Thursday, October 02, 2008

Schiller, Canada's Real Estate Market, and the Worldwide Financial Crisis

Its bemusing to me, to think that anyone thinks that Canada's globalized corporations, including banks, insurance companies and brokerages are shielded from the current financial crisis worldwide.

Its also bemusing to me, that my fellow Canadians are not going to be suffering shortly from this financial crisis, that some call "a crisis in confidence," that some call "a crisis in financial derivatives," that some call "the sub-prime" crisis of the US.

Remarkably, we do not have the "sub-prime" crisis because Canadian's don't get lines' of credit on their homes and spend more than they save (we do).

Remarkably, we do not have the "sub-prime" crisis because we cannot buy a house with 100% financing (we can still until October 28, 2008).

Could our financial institutions play in the derivatives markets (yes)?

And what exactly are the plunges in the TSX telling investors about the sanctity of their financial assets?

Our Bank of Canada Governor, formerly an employee of Goldman Sachs, has overseen the Money Supply, giving us now 3.5% inflation and rising.

How did that happen?

He injected funds like all Central bankers earlier this year, to boost the flagling US economy: in total $600 Billion in "High Powered" money was injected. Inflation a surprise? No. A guarantee.

Robert Schiller, the Arthur C. Okun Professor of Economics at Yale, who studies the housing market extensively, realizes full well that "asset" inflation has absorbed most of the rise in Money supply the Central bankers have over supplied for many years prior with low, low interest rates to "push on a string" the economies of the world, causing many unwise financial decisions, including the period in Canada where you could finance a house purchase 100% through the CMHC or GE Capital.

Well GE Capital has signalled its leaving our market. And the Department of Finance July 9th put an end to CMHC loan's at 100%:

On July 9, the Department of Finance announced adjustments to the rules for government guaranteed mortgages aimed at protecting the strengthening the Canadian housing market. CMHC supports the new parameters and the government’s ongoing efforts to maintain a strong Canadian housing market.

Consistent with the government’s direction, CMHC will no longer be accepting mortgage insurance applications for 40-year amortizations or 100 per cent loan-to-value mortgages on or after October 15, 2008. Those mortgages with a 40-year amortization and the 100 per cent loan-to-value mortgages already insured by CMHC are not affected. CMHC mortgage insurance coverage on these mortgages is good for the entire life of the mortgage.

So Schiller made some comments on the Canadian real estate market and he see's not much difference between the US market (down in excess of 15%) and ours.

For our economy, its coming from the adjustment from asset based inflation we enjoyed, feeling more wealthy, to asset based deflation and price inflation.

For the non-economist, think about money as water (money) being poured into a glass pitcher, and there being two glasses for that water to go into. In Canada, the pitcher has been used to pour into the asset glass. Now its being poured into general prices, and moreover, the asset glass is shrinking, overflowing now with more sellers than buyers in the real estate market at current prices. Where is that overflow of water (money) to go? Prices.

Are the spigots being turned down i.e. interest rates being raised? No.

So what is the expected result? A weakening currency, signifying a troubled country again, with economic problems and a country lacking the leadership to correct these maladies.

How low will the dollar go, as we get more inflation also from a falling currency as most of our consumer goods are imported?

Again, looking at the asset based deflation (securities are included in this category in this post) and price inflation, and the low interest rates still operative at the Bank of Canada, we can expect a below 90 cent dollar, price inflation likely in the 5-8% range shortly, and a deterioration of the employment market.


And since we feel poorer as our homes are not salable at what we think they are worth, we tend to look at the debt we have borrowed against it as an albatross over our necks, increasing financial stress, tightening the spending we have discretion over, and well, surprise we get a full blown recession, if not depression (contraction in the economy v. just a decrement in the rate of growth, still above "0%."

That is called "stagflation" and a phenomenon of 1974 through 1980 until the Monetary Control Act was brought in and Paul Volker had to take severe measures (very high interest rates) against high inflation and a sputtering economy.

Is Canada immune? I don't think so. I think our financial institutions while being conservative in their natures as "Canadian" some must have gone for super normal profits, and have gotten caught with their fly's open.

The question for most home owners is: is this 1990 again? I tend to think it is not, that the asset class in real estate will not shrink as much as the financial asset class. Certainly, Robert Schiller see's otherwise and there are certainly differences between the "Homesteader" laws that allow a person to walk away from their home in some US States, and leave the keys and loss in value with the bank, v. Canada where you are stuck with that debt to the bank (but for Alberta and Saskatchewan I believe). That weak law, that lets someone walk away without penalty, leaving the risk of the depreciation of the value of the home with the financial institution is the US "sub-prime" crisis in a nutshell.

That said, with the feeling of being poorer, some may seek to downsize their homes, and normally we see the weakening of the higher end homes in these types of markets. This is being seen in Canada.

Moreover, affordability in a broad way, will contract demand for homes. Less demand mean builder inventories rise, and construction jobs dry up, and the lack of confidence spreads.

Meantime, the resource based economy out west, is still crying for skilled and non-skilled labour as they have an endless demand for the resources they produce (and locally pollute) from the world at large. Will the "mess" in central Canada, and the required fiscal and monetary policies to cure them, impinge on the growth in the West, or will that very growth mask the regional problems that this country is and will face in very serious ways over the foreseeable future?

For more on Schiller and Real Estate , see here. Schiller homepage at Yale.

Ed. Note: Oddly or not, while I was at the University of Toronto, I worked on the fix to stagflation and inflation as my central focus. Reading Schiller is almost like reading me, while he lacks what tools I developed from the work of his chair's name sake, Arthur C. Okun. In situations such as "stagflation," a Value Added Subsidy is required, the opposite of a Value Added Tax in my opinion. Since our Stephen Harper has stoked the economy with the opposite cut in the VAT, he leaves little ammunition left for stimulating the economy out of the "stag" part of stagflation.

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