Should Canada Crash Toronto Real Estate To Stop Moral Hazard From Spreading? Maybe

Canada’s dependence on real estate has homebuyers thinking they’re too-big-to-fail. It’s too dependent on housing to allow prices to crash, so people see it as risk free. Each time a disaster is avoided, the government reinforces the belief buyers can’t lose money. Not a lot of options, they can either support higher and higher home prices or they crash the economy. This is the definition of moral hazard, and few see any other choice.

New research from the National Bureau of Economic Research (NBER) has another solution — let one fail. This is the suggestion in the new paper, Let The Worst One Fail: A Credible Solution To The Too-Big-To-Fail Conundrum. In the paper, two NYU finance profs argue bailouts create moral hazard for banks. It’s not feasible to let the whole financial system fail to teach them risk exists. Instead, the very worst offender should be left to fail each time to send a message. 

Is this a solution that could apply to Toronto real estate? Let’s take a look at the argument.

What Is Moral Hazard?

Moral hazard is created when a risk-taker and a sucker love each other so much, they have a baby. It’s when a party engages in riskier behavior because someone else is responsible. Behavior that would otherwise not exist without the risk mitigation.

One common example is a driver being more reckless due to vehicle insurance. A tenured professor that puts little effort into teaching is another example. In both cases, the party involved in the changed behavior doesn’t have to deal with the consequences. It’s someone else’s issue. The arrangement is said to create moral hazard. 

Bank Bailouts Have Created Moral Hazard

The most notorious example of moral hazard are banks during the Global Financial Crisis (GFC). Governments perceive the economic cost of letting all banks fail to exceed the cost of a bailout. Banks know this, helping them embrace more risk. The risk grew and grew until right before the GFC, when it took out the global economy. Banks were then bailed out and proven right.

After the GFC, governments pledged to put an end to this and reform “too-big-to-fail” banks. This led to greater loan loss coverage rules for systemically important banks (SIBs). The NBER researchers highlight this means banks have greater risk now, in theory. That’s not how investors and the public see it, and the recent pandemic reinforced that.

“The root of the skepticism is that one cannot expect policy makers to let a majority of banks – or even a significant number of large ones – fail at the same time. As a result, the argument goes, the expectation of bailouts will remain and will continue to distort funding costs and feed moral hazard,” read the paper. 

In plain English, the researchers feel it’s impractical to let all banks fail. The cost to society would be higher than paying out the randsome. Governments don’t have the kind of risk tolerance needed to prevent this, and banks know it. Every time they get a bailout, a bank sees fewer opportunities for loss. 

Researchers Say, “Let The Worst Fail” To Send A Message 

NBER researchers argue bailouts inefficiently increase risk-taking, creating “strategic complementarities.” That’s how smart people say the banks YOLO into the same areas to make money. Referencing another NBER study, they explain that banks correlate risk exposure. Borrowers also increase exposure to interest-rate sensitivity, if they know bailouts are coming. Without consequences, they get almost 0% of the risk but 100% of the rewards. Sweet gig if you can get it.

The solution? Let the worst fail. The study suggests a tournament-like model, where the worst are chosen to fail. They suggest the government target their assistance to those who demonstrated the most responsibility. Reckless players, on the other hand, should get controls like limited compensation. Failures are absorbed by the winners, and they all compete for responsible growth.

Essentially, they’re suggesting prison rules for banks. F*ck up the worst one to send a message. If any other bank wants to try to abuse taxpayers, they’ll at least consider this might be their last days as they know it. 

China Might Be Letting Its Worst Offenders In Real Estate Fail

Letting companies that exploit taxpayers fail? What is this, capitalism? It turns out, China might have already adopted the “let the worst fail” philosophy for real estate. Earlier this year, Evergrande was considered too-big-to-fail and engaged in risky behavior. As one of the world’s largest real estate developers, they felt the state would bail them out in an emergency. It didn’t work out that way.

