Читать книгу When the Bubble Bursts - Hilliard MacBeth - Страница 8

The Elephant in the Room

It thus seems likely that the rise in private sector debt was the fundamental cause of both the great depression of the 1930s and the recent great recession.

— Andrew Smithers, The Road to Recovery[1]

How does one explain the boom in Canadian home ownership and housing construction and the nation’s top world ranking in housing prices? In a word: debt. Lots of it, in fact, provided under generous terms allowing total private debt to grow at an unprecedented and unsustainable rate. Private debt is made up of household debt and nonfinancial business debt, split about evenly between the two types.

The total amount of household debt grew at a breathtaking pace, made possible by eager cooperation from banks that provided credit on easy terms at lower and lower interest rates. In the short-term, speculation using cheap credit can overwhelm income and household formation as drivers of demand for housing — and that is what’s happened in Canada; the exponential growth in credit has overwhelmed the normal housing cycle. We can see from Figure 2.1 [2] that total private sector debt went from about 100 percent of GDP to 200 percent of GDP, a doubling of debt enabled by a bubble in house prices and government-sponsored insurance for lenders.

Homes are bought with credit or borrowed money, in the form of mortgage loans from banks or other lenders. If house builders had to wait for first-time house buyers to save the entire purchase price before buying, they would all be out of business and the housing market would be mostly for renters. As collateral for the loan, the lender takes a mortgage that contains a repayment schedule and lodges a caveat against the title of the property. The lender — in Canada it’s often a bank — collects a monthly payment for the term of the mortgage. As the owner-occupant makes payments the principal gradually declines and the equity or level of ownership grows and the mortgage value shrinks. With rising house prices growth in the owner’s equity is the rule. But occasionally a borrower gets into trouble after losing a job and fails to pay the mortgage payments for a couple of months. Then the lender can initiate a process to seize the property known as foreclosure. The debt is written off and the title for the property is transferred to the bank.

As the housing market continues to inflate over the credit cycle, bankers become more and more comfortable with the mortgage-lending business. They compete to make mortgage loans, and they relax their standards when calculating who qualifies for these loans. Two examples of relaxed standards are the inclusion of two incomes in the household when calculating qualifying income for the mortgage debt servicing ratio and the adjustment to 20 percent (down from 25 percent) for the minimum down payment to avoid buying insurance from CMHC. While these changes were made years ago they exemplify how banks become less worried about potential defaults as the cycle progresses. Economists categorize this process of loosening and tightening credit over the real estate cycle as pro-cyclical (meaning, factors such as the credit cycle tend to exaggerate the highs and the lows of the housing cycle, turning up the heat on housing prices near the top and causing an even deeper downturn during the lows). Pro-cyclical swings during the cycle happen because humans make the decisions to extend credit (approve a loan) or to deny credit. While it would seem plausible that bankers would make clear choices based only on hard and fast rules regarding the amount of risk involved in a loan, it doesn’t work that way. Bankers become optimistic about the economy near the top of the cycle and approve loans that they should deny during the frothy periods. And at the bottom of the cycle, when business is slow, bankers become very cautious and fearful of making a mistake that might cost them their job, at a time when jobs are scarce. So during those times, bankers are reluctant to approve loans even when all the proper collateral and income support is there. Bankers get too optimistic during the good times and too pessimistic during difficult times. So the bankers contribute to the excesses, both at the top and at the bottom of the cycle. In a perfect world, bankers and government leaders would know enough (and have the will) to restrain the credit cycle at the top to resist the formation of bubbles. As we shall see, we live in a world that is far from perfect.

As David Graeber describes in Debt: The First 5,000 Years, the cyclical nature of lending has been with us for millennia. He details the problems in feudal society when farmers got into too much debt and a downturn in the economy arrives, “…especially in years of bad harvests, the poor became indebted to rich neighbours or to wealthy moneylenders in the towns, they would begin to lose title to their fields and to become tenants on what had been their own land, and their sons and daughters would be removed to serve as servants in their creditors’ households, even sold abroad as slaves.”[3] In Canada today we have milder rules about bankruptcy and seizure of property in the event of failure to pay debts, but the cycle of lending and default remains.

