I feel bad about writing too many abstruse theory posts. How many angels can dance on the head of a monetary pin?
Here's something more practical. Think of it as a companion to Livio's post about Canadian house prices. Why would we worry if Canadian house prices are overvalued? One important reason (though not the only one) is that if house prices are overvalued that is one reason (again, not the only one) to expect they might fall. And if house prices fall, people with large mortgages might have negative equity, and this might lead to defaults, and problems in financial markets.
For American readers especially: let's remind ourselves that Canadian mortgages are mostly recourse mortgages, so you can't just hand in the keys to the bank and walk away from your mortgage to escape negative equity. But nevertheless, if you can't make your monthly mortgage payments (because say you lose your job), the ability to sell your house for more than the mortgage (or for the bank to sell it for more than the mortgage) still matters.
Most headlines about household debt just talk about average debt. As I have argued in the past, average debt is a next to useless measure. This is more than just saying that averages don't tell the whole story ("my hands are burning but my feet are freezing so on average I'm just right"). When it comes to debt, the average tells us even less than it normally does.
For every dollar borrowed there's a dollar lent. Credits=debits. Average net debt (debits minus credits) must be zero by definition (OK, for a closed economy). The representative agent, who personifies the average, does not borrow from himself.
Debt must be disaggregated across the population. Some people borrow from other people. Some have positive debt; others have negative debt. What we need to do is look at the whole distribution of debt across the population. Or, more precisely, we need to concentrate on one tail of that distribution. Concentrate on the people most at risk of default. Those will presumably be the people with the highest debt to asset ratios, or the highest debt service to income ratios. Or, better still, those who have both a high debt asset ratio and a high debt service ratio. Because if things go wrong, they won't be able to make the monthly payments, and won't be able to pay off their mortgage by selling the house.
And I'm very glad to see that Will Dunning, chief economist of the Canadian Association of Accredited Mortgage Professionals, has done just that (pdf).
This to my mind is the most important paragraph in his survey (page 32):
"Thirdly, most of the home owners with mortgages have substantial amounts of
housing equity. Most of those who might face unaffordable increases in mortgage
costs could solve their problems by selling their properties. Among those for whom
the estimated tolerable interest rates are below 5%, an estimated 11% have less than 10% equity. This very small group – representing about 25,000 households – would have the least ease of selling out of a problem. 6% (about 10,000 households) have 10-14.9% equity and 13% (about 25,000) have 15-19.9% equity. A substantial
majority (69%) has 20% or more equity."
In other words, he asks 'how many households are most at risk because they have both a high debt service ratio and a high debt asset ratio?'. And he answers: '25,000 households'. He could be wrong of course. But at least he's asking the right sort of question.
I have no special expertise whatsoever in evaluating Will Dunning's Report. I worry about the response rate to the survey data he relies on, and whether there might be any response bias. But apart from that it looks good to me.
Someone reading this must know more than me. What do you think?
Worthwhile Canadian Initiative 
Great comments Whitfit. While increased home ownership may be a noble policy decision based on a perceived “public good”, whatever that entails, there are tangible downsides including reduced labour mobility.
– It limits government underwriting to 90% in case CMHC defaults. In effect the government is instilling some counterparty risk onto those who use CMHC as a “free hedge”.
– The government can delay payments by up to 2 years, so say the inconceivable happens and CMHC is rendered insolvent by a high number of default claims; claimants can tap Her Majesty’s backstop funds but may only receive 90% of their money back after clearance and may have to wait 2 years.
These two points are shams. Prompt payment of claims is a fundamental point of insurance, otherwise it’s not insurance. The point about the 90% limit on claims is also nonsense. First, when the Northland Bank and Canadian Commerical Bank went bust in 1985 the (Conservative) Governement of the Day stepped in to cover all deposits, not just up to the $60,000 limit that CDIC specified. Deposit insurance in the UK with a 90% limit also failed in the debacle over Northern Rock. These sorts of limits have been refuted in market tests.
– The Ministry of Finance can cut off certain lenders from taking CMHC mortgage insurance policies, from what I can ascertain, on not much more than a whim.
– The Ministry of Finance has access to CMHC’s books and will make them public.
