulate prudent home-lending practices that they apparently are
incapable of implementing on their own. You will hear Canadian bankers
talk of the importance of financial stability, yet they routinely have
engaged in price wars to maintain their shares of the mortgage market.
Again, they are doing this because they bear so little of the risk. A
bank executive who failed to exploit risk-free profits to the full
likely would be fired.
It took years, but Ottawa may finally be on the verge of reducing the
moral hazard in home lending. In October, Finance Minister Bill Morneau
said he would explore changes that would require mortgage lenders to
accept a greater share of the pain when mortgages default. Morneau
proposed requiring lenders to pay the equivalent of a deductible,
either a fixed amount or a proportion of the total loss. The Finance
Department currently is holding public consultations of the matter.
The banks, of course, are pushing back. As McKay called for a Toronto
tax on international homebuyers, the Canadian Bankers Association,
pleaded with the government to achieve its goals in a way that wouldn’t
so disrupt the business models of its members. The association, which
represents Royal and the other big banks, suggested allowing private
mortgage insurers to buy reinsurance or allowing the banks to issue
more of a type of bond that bundles home loans into single securities.
These proposals might possibly reduce taxpayers’ exposure to mortgage
default, but they would do nothing to reduce the incentive of Canada’s
biggest banks to push mortgages. Will Ottawa listen to the banks’
entreaties? We’ll likely find out when the budget comes down March 22,
but in the meantime it’s worth noting that the new multi-bank backed
growth fund launched this week is a political creature spawned out of a
meeting between bankers and Morneau in December and has all the makings
of a “sorry” for inflating the housing bubble.
Bankers such as McKay clearly are growing uneasy about the debt monster
they helped to create, but not so much that they are willing to give up
feeding it. The reward from inflating the housing market is still too
great, while it will be the rest of us who will suffer the consequences
if the bubble pops.
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