A dramatic example of the pro-cyclical nature of the lending business comes from the last Canadian real estate crash, which occurred around 1990. A large private company known as Olympia and York, headed by Paul Reichmann and based in Toronto, went on a building and buying spree of real estate assets and publicly-traded companies. They built First Canadian Place in Toronto, the World Financial Center in New York City, and they bought non-real estate companies such as Gulf Canada Resources and Abitibi-Price. They invested billions of dollars, almost all of it borrowed from banks. O&Y started a real estate development in London, England, called Canary Wharf. When the slowdown came, O&Y went into bankruptcy, leaving billions of dollars of debt unpaid. Banks had lent massive amounts of money to O&Y, falling over each other to compete to provide more credit at the height of the boom. It came out after the fact that O&Y had convinced some banks to lend without even seeing the company books!

Of course, nothing like that would ever happen in a period of tight credit when bankers are being careful in their lending. Lending without careful auditing beforehand only happens in overheated markets when banks are fearful of missing out on new business. So the cycle gets exaggerated at a peak by reckless bankers who lend more money than they should to people that are taking too much risk. And this causes the excesses of the highs and lows in the cycle to become even more stretched. The preferred ideal way of managing things would be “counter-cyclical” where lenders would lean against a booming market by saying no more often when things are overheated. But that just doesn’t happen.

Speculative tendencies and pro-cyclical fluctuations have had an impact repeatedly in history, in many different decades and geographic locations. Canada is part of this worldwide trend. Think tulip bulbs and dot-com stock market bubbles as parallels for this boom, rather than real demand driven by income growth, household formation, and immigration.

Figure 2.2 [4] shows how Canadian households added more debt from 2005 to 2009 at a rate that has no historical parallel.

In his book, The Next Economic Disaster: Why It’s Coming and How to Avoid It, Richard Vague describes the danger of a rapid expansion of private sector debt. He suggests that the doubling of U.S. mortgage debt from $5.3 trillion in 2001 to $10.6 trillion was the “immediate cause of the 2008 crisis.”[5]

The U.S. mortgage market, just prior to the 2008 crisis, was the largest market of any credit instrument in the world. Their mortgage market was twice as large as their total federal debt. Canada’s mortgage market grew to $1.2 trillion in 2014, expanding rapidly since the 2009 crisis making the Canadian mortgage market twice the size of Canada’s federal government debt. On an adjusted basis, using a 10-1 conversion for the relative size of the two countries, Canada’s mortgage market is the same size as the U.S. market was just prior to their crisis.

Vague postulates that any “major economy” that has “growth in private debt to GDP of at least 18 percent in five years combined with an overall private debt to GDP ratio of 150 percent or more means that a crisis is likely.” We can see from Figures 2.1 and 2.2 that Canada meets both criteria with room to spare with an increase of more than 30 percentage points from 2004–09 and a total private sector debt of almost 200 percent. Vague points out that other analysts tend to focus on government debt while ignoring private sector debt. But it is the “over lending” to the private sector, both household and non-financial corporate borrowers, that caused the crisis, not the stock market crash or subprime mortgage collapse that incorrectly gets the blame.

At some point Canadians will shift, voluntarily or involuntarily, from piling on more and more debt to trying to reduce their debt obligations.

If Vague is right, there will be an economic crisis, followed by a period of painful debt reduction or deleveraging.

It is going to be a very tough slog for Canadians and the economy once consumers stop adding to their pile of debt and start focusing on paying it back. This change from adding debt to trying to reduce debt obligations will happen but there will need to be a catalyst event. It will happen when one of these trigger events occur: first, if interest rates rise by enough to squeeze the monthly payment cushion; second, if there is a recession and people lose a job or worry about losing a job; or third, if the housing bubble bursts and people lose their enthusiasm for speculation in the housing market. Or perhaps the inflection point will be a Minsky moment, as described below.

Financial Instability and the Minsky Moment

Hyman Minsky (1919–1996) was an economist who studied the credit cycle and booms and busts in asset prices. Minsky believed that the credit cycle made the booms and the busts worse, because lenders become more willing to extend credit near the top of the cycle and try to withdraw it at the bottom of the cycle.[6] The boom phase that Minsky described portrays what has happened in the last fifteen years in Canada, with the cooperation of eager borrowers, speculators, the Canadian banks and other lenders, the Canada Mortgage and Housing Corporation (CMHC), private mortgage insurers, and two successive Canadian governments, all of which have combined to exacerbate the normal housing cycle into an overheated housing boom. The late finance minister James Flaherty had introduced some restrictions during his tenure designed to slow the growth rate of debt but those measures were not, by themselves, bold enough to reverse the boom phase. Minsky described this type of euphoria state that precedes a collapse in asset prices, withdrawal of credit, and significant damage to bank balance sheets.