China is smack in the middle of its “housing is for living in, not for speculation” campaign. Consequently, they decided the controlled demolition of the developer would cool housing. The CEO was forced to sell stock and pay over $1 billion of their own wealth to repay debtors. The company’s assets were also chopped up and sold to more responsible players.

Finally, Beijing made its point about Evergrande, and can now bail out the remaining investors, right? Nope. Beijing let the developer default on payments to let others know no one is too big to fail. Risky move, but they spent a fortune to send that message.

China isn’t stupid. They know this can have wide and cascading effects on their economy with a greater cost than a bailout. That’s why they’ve been injecting hundreds of billions into the financial system. A bailout, just not for those that screw around. 

Canadian Real Estate Buyers Think They’re Too-Big-To-Fail

What does this have to do with Canadian real estate? Most Canadians see housing as too-big-to-fail. Not a day goes by where someone doesn’t tell me they see it as a risk-free asset. The economy is too dependent on it, they say — it would be detrimental. Mom, pop, and their $2.1 million Point Grey bungalow that they bought for $60k, thinks they’re too big to fail. They’re even using that money to leverage up and buy more homes. Why wouldn’t they?

US Federal Reserve data shows the Canadian real estate bubble began in 2015. It was driven mostly by Toronto and Vancouver real estate until the bubble popped in 2017. Chinese capital controls, higher interest rates, and a foreign buyer tax all landed. Single-family homes fell ~12% in both cities, respectively. The media wrote about people losing money, home sales fell, and the frenzy was over. Moral hazard was suppressed and people believed in risk. 

In 2018, Canada’s money supply growth began to slow. By the end of the year, the central bank was worried about household vulnerabilities. Those overleveraged buyers in Toronto and Vancouver were too stretched by falling values. 

A few days later, the central bank began to inject millions into mortgage liquidity. This helped cap mortgage rates from rising, and cheap mortgages revived home sales. Most people don’t even remember the correction. One board even restricts agents from showing sale prices from that year now. Moral hazards began building across the country.

When 2020 rolled in, Canada’s first response to the deadly virus was exactly what you’d expect. Politicians sprung into action and sourced PPE. They reviewed the data and monitored the situation carefully. The border was closed and mass testing began at airport terminals. Everyone was on peak alert, and the country prioritized the economy second to people.

Just f*cking with you, they didn’t do any of that. One of their first actions was to cut interest rates three times. They worried that wouldn’t make mortgages cheap enough, so they expanded bond buying. At the same time, they told PPE suppliers they weren’t a priority, turning down N95 supplies. It was all happening too fast — a deadly bug that might prevent people from buying homes was spreading. About a month later, they said to wear a mask. Kind of. 

Bailing out a housing market before it crashed had never been done before. Toronto and Vancouver home prices didn’t drop like the housing agency said they would. They soared to new record highs, regaining the lost ground. They created demand by flooding the mortgage market, a quarter going to investors.

BMO estimates the excess home sales created by the BoC to be an annualized $150 billion. That’s not total home sales. It’s the number of home sales above and beyond a typical market. They were intentionally incentivizing home sales beyond what any normal market would have supported.

The worst players suffered no consequences — actually, they were rewarded. Predictably, this created an epic level of moral hazard. Not just in Toronto or Vancouver, but people in rural Ontario are paying 60% more than they were a year before. Prominent institutional credit agencies warn Canadian home prices are up to 91% overvalued

Still, you’d be hard-pressed to find Canadians that think home prices can fall. Heck, rental prices were even rising along with vacancies in some cities. The average Canadian now thinks a good economy is good for home prices. However, a bad economy is GREAT for home prices.  

Should Canada adopt the “let the worst fail” plan proposed by the NBER researchers? Well, the most overvalued real estate market in Canada isn’t Toronto. That honor goes to Hamilton, with IMF data showing it’s the most overvalued major city in Canada. It also happens to be one of the two real estate bubbles the Bank of Canada currently sees

The problem is, no one knows what the heck a Hamilton is. I mean, most people couldn’t find it on a map, all tucked away… up there? Crashing its home prices wouldn’t send a message of risk, it would look like a small city’s failure. Toronto is the only city in Canada capable of communicating that kind of message. 

