Why Ottawa should bail out homebuyers if house prices tank

If American households ruined by the housing crash would have received as much attention as Wall Street, the world would be a different place today



If you don’t know them personally, you’ve read about them: the woebegone residents of Vancouver, Toronto, and the surrounding areas of those two cities who bought too much house. Some of you pity them; so unfair their time to buy arrived at the frothiest stages of a property bubble. But I bet just as many of you are disdainful. You ask: Why the hell don’t these people rent?

Hold onto those competing impressions. We will be coming back to them.

The economy just survived a scare. For a few weeks in May, Home Capital Group Inc. looked like it would become the first Canadian financial institution to collapse since the 1990s. But HomeCap still is with us, and the chatter that its troubles herald a housing meltdown has subsided. “From the very beginning, we have seen this as a Home Capital issue as opposed to a broader issue,” Finance Minister Bill Morneau told the Globe and Mail on May 12.

Home Capital, a subprime lender, is too small to cause much trouble on its own. (Its mortgages account for about one per cent of the total market.) Most of its customers would be covered by government insurance, the Office of the Superintendent of Financial Institutions would ensure an orderly death, and vultures would swoop in quickly to grab the valuable assets.

READ MORE: The war for control of the Home Capital story

That doesn’t mean the episode should be dismissed. Speculative bets against the Canadian dollar and the country’s banks spiked, suggesting confidence in the country’s financial system was rattled. That matters. As Joe Castaldo of Maclean’s described in excellent detail, psychology is the difference between boom and bust. Goldman Sachs, the New York-based investment bank, put the odds of a Canadian financial crisis in the near future at 30 per cent. Carson Block, a muckraking American investor known for exposing companies with dodgy financials, told Bloomberg News on May 31 that he was “starting to believe that there could be some real problems with Canada.”

Short sellers such as Block can’t always be trusted. But academic research also offers reason for concern. Atif Mian of Princeton University and Amir Sufi of the University of Chicago have teamed up to do some of the best work on the origins of the financial crisis. Their newest paper uses historical data from multiple countries to show that an increase in the ratio of household debt to gross domestic product over a three-to-four-year period predicts a decline in economic growth. Canada fits the description. The past isn’t prologue; however, we ignore its lessons at our peril. It is time to start preparing for the worst.

READ MORE: The risk of a financial crisis in Canada is growing

And that brings us back to those suffering new homeowners in Vancouver and Toronto.

If things go bad, they will deserve a lot of the blame. Governments, the central bank, and lenders tempted them with numerous incentives to buy, but no one forced them to take out mortgages they couldn’t afford. But what if I told you the only way to end the recession they might trigger would be to use your tax contributions to bail them out? Don’t like the sound of rescuing your profligate neighbours? Sorry, a crisis is no time for schadenfreude.

David Dodge, the former Bank of Canada governor, told me earlier this year in an interview about housing policy that he would nationalize the mortgage insurance industry; not because he is a Communist, but because it always will be taxpayers who clean up the messes of bankers, especially when it involves houses. “History tells us, and political analysis tells us, that no government can stand aside while the financial market is being brought down by the collapse of the mortgage market,” he said.

Ottawa’s instinct likely would be to save the banks. That’s just how these things go. The received wisdom is that you fix a financial crisis by making sure the lenders are solvent. That way, they can keep the economy going by lending to businesses and households.

Mian and Sufi want policy makers to update their crisis playbooks. The banks got most of the money when the U.S. financial system imploded in 2008 and it didn’t work that well. The biggest banks survived, but they stashed most of their rescue funds. The Great Recession was followed by an epically slow recovery.

READ MORE: A day of insanity that typifies Toronto’s housing market

In retrospect, the flaw in the U.S. rescue efforts is obvious. In their 2014 book House of Debt, Mian and Sufi argue the recession was caused by a decline in consumer spending. Low interest rates, a willingness among creditors to lend to just about anyone, and widespread fraud eventually led to a wave of defaults in 2006 and 2007. The poorest households were wiped out first. As home prices crashed, many were left with assets worth less than the mortgages. That was critical because those are the people who have the highest propensity to spend. The U.S.’s post-millennium credit binge ended up flooding its main economic engine.

If those ruined households would have received as much attention as Wall Street, the world would be a different place today. Washington’s priority should have been organizing a mass rewriting of home loans to align the principals with the reduced value of the assets. That would have supported demand by allowing homeowners to get above water. By reducing the number of defaults, such a program also would have buoyed housing prices. Creditors make little effort to get the best price for the assets they obtain in foreclosures. Fire sales kill property values.

Former president Barack Obama wanted to help homeowners. His attempts floundered, mostly because when the time came, there was too little political support to make the programs work. American taxpayers, via their elected representatives, loathed saving millionaires and billionaires on Wall Street. But they essentially refused to help their neighbours and fellow citizens. That decision probably felt right; anything else would reward stupidity. But I wonder how it felt living through double-digit unemployment rates? Stupidity was widespread.

READ MORE: How Canada completely lost its mind over real estate

The argument against rescuing homeowners is moral hazard. That’s the notion that those who know they will be saved will inevitably engage in risky behaviour. It’s endemic in finance. The biggest banks borrow at lower rates than smaller rivals because creditors assume—like Dodge said—that governments always will rescue any institution that is “too big to fail.” Canada’s banks drove down mortgage rates in a fight for market share because the federal government insures most of the risk. Some economists reckon the same principle applies to individuals. So if the government bailed out homeowners, it only would be encouraging future buyers to take out big loans. Maybe. But Mian and Sufi argue that households think differently than big institutions. They say moral hazard assumes a level of sophistication that most individuals simply lack. Banks and other big companies employ lots of smart people to figure out ways to game the system. Some individuals might take a similar approach; Mian and Sufi say most couldn’t be bothered.

