It’s been a bad few days for the doomers. Houston sinks into a watery morass, taking the energy biz with it and gas spikes. North Korea’s dipstick leader overflies Japan with a missile, Trump erupts, but markets go up and gold shrugs. Canadian housing sputters and limps, but the banks bring in new billions. The US is ripped by race issues and white supremacists, yet consumer confidence rises the most in 17 years.
The American stock market is at a record level, global growth is robust and there’s one thing central banks want for Christmas. Normalized rates. Those people who have spent the last eight years in cash, GICs or precious metals got it wrong. There was no rerun of 2008, nor will there be one. There’s no reason to believe markets will crash simply because the Dow has hit 22,000.
The Canadian residential real estate market represents far more risk than financial assets, which was one of the points of yesterday’s post. Wealthy people are different from the rest, and have a vastly smaller amount of their net worth in a single asset at one address. They’re diversified, whereas Mr & Mrs Front Porch are not. If 1%ers do not own businesses, they almost always possess business equity. The returns there over decades have far outstripped those of housing, a pattern expected to continue.
This week CMHC admitted the obvious. Changes to moister mortgages brought in last year have crashed loan volumes. Down an incredible 41% – right in the middle of the greatest housing boom in national history. “Volumes decreased largely as a result of the new regulations,” the agency said in an understatement. In fact, CMHC I left now with more than $100 billion in excess loan capacity, with new mortgage growth slowing to a crawl.
The reason is as explained here a few days ago. When the kids were suddenly compelled to qualify for insured loans at an effective rate for 4.64% (about 2% above bank rates), they couldn’t. The stress test worked. They failed. They lacked the financial resources – down payments or incomes – to afford the homes they wanted to buy.
So they decided to cheat and lie, usually with the help of families. Instead of proving to CMHC they could carry loans, they went around the agency. By amassing 20% down in money from other sources, they avoided having to buy insurance or face any test. And that’s why CMHC volumes crashed at the epicentre of our real estate mania. It’s also why banks suddenly saw uninsured loan volumes bloating at 14% annually, and why their regulator freaked. Untold thousands of people who can’t actually afford their homes have transferred their risk from the feds to the lenders.
Soon this ends. All buyers, regardless of how much money they have to throw at a property, will be tested as if mortgages cost a full 2% more than current rates. Meanwhile current rates will be rising. Those who say the moister stress test had no effect on dampening prices are correct. Those who say the new test will have the same effect are decidedly wrong. There is no place to run and hide anymore, save some slap-happy CUs and subprimers who want 8%.
Now, back to the doomers.
The Canadian real estate market’s a great example of what happens when money’s too cheap. Asset values inflate because borrowers have no discipline. When rates fall people don’t do the smart thing and pay down debt. They want more of it. They spend the bucks. Prices go up. The result is an economic nightmare – inflated assets (destined to correct, as they always do) and inflated debt (which ain’t going anywhere).
To stop the borrowing, central bankers withdraw stimulus, which is as unpleasant as it sounds. Rates rise, credit tightens, asset values correspondingly decline. People who bought at peak house levels with big mortgages quickly see the evil side of leverage.
The Bank of Canada started this process in July. It will continue in October. The Fed has been at it for a year. The Bank of England is probably the next to join. Because tightening cycles occur over long periods of time, there will be four to six more increases between now and the end of 2019 if history is any guide. And given the first paragraph of this post, what reason would there be to halt the process?
Recall that a recent by Forum Research found 34% of people polled said the single, itsy-weensie rate increase so far (0.25%) will hurt their finances. Of those, 12% said the impact would be “extremely negative.” In the 35-44 age bracket, the proportion of people saying any hike at would whack them rose to 44%. For people making eight grand a year, it was 39%. Among those making $100,000, 41% are scared.
In summary, the world is fine. But I’m worried about you.
Forget all of the class warfare, the anti-business sentiment, the sniping between bosses and workies and the anger people feel about their financial struggles. Here’s the big question: why’s there such a disparity of wealth?
It’s endemic now. This eat-the-rich sentiment has allowed the Trudeau government to punishingly increase taxes on the successful (people making over $225,000 a year), gut the TFSA (because only the rich can find $10,000 a year to invest) and now propose draconian new levies on small business people, docs, lawyers, IT dudes and entrepreneurs who create half the jobs.
