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
