Bank of Canada grows balance sheet, including mortgage bond holdings to prop housing
August 17, 2019
Erik Fertsman
Canada's central bank, the Bank of Canada (BoC), has been buying-up a whole lot of things over the last 10 years. Normally, central banks load-up their balance sheets to help their economies jump out of financial ruts induced by recessions. But these are the good times, and everything is hunky dory according to the country's commercial banks, and BoC chief, Steven Poloz. So, what the heck is going on?
The Bank of Canada's balance sheet
There's two sides to the BoC's balance sheet: on one side you have assets that the bank has purchased. These assets earn interest for the bank, which is then distributed to the Ministry of Finance after operating expenses are deducted. On the other side you have the bank's liabilities. Recently, both sides of the balance sheet have grown, and this growth now looks exponential. Check it out:
As of July, the bank had a total of $118 billion CAD worth of assets. This was a jump of nearly $2 billion CAD from the previous month, and looking at the chart, the pace of asset purchases has been increasing since the bank began aggressively buying assets as the 2008 financial crisis got under way. So why has the bank been piling things onto its balance sheet?
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Targeting inflation via interest rates
To ensure the bank's finances are balanced, the bank matches its liabilities with assets. The largest category of liabilities is composed of physical notes and coins in circulation; you know, those nice polymer bills and nickel-plated coins we often find in our pockets. The bank has a monopoly on physical cash, and it creates these notes and coins according to the demand for them among commercial banks.
Since 2008, however, the Canadian economy hasn't been doing terribly well, so the bank has found itself stepping in to help "spur" economic growth. The way it does this is by engaging in something called "inflation-targeting" through interest rates. Because interest rates are generally tied to government bond yields, the way you do this is by manipulating the value and yield of those bonds, which have an inverse relationship (when bond prices go up, yields go down).
Post-2008, the BoC has been aggressively and in a "noncompetitive" way, purchasing Canadian government debt via treasuries (which are short term debt instruments) and bonds (longer term debt instruments). As a result, the bank's balance sheet looks like this:
The overwhelming majority of the BoC's government debt holdings consist of shorter term bonds and treasuries. Now it's holding over $40 billion CAD worth of bonds that are 3 years in length or less, over $26 billion CAD worth of short-term treasuries, and around $35 billion CAD worth of longer term debt. In other words, the bank is trying to bring down the interest rates charged on debt contracts in Canada.
Now, this has a whole host of benefits for Canadians. For one, it brings down the cost of consumer credit for Canadians. This is especially the case for Canadians financing large-ticket items like homes and cars. Even student loans have smaller interest rates, so it's helping millennials! There's just one problem though: economic growth has been anemic and teetering on zero growth throughout various moments ever since the 2008 crisis.
The only things that seem to be doing great across the board since 2008 are the stock market and housing prices. This low interest rate/low economic growth environment has done little in terms of efforts to increase wage growth over the last 10 years, and it's created massive inequality between and within different age groups
across Canada.
And now,
credit growth is slumping in all categories except commercial loans, and
home prices when observed from the national level are beginning to contract. As well, commercial loan growth doesn't seem to be doing all that much for GDP, and slack in mortgage credit growth is really weighing down on home prices.
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The Bank of Canada is now buying mortgage bonds
Back in March, we started to notice something interesting in the share of the Bank of Canada's assets. Here, take a look:
See that small yellow slice in the donut? (On mobile you may need to go into landscape mode to enlarge the chart.) The BoC is adding Canada Mortgage Bonds (CMBs) to the list.
What are CMBs? These are mortgages issued by banks that are guaranteed by the Canadian Mortgage and Housing Corporation (CMHC). After insured-mortgages are created, the banks bundle some of them up and sell them as bonds to investors. Being insured by CMHC gives them a high credit rating by the rating shops. This means they pay a super low interest rate to investors who hold them, because they are safe.
Why is the Bank of Canada buying them you ask? According
to the BoC, back in November the bank began "expanding the asset it acquires outright... for balance-sheet management purposes only and has no implications for monetary policy and financial stability objectives of the bank." Their main reason for this is, "to offset the continued growth in bank notes and further reduce its participation at primary auctions of Government of Canada bonds."
However, analysts or those familiar with the policies of the US's central bank, the Federal Reserve, will know that mortgage securities were a central component of the Fed's quantitative easing program that began after the 2008 crisis. What's more, according to the data in the first chart of this article, the bank has been adding
government bonds, not "further reducing" them. So, it's not entirely convincing that the BoC's policy of purchasing CMBs is for "balance-sheet management purposes."
Purchasing CMBs to prop housing prices
Why is the BoC telling us that the CMB purchases are for balance sheet management purposes, when it's basically a copy and paste of the Fed's program?
Well, check out this chart below where I've plotted GDP, the BoC's CMB holdings, and residential mortgage credit growth:
As you know, mortgage credit growth (orange line) has been slowing since the summer of 2017. It just so happens that home price growth has been slowing since then, as well. I've previously shown just how closely related mortgage credit quantities and home prices are. Meanwhile, GDP has been following the same pattern (grey columns on the chart above).
But more importantly, in the chart above, we can see how mortgage growth started to turn around as soon as the BoC began buying CMBs (teal line). Wow.
By engaging in CMB purchases, the BoC is effectively doing the same thing it is doing with government debt: buying mortgage bonds to put upward pressure on their face value, and so, it lowers the yield. In other words, the BoC has stepped into the market to lower mortgage interest rates, since investors who normally buy these bonds are probably looking for a higher return (by demanding higher interest rates on the bonds).
Now, it seems to me that the only way to squeeze a higher return out of the bonds is for the underlying mortgages to carry a higher interest rate. The BoC probably doesn't want that to happen, though. So instead, it's buying them to keep rates down. This is significant for two reasons: the mortgage market in Canada is now experiencing more artificially suppressed interest rates, and their goal, most likely, is to stabilize their 2-years-worth of contracting mortgage credit growth.
Purchasing CMBs provides the mortgage market - dominated by the large commercial banks - with secondary market support. This way, the banks don't have to worry about underwriting mortgages, particularly if there are now more evidence risks. If banks write a mortgage they are iffy about, they know the BoC will take it off their hands. This lets them keep rates low, and in turn, credit churning.
The bottom line: the BoC's CMB purchases support home prices across Canada. Home prices are directly correlated with total mortgage credit quantities, so you need to keep mortgage growth going or home prices will suffer - just like they are now, nationally and among provinces. The question to ask now is: will it work? I suspect housing affordability and monthly mortgage payments are beyond Canadians.
The only way to change this is for house and rent prices to drop, or for Canadian wages to get a big boost. I suspect it will be the former. And as home prices drop, the risks will increase for the banks in their mortgage lending divisions. The BoC's CMB purchasing program is likely here to stay indefinitely...
Cover image source: Andrew Gook
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