– The Ministry of Finance can cause CMHC to increase capital reserve ratios if it deems it is taking on too much unhedged risk.
They government always had these powers. They are just making them more public. Bit of a yawner if you ask me.
I do take issue with the “free hedge” assertion. We may be talking across one another. The bankers on this thread are asserting a bank manager point of view; I on the other hand have insurance training and come at it from that point of view. In banking interest is determined by the time value of money and the default risk, though loan management means the former dominates the later. If you are an excess risk often you just don’t get a loan, period. Or get it insured, or have a higher downpayment. Interest doesn’t govern default risk as much as many think it does. There are other tools for that.
In insurance we want to take risk. The premium and payout obligations are determined, the actual risk incurred is what forms the insurance counterpart to interest. Banking is more interested in the time value of money, insurance is more interested in default risk (or death, or disability) and doesn’t care so much about the time value of interest. So taking on default risk is what insurance is all about, the corollary is that an insurer should adequately compensated. CMHC has been a net revenue payer to the Crown for decades, so I believe it is charging an adequate premium for its services. Since we are taking risk there is a residual risk that can’t be handwaved away, that risk lies with the government.
Those in the thread who wondered why mortgages aren’t nationalized need to break it down thus: the capital is provided by the bank, the interest is determined by the time value of money. The default risk is ceded to CMHC for a premium. At no time in CMHC’s history has it had to resort to the Crown for excess coverage, though it is macro-prudential that it can. Therefore the system is working. In the beginning in the 1930’s the government did provide direct NHA mortgages, capital and all. It is more efficient and enlarges the pool to its greatest extent if the banking sector provides the capital and the government covers the default risk.
The thing with insurance as compared to banking is that you can’t slice and dice risk too much, else you are not pooling the risk and not actually insuring anything. If you underwrite too strictly you’ll choke the market and not get anywhere, underwrite too softly and you’ll go under. The later hasn’t happened to CMHC in six decades so I’m not seeing the problem.
On a final note, CMHC HAS been successful in its mission of making ownership an alternative to renting. For a payment P you can rent or own, and most families with children and stable incomes choose to own. For example my parents and grandfather were United Church ministers. The United Church requires that ministers be provided with a manse (family-sized house) manse or a housing allowance. Given the United Church’s size and the fact that it serves all of Canada, it forms an excellent point to compare the value of renting vs. owning. In fact the trend given the availability of mortgages is for owning (housing allowance) to dominate over renting (manses).
Determinant: “This also has the happy effect of insulating mortgage defaults from the rest of a banks balance sheet, protecting the broad money supply the Canadian economy uses. This is a critical feature to prevent the Canadian economy generating its own Depression and it needs the sovereign ability to issue money to work.”
I understand the need for governments to step in and underwrite natural and other disasters and this was convincingly advocated by Keynes and others. But debt accumulation is a different beast entirely in that the “disaster” is a consequence of lending and monetary policy. I understand the need for the government to want to influence marginal debt accumulation using CMHC as a vehicle — and the past 5 years have shown how powerful an effect this can be — but I think it a flawed line of reasoning that the potential deflationary fallout from recent asset and debt bubbles justifies the existence of an emergency government backstop for just such events in the first place. Why were debts allowed to inflate to the point where they are considered a significant deflationary risk in the first place?
My concern with a blanket statement that government guarantees on deflationary events are necessary to avoid deflation is that it misses the broader issue, that certain “disasters” are completely avoidable. On this front the absolute government guarantee on mortgage debt appears to have limits, at least after reading the recently read Bill C-3. Your and other’s comments here are timely.
Determinant: That is a very interesting point re: the distribution of roles between the banks and CMHC on capital provision and default risk.
I don’t think I truly appreciated that banks bear virtually no default risk in their investment in Canadian residential real estate. The fact that there have been not major crises in six decades, with such low insurance costs is also interesting. That either means that the system works, or that the kinds of events that would lead to problems have not occurred.
You are certainly correct that the policy goal of having people buy real estate has worked. I am still less than convinced it is all for the good, though.