If the comments on this pathetic blog again yesterday indicate anything (God have mercy if they do) a broad swath of society believe anyone making decent money, income-splitting with their spouse, driving an Audi, owning two houses or operating a company is the enemy. The solution, they say, is to tax the crap out of them. There should be no advantage given to anyone who trades risk, pension, health benefits or security for more cash flow. Drop the hammer, Justin.
So where did this come from? Just to our south, rich guys are celebrated. They elected the ultimate one to be leader. He’s about to cut corporate and personal taxes, including for the wealthy. And the deplorables cheer.
Seems Canadians are different for a few reasons. It’s estimated that 55% of Americans have exposure to the stock market, for example, whether through direct equity ownership or assets like ETFs. The thing of choice for a 401k (the main US retirement saving vehicle) is a stock or equity fund. In Canada most money in RRSPs and TFSAs is cash or GICs. Only 19% of Canadians have stock market exposure. But, of course, 70% of us own houses. For the Boomers it’s closer to 85%.
Homeownership rates here have been inching upwards for a generation, even as houses get stupid expensive. In the US the proportion of people owning has fallen to a 25-year low of barely over 60%, even when houses cost (on average) half what they do here. In the decade since the American real estate market blew up, the divide has sharpened with Millennials there preferring to rent, while the Moisters here stay ravenously house horny.
As a predictable consequence: Canadians have never owed as much money, and debt continues to grow at three times the inflation rate. US household debt has been steadily decreasing. In Canada, it seems, we equate mortgages with wealth. Leverage is smart. Real estate’s riskless. And we trust nothing but dirt. And debt.
Now here’s the point of distinction, which governments conveniently ignore. It’s the nature of wealth that is widening the gulf between the 99% and the 1%. The masses are addicted to real estate in a cult-like trance, fed by cheap rates, abundant credit and pro-housing policies. But over the course of a lifetime – any lifetime – growth assets like equities have outperformed housing as a generator of wealth, with more liquidity and far less cost. Canadian real estate has appreciated over the past thirty years by an average of 3%. Stocks have advanced more than 7%. The cost of buying and selling real estate is huge compared to financial assets. And the massive leverage required (we have $2 trillion now in mortgages) means exaggerated losses when markets decline, as they now appear poised to do.
Has housing made some people rich with windfall gains? Of course. In a limited time, and in isolated markets. But unless those properties are sold, at the correct moment, releasing the gains, the wealth is trapped – providing no dividends, interest or distribution cash flow. In other words, this is wealth not creating more wealth, and 100% prone to market fluctuations. Risk, risk, risk – especially when purchased with credit credit and during times of asset inflation.
Meanwhile wealthy people have adopted a different approach. Instead of owing the debt, they own it.
Wealthy people – the 1% in terms of income (above $225,000) and assets (over $1 million in liquid wealth) – own a disproportionate amount of financial assets. Stocks, funds, preferreds, bonds, trusts plus business equity. Unlike the middle class, where the bulk of net worth is buried in one asset on one street in one city – subject to market volatility, interest rates, the economy, local employment, zoning, property taxes and buyer emotion – this provides a far broader diversification, plus balance and liquidity. Over the sweep of adulthood, it forms a more predictable, effective, efficient and predictable way to grow wealth.
In other words, the rich hold assets, the rest have debt.
That chart above is the work of US economist Ed Wolff, who found that over 70% of the wealth 1%ers have is in financial assets, while for the middle class the number is 12% (and more than 60% is in one place – a house).
Because broad economies always grow (with recessions being the rare but predictable exception), yet real estate markets are massively influenced by local factors and irrational hormonal sentiment, the wealthy have experienced a steadier, more predictable rise in net worth. Moreover, keeping your dough in liquid financial assets means you can gain exposure to global growth, and are not locked into local conditions as with a house. It’s also possible to generate cash flow, usually tax-advantaged, which can be invested in more stuff.
Compare that to middle-class Canuck households, where surveys tell us 50% live paycheque-to-paycheque and a third are already hurting because of a minor quarter-point interest rate bump. Yup, lots of them are ‘wealthy’ because of the equity trapped in their homes, but they have debt and little money. Not a stable long-term strategy.
All forms of investing carry risk, of course. But not the same kind. As indebted homeowners in Toronto (and soon Vancouver) are discovering, there’s a reason they don’t feel rich any more. They never were.