Popping The Toronto Real Estate Bubble With Minimal Fallout

How can one pop the Toronto real estate bubble in a controlled fashion, with few consequences? Easy. Just do the exact opposite of what Canada is currently doing. 

The Federal government has responded to higher home prices by facilitating more credit. Experts are 100% in agreement this is how you grow prices, not shrink them. That doesn’t seem to matter.

On top of that, Toronto real estate is eligible for larger subsidies than small cities. Once again, experts are in agreement this is how you increase home prices. You’re forgiven if you think they aren’t even trying.

Cities Around The World Are Doing The Opposite of Canada

Other global cities are taking the opposite approach, and limiting activity. For example, South Korea recently made mortgage borrowing in important cities more difficult. By limiting credit for expensive homes, they’re placing friction above a certain price. It generally takes 12 to 18 months for credit-related changes to show their full impact. 

South Korea may be trying to destroy short-term value, but they realize that’s the short game. If they let home prices run, it can create systemic and demographic issues. More dollars spent on housing means less spent in the city on the things that make them attractive. It’s both arrogant and silly to think there isn’t competition waiting to eat the lunch of these cities with a higher quality of life. Stop smiling, Halifax.

Wuhan, China also recently implemented regional measures to cool home prices. A household is limited to one home and needs to apply for a ticket to buy one, good for just 60 days. If you’re caught trying to buy more, your whole household loses its homebuying privileges. Real estate professionals trying to abuse the system are put on an ominous-sounding “blacklist.”

Not likely to be a popular measure in the West, but it is a regional approach. The point is, cities realize losing young people turns them into retirement villages. High home prices are a brief gift to current owners, but a death sentence for long-term value creation. 

Circling back to Canada, should it crash Toronto real estate to send a message across the country? No idea. But they should at least stop putting in extra attention to boost home prices.



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  • Trader Jim 2 years ago

    The best time to pop a bubble is immediately. The next best time is now.

    Essentially 30% of the population that forgot to buy anything but a home now dictate the whole economy.

  • Ethan Wu 2 years ago

    Have you spoken to the average Canadian? Part of a bubble is no one sees any consequences for any issue.

    “you’ll have to pay more!”

    Okay, and that comes out of spending.

    “well you’ll have to spend more”

    Okay, but where do you work? Unless you’re a real estate agent, this eventually erodes free cashflow in the economy. It’s like the world’s worst run company at the trough.

    • RW 2 years ago

      The finance minister bragged about needing her dad to co-sign a mortgage for a home that was too expensive for her. I think it’s safe to say we have no one responsible at the helm. A bunch of trustafarians.

      • D 2 years ago

        The finance minister has no history in finance, no business degree, no accounting or economics degree, no designation or other qualification like a CPA or CFA and yet she is the the finance minister. Absolutely disgraceful.

  • kevin N 2 years ago

    This article encapsulates everything that’s wrong with Canada. Complete morons like Adam Vaughan telling the public the gov’t will support real estate prices at any cost. Areas of Toronto seeing 30% increases in real estate values in under a year during a pandemic? It’s sick. My wife and I bought in 2003 and I thought wow the prices increases are crazy the last 4 years I’ve been looking. Flash forward 18 years and it’s gone parabolic. As this article has pointed out, everybody has been brainwashed into thinking there’s no risk. I live a block away from thousands of morons who think they deserve townhouses worth 2 million each in the centre of Toronto… these people are TCHC residents. That is public housing.

    The gov’t needs to let the market have a 30-40% correction. Force people into realizing that they need to be careful. Respect value of an asset.

  • Brian 2 years ago

    There are a lot people who wish to be a billionaire buying a house in Toronto. It is cruel to stop their dreams.

