The Bank of Canada’s nervousness stems more from global uncertainty and its own interest rate policy
By Robert McGarvey : The Bank of Canada is at it again, warning the public about a potential ‘correction’ in the housing market. Senior officials are clearly worried: “The elevated level of household debt and stretched valuations in some segments of the housing market remain an important downside risk to the Canadian economy”.
The Bank is right about one very important part of the problem: Canadian property valuations are being distorted by historically low interest rates. But who’s responsible for that condition? The Bank of Canada.
Despite these distortions, the Canadian housing market is robust and supported by the relatively strong Canadian economy. In addition to solid domestic demand, Canada is a magnet for many of the world’s economic migrants and their marginal demand is driving condo prices up in major Canadian cities.
The real source of the Bank’s angst is the growing disparity in house prices between the U.S. and Canada. But the truth is, structural flaws in the U.S. mortgage market are undermining stability in the U.S. housing market, making the Canadian market appear to be oversold.
Houses play an important role in the wellbeing of Canadians. Homes provide a living sanctuary, the vital foundation for raising a family and for the provision of food, clothing and shelter. But houses do more than provide for basic needs; they are also Canadians’ most important financial assets.
The asset qualities of a house mean its value rises (or occasionally falls) with the economic tides and – more importantly – this value is leverage-able. Consider that the asset quality of a house allows a family to borrow the money to pay for their house by securing that loan against the value of a property they don’t yet own. Without this essential asset quality, very few of us would own houses today.
In addition, the asset qualities of a house allow it to store (in its accruing value) any subsequent investments made to improve the property, such as adding an addition or beautifying the yard.
Naturally many other asset classes have these qualities, but what makes housing markets more stable than most other markets is a unique alignment of interests.
The home mortgage industry has aligned all the important players behind preserving and enhancing the asset value of the property. Homeowners (unlike renters) generally provide care and attention to their valuable property. The banks, as holders of the mortgage, have a strong vested interest in their loan portfolio and the stability of the housing market. Governments at all levels are dependent upon property-owning homeowners – the bedrock of our democracy and the asset foundation for the nation. This alignment of interests and the accumulation of the value it supports shelters the housing market from the volatility seen in many other commodity markets and – critically – from the astonishing weakness that exists in the U.S and other housing markets that have been ‘securitized’ in recent decades.
In the securitization world, banks no longer write mortgages and earn income from the interest. Instead they ‘originate’ loans, providing a variety of fee generating services to homebuyers while processing their loan applications. Having originated the loan, the bank then pools the mortgages and sells them to an ‘issuer’, normally a special purpose vehicle (SPV), set up by a financial institution, often a major Wall Street investment bank. Having pooled and sold the mortgages, the originating bank has no more interest (or risk) in the loan. The Issuers, for their part, recover their costs by repackaging the loans into tradable, interest-bearing securities that are sold to investors. The investors receive fixed or floating rate payments from a trustee, funded from the mortgages, minus, of course, the usual fees and other service charges.
What’s wrong with this picture? Plenty. In a nutshell, securitization has degraded home mortgages in the U.S., converting them from a reliable asset class into a volatile stream of fee generating services.
Loan originators in the U.S. no longer have a banker’s interest in the original purchase; after all, if the loan is not as solid as it should be, well . . . it will soon be someone else’s problem. Securitization is one of the reasons why so many notorious sub-prime mortgages were originated in the run up to the 2008 Financial Crisis.
The critically important alignment of interests and incentives in the U.S. housing market has been undermined. Nowadays no one is focused on the stability of the asset; not the homeowner with their non-recourse loan, not the originating bank whose focus is on generating service fees, not the issuers, whose business is repackaging and selling the loans, not the investment banks which earn substantial fees selling marketable securities to unsuspecting investors. Even Fannie Mae and Freddie Mac, the government sponsored enterprises established to facilitate increased home ownership in the U.S. became big players in the home mortgage service game.
Is the Bank of Canada right to be nervous about the housing market? Of course, but its nervousness has more to do with global uncertainty and its own interest rate policy. Before jumping to conclusions about price ‘corrections’, the Bank needs to consider the damaging effects of securitization on the American market and help Canadians avoid a similar fate.
Robert McGarvey is an economist and co-founder of Genuine Wealth, a Canadian enterprise whose mission is to help businesses, communities and nations mature into flourishing economies and enterprises of wellbeing.
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