The lending cycle, as outlined by Minsky, grows slowly at first, developing gradually as increased borrowing by businesses and households continues to be supported by rising asset prices, incomes, and expanding balance sheets. This he called “hedge finance.” As the cycle continues banks are seduced into expanding their lending business by the rising values on the collateral side (houses are collateral) and the very low level of defaults. Borrowers are comforted by their ability to borrow more and more, often borrowing enough in new loans to pay off previous loans and the interest on those loans too. This second phase he called “speculative finance.” As long as borrowers have sufficient cash flow to pay off the interest and qualify for new loans when it comes time to rollover existing loans, the cycle continues. Often governments and central banks contribute to the growth and add to complacency by relaxing the standards for bank loans and leverage ratios for banks. Financial innovation becomes rampant with clever participants finding ways around any rules that put limits on the amount of borrowing.

The irony is that the longer the lending cycle and the related boom in asset prices continue the more comfortable, complacent, and confident the participants become. Individuals who were originally reluctant to borrow large amounts become willing to take on larger loans; the ease with which the interest payments are covered, and the loans are rolled over into new loans, convince them that there is no danger. Lenders, who should know better, are also lulled into complacency by the feeling that there is a permanent upward trend in asset prices. This last phase, when eventually receipts are insufficient to cover interest payments, he called “Ponzi finance.”

Minsky called his ideas the “financial instability hypothesis.” In lay terms, his theory suggests that the financial system swings between robustness and fragility – swings that are in tune with the business cycle and the credit cycle. Instead of trending towards equilibrium, the system swings between boom and bust. His theory did not gain a large following in the beginning, as he was in the shadow of more famous economists and defenders of free market ideology (such as Milton Friedman) who argued that markets, if left alone, would tend to equilibrium.

Minsky pointed out that the longer a trend continues without interruption and without a significant negative shock the more convinced people become that it will continue forever. In the current period in Canada, which extends back to the early 1990s without a major crisis, real estate speculators, foreign investors, and most Canadians have come to believe that house and condominium prices will continue on an upward trajectory indefinitely. This belief, as odd as it seems to some of us, is widespread among speculators, homeowners, and especially young adults. I can imagine asking a hundred people on a busy downtown street in Toronto or Edmonton a question like, “Is housing a good investment?” Alternatively, how about this: “In the long run do you think house prices will rise?” or “Is it a good time to borrow money to buy a house?” The answers, I am sure, would be: “Yes,” “Yes,” and “Yes.” A similar survey taken in the United States after the housing crash of 2007–09, or in Canada after the real estate crisis of the early 1990s would get responses with a more mixed outlook, including some very negative views on the future of real estate.

An unqualified belief in housing as an investment (which really means a belief that house prices will rise indefinitely) causes many people to take out bigger and bigger loans, which invariably means larger risks. However, Minsky would point out that, as the credit cycle extends in time, the system is also becoming more and more fragile while complacency grows, leading to the inevitable crisis.

The term, “Minsky moment,” started to gain popularity when, in the summer of 2007, two New York–based hedge funds collapsed. The funds specialized in subprime mortgage-backed derivatives and were run by Bear Stearns, a global investment bank and brokerage firm based in Manhattan. Bear Stearns had been named “most admired” firm in the securities division of a Fortune magazine survey for two of the previous three years prior to 2007. The start of the global financial crisis, can be traced back to the collapse of these funds, named the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leverage Fund. Both funds were based on subprime loans to highly indebted people with poor credit histories that were acquiring residential real estate at elevated prices, although you couldn’t tell that by their exotic names. The funds specialized in a type of derivative called a collateralized debt obligation (CDO).