  • Arthur 2 years ago

    Lots of options.
    Let’s start with Government and Bank of Canada.
    Inform the public about the repercussions of failing in BofC’s inflation mandate.
    Publish BofC inflation monthly expectations for 2022. Do the math – projecting another failure – get another Board of Governors able to meet their mandate.
    For the whole country’s benefit – RAISE THE INTEREST RATE NOW!

  • JT 2 years ago

    In the area of Toronto I live in the selling prices for homes are tied to the rent that can be collected from the maximum number of units that can be created in the house. Income is not part of the equation at all. In fact, with a 30% down payment you would need a household income of $200,000 to qualify for the mortgage. In 2016 (last census #’s) the avg. household income in the neighbourhood was $80,000 and certainly did not more than double in the last 5 years.

    Yesterday on the local news there were some “experts” saying to increase supply they needed to change zoning rules to allow for duplexes and triplexes in traditional single detached home neighbourhoods. Insights for the “experts”, this has been already happening without approvals for the last 10 years so clearly this is not alleviating the supply issue they keep saying is the problem.

    Moral hazard is so widespread in the market I don’t know how it can possibly spread further.

  • Dennis_K 2 years ago

    I really enjoy the elegance of this article’s proposed solution, in light of the NBER paper (I was actually a fan of letting the banks actually ‘fail’ back in 2008 – by having the U.S. government nationalize the top 2 and take 50% ownership in any others looking for ‘help’), but I’m afraid that it wouldn’t be practical to allow just the Toronto or Vancouver markets to fail. After all, a bank is a defined (legal) entity, that can be acted upon – the ‘Toronto real estate market’ is not.

    In that context, would the entire (Canadian) real estate market actually ‘collapse’? As much as I would like to see it happen, I honestly don’t think it will – if only because the reasons for excess liquidity and the presence of non-essential buyers continues to this day. Very low interest rates, the ease of which dirty / black money (both foreign and domestic) is funnelled into real estate (thanks to no anti-money laundering regulation imposed upon lawyers, and the lack of the enforcement thereof on the real estate profession), the ease of which non-domestic capital is funnelled into real estate (again, thanks to the real estate profession having every incentive to do so and no policy emphasis on housing for resident citizens first), and the unregulated (and as well as incentivized) use of residential real estate as a commodity (i.e. speculation, investment, reno-flips, etc. – again, thanks to no policy emphasis on single-family residential housing for resident citizens first), have all lead to pricing that is way out of line of median incomes. No only this, but we have (at least in Ontario) a regulatory structure around the real estate profession that gives them every incentive to foment price escalation without any negative consequence – don’t be naive; there has been no fiduciary responsibility exercised here in any real, on-the-ground sense. So no, without any reigning-in of of the multiple reasons that have led to the crisis, no impending collapse should be anticipated.

    In my personal opinion, if we wanted to ‘send a message’, we need to send real estate lawyers, bankers, real estate agents & brokers, as well as the executives at CREA, OREA and TRREB, to prison for a very long time — while also permanently losing their professional licenses & accreditations — for doing their part in facilitating and fomenting the mess we’re in. Remember – all these folk have profited very handsomely from this mess, while adding little to no value, and in the end being accountable for nothing. So no, you can’t tell me you were ‘just doing your job’ and that you were just taking instructions from your clients – not good enough – you are the experts, you know better, and you had seen the social disaster coming, all the while padding your pockets.

  • SH 2 years ago

    You didn’t mention the mortgage deferrals forced by the government on the banks, a bailout to the overleveraged.

  • Irena Pesula 2 years ago

    I my opinion the whole thing started with rental apartments not been build do good 3 decades.reasonable rental large enough for the family,is the 1th step where people stay and try to save down payment to buy.That first step has been practically eliminated now since existing rentals are scarce and overpriced.This will create huge problem.

    • GTA Landlord 2 years ago

      The apartment rental issue begins with rates falling lower. The amount people could borrow expanded faster than incomes, putting incentive on building condos.

      If rates were higher then rentals would make more sense to build. Stephen has a good thread on this somewhere on Twitter.

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