Canada’s largest bank warned the country’s real estate markets are approaching systemic risk. Not credit risk, banks are more than adequately protected. Instead they see it as a risk for the whole darn economy. RBC senior economist Robert Hogue, who isn’t a traditional bear, warned the market is out of control.
Canada’s nurturing of the housing bubble created buyers that don’t see risk. Instead, they now firmly believe policy will be used to prevent prices from ever falling. This has created a once-in-a-generation build up of moral hazard, now threatening the whole economy. All for 400 sqft condos, eh? Spicy. Let’s dive into his recent statements.
Canadian Real Estate Markets “Threaten To Destabilize” The Economy
Hogue didn’t hold back, warning “overheated markets threaten to destabilize the economy down the road if or when a correction occurs, with possible heavy costs for governments. The threat is particularly potent because excessively high price expectations are widespread. Canada hasn’t had a market overheating of this scope since the late 1980s.”
The statement echoes an increasingly popular sentiment — people see no market risk. The only risk they see is not making sweet gains, and having to buy at higher prices. It’s a dangerous game when the average person starts thinking their teardown bungalow is too big to fail. Homeowners think the Government is powerless to their master investment strategy.
Canada Is Increasingly Diverting Capital From Productive Investment
The economist believes this exacerbates a related issue — the misallocation of capital. “Capital used to inflate real estate values isn’t going to more productive purposes in our economy. The misallocation of capital undermines longer-term growth prospects.”
The two issues compound into a very dangerous one — people aren’t just overpaying for housing. They’re diverting money from “productive investment.” That’s a term you’re going to hear a lot soon, meaning one that has productive value such as increasing output. This is opposed to a non-productive investment, that only appreciates due to scarcity. Think diamonds, and Milli Vanilli trading cards.
The lack of productive investment means people are concentrated in a single area. This reduces general economic growth, compounding the risk. If there’s failure in that single area, there isn’t much of an economy to bail it out.
Canada Backstopping Real Estate Prices Will Lead To More Inequality
Hogue also warns of the risk of rising inequality from backstopping the market. “Sky-high property values can exacerbate inequality, widening the divide between haves and have-not,” warns the country’s largest bank. “Exorbitant land prices make it more expensive to build more affordable housing.”
If home prices rise more than the median income of households per year, those that don’t own are locked out. By backstopping markets, those with property receive the benefits of the moral hazard.
This isn’t just problematic for bleeding hearts worried about renters. Young adults drive economic growth, with the highest level of consumption. They are the driver of the economy from the lowest level. If they’re locked out of the market, they move. If enough of them do and take the economy with them, it causes long-term failure of cities. This is a problem more commonly seen in developing nations, than advanced economies. Yet here Canada stands.
Canada’s strategy to help first-time buyers has mostly focused on toxic leverage. Extending mortgage lengths, second state mortgages, and lowering down payments are examples. They’ve also used developer subsidies to add middle class supply at non-market rates.
Let’s assume this is well intended, but address how bad of an idea it has been. This reinforces a higher price floor, creating even more moral hazard. Prices don’t need to fall, the government will top people up, pushing them higher. Earlier this week, the IMF suggested Canada should stop this for the same reason Hogue is suggesting — inequality.
Okay, Bob — What’s The Fix?
The economist suggests, “policymakers should look at a range of options to discourage speculative activity as this could generate further volatility.” He cites New Zealand’s approach to phasing-out mortgage interest tax deduction, to be “interesting.”
“Policymakers should put everything on the table, including sacred cows like the principal residence exemption from capital gains tax,” he suggests. Most likely causing everyone in the real estate industry’s blood to boil. “These considerations will be complex, controversial and no doubt fraught with unintended side-effects.”
“Policymakers should put everything on the table, including sacred cows like the principal residence exemption from capital gains tax”Robert Hogue, RBC Economist
Many policies, like capital gains exemptions, were designed when interest rates actually increased. RBC believes “policy support for homeownership needs to be recalibrated,” for the Bank of Canada’s commitment to keeping interest rates low for an extended period of time.
Currently, “many Canadians believe the policy environment guarantees property values will rise indefinitely.” The bank suggests, “governments should take a broader look at the support they provide to home ownership, and the degree to which it contributes to extrapolative price expectations.”
Less eloquently explained, they are suggesting Canada adopts prison rules. Demonstrate to households that risk still exists, so other people stop f*cking around. They also suggest more strict stress tests, raising minimum down payments, and lowering the cap on refinancing. All things you would never imagine a bank suggesting, but they just did.
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