What goes up… What should we expect? – Part 1

In the 10th anniversary of the Great Financial Crisis, I was chatting with a colleague of mine, who told me that what happened in the US could not happen to Canada. He argued that our banks are better, our politicians and economists learnt from what happened in the US, and this time is different. Unfortunately, that phrase has been used for centuries by people to justify the unjustifiable. Carmen Reinhart and Kenneth Rogoff write:

The essence of the this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply. Unfortunately, a highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstance provoke a crisis of confidence that pushes it off.
Reinhart, Carmen M.; Rogoff, Kenneth S.. This Time Is Different (Kindle Locations 642-646). Princeton University Press.


The best we can do is to learn from our own history and those from other countries and try to understand what could happen in Vancouver, given the anomalously high prices in real estate. We’ll get there, but first I’ll begin discussing debt and where we are for the factors discussed in my last blog posts.

Debt level

As we have now discussed, one very important factor in the high prices has been the access to cheap credit . This chart plots the inflation adjusted teranet index showing some of the changes that made credit more accessible:

Not only was credit easier to get, but also it was cheaper. Interest rates have been dropping for years, as this chart shows:

So credit was cheap, and easy to get, what did people do? They ranked up debt of course! Betterdwelling shows how much household debt has grown in Canada:

The problem with that, is that it is not adjusted by inflation and changes in productivity. So let’s rather look at the household debt to disposable income (that is income after paying taxes). In Canada (where 1/4 people live in Toronto or Vancouver) the debt to disposable income has followed closely the change in house prices:

source

This level of debt is very close to what the level of debt was in the US prior to the Great Financial Crisis:

So we can conclude that people are very indebted. Grabbing an image of Ray Dalio’s excellent video on debt cycles, we have created a situation in which people have acquired a lot of assets with credit that at one time in the future will have to be repaid (or will it be?):

Debt cycles

Ray Dalio’s book on Debt Crises is once again excellent at dissecting the different stages of Debt cycles:

As you saw in the charts above, and as we discussed in our blog post, we have passed the ‘bubble’ stage, we are currently at the so-called ‘top’ of the cycle:

When prices have been driven by a lot of leveraged buying and the market gets fully long, leveraged, and overpriced, it becomes ripe for a reversal. This reflects a general principle: When things are so good that they can’t get better—yet everyone believes that they will get better—tops of markets are being made.
While tops are triggered by different events, most often they occur when the central bank starts to tighten and interest rates rise. […]
Whatever the cause of the debt-service squeeze, it hurts asset prices (e.g., stock prices), which has a negative “wealth effect” as lenders begin to worry that they might not be able to get their cash back from those they lent it to. Borrowers are squeezed as an increasing share of their new borrowing goes to pay debt service and/or isn’t rolled over and their spending slows down. This is classically the result of people buying investment assets at high prices with leverage, based on overly optimistic assumptions about future cash flow. […]
Typically, in the early stages of the top, the rise in short rates narrows or eliminates the spread with long rates (i.e., the extra interest rate earned for lending long term rather than short term), lessening the incentive to lend relative to the incentive to hold cash. As a result of the yield curve being flat or inverted

Dalio Ray. A Template For Understanding BIG DEBT CRISES (p. 21) 
Greenleaf Book Group

Indeed the Bank of Canada has risen interest rates 5 times between 2017 and 2018, which as Ray Dalio predicted, has resulted in a significant slowdown in consumer spending (as of Feb 2019). And again, as Ray Dalio predicted, the Canadian yield curve inverted in May 2018.

Recap of current conditions

Let’s recap all of the factors we’ve discussed so far and where they are right now:

FactorHow it affected the boomCurrent status
Low interest ratesMade credit cheapStill low, but interest rates have gone up 5 times in the last 2 years
Fear of missing outIt reinforced a positive loopCurrent sales in Vancouver have plummeted, reaching low after low in year to year comparisons. See January numbers for example.
Bidding wars have disappeared
Government guaranteesIt enabled lendingCMHC has continuously reduced the access to credit by reducing the amortization periods, capping amounts that can be insured, and increasing requirements for downpayments. Ratespy has a nice table summarizing the changes.
Shadow bankingAllows for mor borrowingPrivate lending is on the rise, just as it was in the US after credit started to become tight.
Tax structureIt was easy to evade paying taxesMany layers of government have instituted changes, from asking people to declare in their taxes the sale of their primary residence, to the creation of a registry for presale of condos.
On top of that all levels of government have created new taxes that are supposed to fight speculation.
The federal government limited the use of the capital gain exemption on primary residence for non-residents. Before non-residents could buy and sell the house within the same year and not pay taxes on the capital gain, not after 2016.
The provincial government introduced a tax in 2016 for foreign buyers of 15%. This went up to 20% in 2018. Besides, the new NDP government introduced a speculator tax (for owners who don’t pay income taxes in BC), an increased the taxes on the transfer of luxury houses and imposed a property tax for houses worth more than 2 million
The municipal government of Vancouver introduced an empty home tax in 2017.
Foreign investmentIt fuelled the boom in 2015-2018China is cracking down on the investments to buy properties abroad. This has impacted Australia and Canada significantly.
Illegal activitiesDirty money flooded Canadian casinos and luxury Real EstateNew BC Attorney General is cracking down many of these illegal activities.

Summary

Canadians have very high levels of debt, that have reached the levels seen in the US just before the 2008 Great Financial Crisis, which started their deleveraging. Credit that was made easy and cheap for a very long time, has tightened. Interest rates have gone up, and more and more regulations have been imposed. Consumer spending has slowed down, the yield curve has inverted, and many of the factors that contributed to the high prices have changed significantly. We can conclude that the boom phase of the cycle is most likely over. In the next part I want to discuss what has happened in the past in other cities in similar cycles, to have a rough idea of what to expect.

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