The fuel behind the Canadian real estate bubble: bank residential mortgage credit
July 24, 2019
Erik Fertsman
In one of our posts a month ago titled "What's the fuel that's pumping Canadian real estate? Hint: the money laundering theory of home price inflation is wrong", I wrote
about how a lot of the reasoning behind explanations of home price inflation in Canada is fallacious. Rather than blaming foreign money or buyers, it's important to consider internal Canadian factors, first and foremost, as they have a far greater impact. These include access
to credit for home buyers, and the quantity
of credit getting doled-out to home buyers.
In that article cited above, I explained how there is a strong correlation between commercial bank credit quantities and home prices. I also showed how mortgage rules that essentially restricted "higher-ratio" borrowers - those with debt-to-income ratios above 400 percent - from getting credit, has had a negative impact on total mortgage originations (i.e., residential mortgage credit growth). If we follow this path of reason, it's a much more powerful way of understanding home prices and where they're going.
Residential mortgage credit is dominated by commercial banks
Now that we understand the overall logic, it's important to move into the details, and fine-tune the connection between home prices and credit quantity. We can analyze access, but quantity is an outcome of access; so for now, we can set measures of access aside.
Below, I have a chart with total residential mortgage credit, and I've included its subcategories. Let's take a look:
*Between 2011 and 2013 Canadian companies reporting financial statements under Canadian Generally Accepted Accounting Principles (CGAAP) switched over to International Financial Reporting Standards (IFRS). This affected the way corporations reported and valued assets and liabilities on their balance sheets. You can read more about this here.
What you should see there are four specific categories that matter for our purposes here: 1) chartered bank credit (orange line); non-bank credit (red line); credit issued under the National Housing Act (blue line); and, credit issued by special purpose companies (yellow line). Together, they make up the total outstanding balances among major financial institutions (teal line), as calculated by Statistics Canada.
What should be clear is that the orange line, chartered bank credit, has absolutely dominated the data series. This is because the residential mortgage market is dominated by the commercial banks and their loan divisions. Non-bank credit pales in comparison. So much credit has been created by the banks that I've had to put the chart into logarithmic scale in order for all the data spanning 50 years to be visible.
To demonstrate just how much commercial bank credit dominates real estate lending, I've created this donut chart below:
This snapshot of August 2018 shows you how over 75 percent of outstanding residential mortgage credit belonged to commercial banks. Go ahead, play with the interactive donut.
Why is this important, you might ask? Unlike the other sources of mortgage credit (non-banks, NHA, etc.), banks create money out of thin air. If you are interested in learning about this banking trade secret, read this post I wrote recently. To make a long story short, this said digital fountain pen money that commercial banks have a license to create, has increasingly been tied to asset price inflation in economic and financial studies.
In fact, in many cases, there is a statistically significant correlation between the quantity of bank credit issued for asset purchases, and the price of the assets being purchased with the bank credit. This is true even in cases where multiple confounding factors are introduced, such as non-bank and government money.
Unlike banks, non-banks and the other sources of residential mortgage credit, in the charts above, do not have this "digital fountain pen money" privilege. Instead, they must lend existing
bank deposits (this form of money I also explain in my recent post). Some proponents of MMT, or modern monetary theory, assume that government (the money lent under the National Housing Act) is also created out of nothing.
However, this has not been proven, and all evidence points toward the bond market as the source of money for government spending. The government can only lend money it has raised through the sale of government treasury bonds. Banks do not have to raise money in the bond market to lend; they only do this to "boost" their tiny capital ratios. Banks in Canada have zero
reserve requirements.
So, they don't have to go find money to lend; they go lend money first and then work on boosting their capital ratios. If anything, this could be called "backward looking" reserve requirements, driven and enforced primarily by banks themselves. Canada hasn't seen a banking crisis in a long time, so we have yet to see if this kind of regulation even works! It's experimental.
What does all this mean? Commercial bank credit overwhelmingly dominates the Canadian real estate lending market, so we have reason to suspect that there is a strong correlation between the quantity of credit that banks create, and home prices.
How residential mortgage credit growth among commercial banks is impacting home price growth
I won't be showing you p-values and t-values today, but we can take a look at a few important series of data that demonstrate this correlation between total credit growth among banks and home price growth.
Below is a chart that contains the data going back 20 years for home price growth rates at the national level (teal line), Vancouver (orange line), Toronto (red line), and Halifax (blue line). I've stacked this information up against the commercial bank credit growth rate, specifically, residential mortgage credit growth (dashed black line):
If you are having trouble visually inspecting the chart, you can click on categories in the legend at the bottom of the chart, which will turn off select lines. Also, try to ignore the over-shoot in the bank data for 2011 and 2012. This occurred due to a change in accounting standards, from CGAAP to IFRS.
What should be telling, though, is the correlation between bank credit growth and home price growth - particularly at the national level. On a few occasions, Toronto and Vancouver over-shot the bank data. These regions may be explained by the presence of foreign hot money, but we don't know for sure. Price momentum is a complicated thing, and it could have been due to a cocktail of supply issues, consumer exuberance, and foreign buyers.
However, the overall trend for home price growth is to follow credit growth rates, more so than any other dataset (like interest rates!). This is more clear when we zoom in on the data for the last few years:
In February 2017, just months before the housing market consolidation period started in the summer that year, we had a 2 to 4 percentage increase in home price growth in Toronto and Halifax, along side a 0.5 percent jump in credit growth. In Vancouver, price growth dropped that same period, which makes sense because of the tighter mortgage rules that kicked-in for that market 4-6 months prior. You can see that prices began slumping in September 2016 for Vancouver.
Since the end of 2017, credit growth among banks has slowed down considerably to levels not seen for a quarter of a century, if you don't count the 2008-2009 financial crisis period. What has home price growth done since the beginning of 2018? It's followed the trend set by bank credit ever since.
Cover image source: Marc Sendra Martorell
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