I’m not predicting an economic catastrophe in Canada. The country’s banks likely have enough capital in reserve to withstand a wave of defaults if prices in Vancouver, Toronto and elsewhere correct dramatically. There would be little reason to worry about a big lender going bankrupt. But there are good reasons to take seriously the possibility that Canada’s credit binge could end in a recession. Probably, we would just muddle through it. Another contribution of Mian and Sufi is evidence that financial crises divide the political process, making timely action difficult. Politicians would be scared to rescue the same homeowners who caused the recession. But it would be the right thing to do.


Why Ottawa should bail out homebuyers if house prices tank

  1. Nope. Bailing out the homeowners and/or the banks would be absolutely the wrong things to do.

    The right thing to do is what Iceland did. Nationalize the banks (one can re-privatize them later) through a government controlled bankruptcy process AND Bail IN (not Bail OUT) their bondholders. And let the housing market reset itself.

    The housing won’t go anywhere. So people lose their homes and have to go through personal bankruptcy. The housing will still be there for them to rent and buy at greatly reduced prices.

  2. IMO Kevin Carmichael significantly understates the danger of moral hazard in this case. It doesn’t take ‘sophistication” or “lots of smart people” to understand if the government would bail you out if you took out too big a loan. It merely requires understanding how your mortgage works, which is something all prospective home-owners should know. So, yes, those that are not risk averse will surely borrow too much *if allowed to*, secure in the knowledge that minimal monetary harm could befall them if worse comes to worst, and leaving the taxpayer to pay for their folly.

    • I agree with your overall view but wish to make a few points. I recall reading a while ago that banks had “silently” changed the type of mortgages they offer. No one is issuing collateral type mortgages anymore. So this kinda weakens your argument that sophisticated buyers who are not afraid of risk will continue to borrow too much “if allowed to”. In fact the lenders can go after any of your assets to satisfy their outstanding loans. I see unsophisticated buyers who can’t afford risk (else they might be ruined) being coerced into overextending themselves. And the lenders are certainly not in the position to give them objective advice.

    • There is already talk that interest rates cannot rise because Canadians cannot afford it; and I think there’s actually some truth to that. I would be interested to know to what extent the average home owner believes house prices are guaranteed already through an assumption that government would intervene in the event of price declines. I’ve heard anecdotes of millennials believing exactly that but I think the tendency is more to not even consider the possibility that prices may fall in the first place. On a side note, to some extent the Feds could support housing prices just by increasing the allowed amortization.

      • I think the more compelling reason why interest rates won’t rise is because of extreme pressure from governments who are having difficulty covering the payments on their current debt. Ontario is the prime example and the Federal Government’s spending addiction is heading them down the same path.

        • Price-fixing by central banks will inevitably break down. Market pricing will eventually reassert itself when the confidence game fails. The ability of central banks to control interest rates with out of control indebtedness by citizens, governments, and businesses will be seen to have been an illusion.

      • I agree Owen that there can be some tweaking in amortization periods and equity requirements to support the market in the event of a major decline. This may help some homeowners who are “on the bubble” and about to lose their homes when it’s time to refinance.
        Hopefully such measures will ensure a soft (ish) landing for the economy when home prices come down

  3. No bail out to banks. Period. No bail outs to home owners. Period. moral hazard indeed.

  4. So where does that leave people who have been staying out of the market, renting waiting for housing prices to return to sanity? Not necessarily waiting for a crash, but at least waiting for a point where price to rent and price to income ratios actually make buying a reasonable action vs. renting. Why are home owners valued more than renters?

  5. The difference between the US housing crash and the upcoming Canadian crash is that the public is already responsible via CMHC insurance for billions. The banks are already insured by the public.
    In effect, we have already socialized the risk.
    Meh, so much wrong with this article…

  6. I’ve been told by bankers, politicians, and realtors for so long that there is no Canadian housing bubble it’s hard to believe we will have to bail anyone out. Yes I am being sarcastic.

  7. Moral hazard. Why should I as a taxpayer pay for it? I save my pennies, have low debt and now my tax monies have to go to pay for really, really bad Conservative public policy.

    I have a better suggestion. All the people who supported the bad public policy team cough up the cash for capital welfare. All the people who have been harping about tax cuts, time to pay.

    Private profit, public risk. Now that’s what I call ‘free market’. Ain’t that right freeloaders?

  8. As simply and forcefully as I can say it … NO WAY!!

  9. Uhm, no. Your basic argument, paraphrased, is ‘if only we had kept consumer spending, which was entirely based on a false sense of wealth from inflated property values, going longer we could have saved the economy.’

    Debt – driven consumer spending, whether based on debt the consumer acquired personally (mortgage, line of credit, etc) or debt the government acquired on their behalf (bailouts) is not a path back to a sustainable economy.

  10. “psychology is the difference between boom and bust”

    The difference between Singapore and Somalia comes down to psychology? And “boom” is the only alternative to “bust”? Both are pathologies with their own costs.

    Samuel Johnson, 1777:
    “Depend upon it, Sir, when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.”

  11. What utter BS May
    Be these prople should have bought homes they could afford, not try to want it all now and pay for it overtime.