Sina Motamedi: I didn’t know that the point of coming here was to win – though I will say that I have learned a lot from Determinant and the other posters in this thread, so I will claim to have won 😉 I do believe that is the point – to learn and better understand, not to “win” a thread.
A bit of both. The developed world managed to avoid a general 1930’s meltdown until 2008. Even then Canada repeated our own Depression history by NOT having a banking crisis. Plus claims history has shown that once people reach 20% equity they have very little default risk. The bulk of the risk is concentrated in the 5-20% equity range. This is the segment that banks insure. They don’t insure other loans because the default cost is negligible.
” The government can delay payments by up to 2 years”
If history is any lesson at all, Her Majesty would pony-up pronto in the event of a macro level catastrophe that lead to large scale coordinated/correlated defaults.
I have a hard time believing such a catastrophe is in the card. I’ve never been accused of optimism, so maybe I’m just naive … After all it wasn’t that long ago that it seemed inconceivable that the US would be starring down the barrel of a lost decade. Seems to me that because it isn’t possible to walk away in Canada without the risk of being sued into bankruptcy I really have a hard time imagining what sort of catastrophe would lead to mass coordinated default. It would have to be so bad that people simply don’t care about the risk of being sued. And if it came to that, I think CMHC might be the least of our problems.
Jesse:
The question here is why to bad things happen to good people? We don’t have perfect foresight of our actions. In a system with significant default costs we have to plan for the worst. The flip side is the Total Debt and Net Debt rules that Canadian banks always applied which helped greatly. But so long as we insist on making somebody pay for defaults, we have to find a victim when bad things happen. Insurance is a game of pass the victim.
Not all states have non-recourse loan statutes. Look at Nevada with both the residential and commercial mortgages….one of the worst states affected by the housing bust and Nevada is a RECOURSE state. It still didn’t prevent prices from declining.
@Determinant: “But so long as we insist on making somebody pay for defaults, we have to find a victim when bad things happen.”
I understand the reasoning for, and mostly agree with, the government underwriting correlated events. From what I can tell, while Canada may have not had “subprime” or whatever, there is still the problem of increasing loan exposure via assets that are obviously (in my view) overvalued.
It is incorrect to cite a de facto government guarantee as free license to accept asset bubbles, though I do not think you are explicitly stating this. As I mentioned further up, I see CMHC and the government as begging the question through their policies in the past 5 or so years. Affordability is poor because land prices are high, therefore policy should be designed to improve affordability at current market prices, in part by underwriting mortgage insurance and providing preferred interest rates. It “begs the question”, why are land prices high, exactly?
Jesse: “Affordability is poor because land prices are high, therefore policy should be designed to improve affordability at current market prices, in part by underwriting mortgage insurance and providing preferred interest rates. It “begs the question”, why are land prices high, exactly?”
But, might the high price of land and affordability policies not be connected? I wonder if all we have done is inflated the cost of housing to the maximum that a family’s cashflow can sustain, and maximizing the capital that banks will push into the housing market, because the default risk has been pushed on to the federal government, and thus the mortgage issuers have low to no risk on their balance sheet for those assets. Any move to increase affordability might just push up prices, and have no effect on affordability.
See:
Gordon Tullock, “The Transitional Gains Trap”
Bell Journal of Economics, 1975, vol. 6, issue 2, pages 671-678
Abstract: Many government programs which appear to be designed to help some particular industry or group do not seem to be succeeding. The explanation offered here is that the program, when inaugurated, generated transitional gains for the individuals or companies in the industry, but that these have been fully capitalized, with the result that the people in the industry now are doing no better than normal. On the other hand, the termination of the particular scheme would, in general, lead to large losses for the entrenched interests.
OT nitpik: “Begging the question” is a logical fallacy. “Raises the question” is a new line of inquiry.
http://en.wikipedia.org/wiki/Begging_the_question
@Whitfit: “But, might the high price of land and affordability policies not be connected?”
That’s my point. Justifying the need for a government guarantee so as to improve affordability adversely affected by a government guarantee is a logical fallacy, begging the question.
(Patrick yes that’s why I put “beg the question” in quotes because it both annoys and amuses me when politicians use the dual-purpose phrase. So I raise the question, why are land prices high compared to the utility said land provides, really?)