Bear Stearns, the sponsor of the funds, folded on March 14, 2008, after eighty-five years as one of the top U.S. financial institutions. The assets of the firm were bought for pennies on the dollar by JP Morgan Chase & Co. and with the help of a government guarantee. Minsky couldn’t have foreseen the collapse of those Bear Stearns hedge funds and the worldwide mayhem that ensued, but he would not have been surprised.

The term Minsky moment describes nicely the ultimate crisis that follows a period that starts with complacency, leads to rising indebtedness, and grows to include rampant speculation on borrowed money. At some point, the debt levels become too large and the cash flow from the assets purchased is not large enough to cover the interest costs. However, the lenders realize belatedly that some of the borrowers are unable to cover the interest on their loans and they demand repayment of the loans. But the only assets borrowers have to sell are ones that they have purchased with borrowed money, and once they start to sell them, the value of their assets fall, and more loans get into trouble and the situation spirals out of control. As borrowers declare bankruptcy, the banks seize the assets that were used as collateral, and try to minimize their losses by selling those assets. But if the number of speculators was large and the asset class they were buying was illiquid, the banks will have huge difficulty selling the assets. In the process of selling, the banks will push asset prices even lower — forcing more borrowers into trouble. Eventually, even cautious borrowers who were careful not to stretch their borrowing to the maximum amount find that they are under-collateralized for their loans. At this point, the banks are in trouble since leverage ratios in banks don’t allow for losses of 30 percent or greater in the value of collateral. Once the banks are in trouble, the government must step in to stabilize the situation. This happened in the United States, Ireland, Iceland, Spain, Portugal, Greece, and other countries within the last six years, as a result of situations that were often triggered by excessive borrowing to buy illiquid real estate assets.

In Canada, if a Minsky moment were to arrive in the next couple of years, the government would be heavily involved. More than 60 percent of all mortgages outstanding carry some form of mortgage insurance guaranteed by the Canadian government. As of December 2013 the CMHC had outstanding insurance coverage valued at close to $600 billion (the limit set by government). Genworth Canada, a private mortgage insurance company (56 percent-owned by Virginia-based Genworth Financial), carries up to $250 billion (90 percent government guaranteed) of outstanding insurance obligations, bringing the total of those two close to $900 billion. Obviously, if housing values were to collapse due to a Minsky moment, both of these organizations would run into difficulty. The government would have to step in to fill the gap and cover the losses. If the government didn’t step in, the impact on Canadian banks and the financial system would make the collapse of Bear Stearns and Lehman Brothers seem like a Sunday picnic on a sunny day by comparison. After all, the gross domestic product (GDP) of Canada is only $1.8 trillion annually and there are more than $1.2 trillion in mortgages outstanding plus hundreds of billions of other debt.

The credit cycle, fuelled by the availability of cheap and easy credit, allowed Canadian housing prices to soar and residential construction activity to reach record high levels. Excesses such as these are normal at the peak of a real estate cycle, and reversion to the mean is the rule. Reversion to the mean is a statistical term meaning that observations well above average tend to move back to average and similarly for observations well below average. Every bubble in real estate and property prices that has ever formed has subsequently reverted to the long-term average (mean), and most over-correct well beyond (below) the long-term trend line due to the excessive pessimism that participants develop during the correction.

The housing market peaked in the United States in 2006 at levels that were elevated to an extreme similar to current levels in Canada. The difference is that, since 2006, U.S. home prices have corrected by a huge amount, enough to eliminate most of the excess above the rate of inflation and the bubble completely deflated back to the trend line.

In Minsky’s terms, the U.S. housing market went through all the stage of hedge, speculative, and Ponzi finance, culminating in the collapse of two funds specializing in CDOs and bringing down Wall Street firms like bowling pins. In Canada the finance of houses and condos is in the speculative stage or the Ponzi stage with lots of investors subsidizing monthly payments from other income.

Canadians shouldn’t need to look any further than the financial crisis in the U.S. to see what will be in store for housing markets. However, we know that denial can be unshakeable when it comes to housing. Everyone seems to be an expert and most people have a personal stake in clinging to the belief that house prices can only rise, never fall.

Some Canadians will need more convincing, however, so next we will look at the American Minsky moment as well as booms and busts in housing markets around the world, including Spain, Ireland, and others.

Many people believe that it can’t happen here, or that it can’t happen to me. As we’ll see, not only can it happen, it’s only a matter of time until it does happen.