Moody's Investors Service estimated that in the event of U.S.-style housing price carnage in Canada, the domestic financial system will take an $18-billion hit of which two-thirds or about $12-billion will be borne by the banks. These are big numbers, very big numbers, but still not large enough to cause a financial crisis.
The Moody's estimate is based on a worst-case scenario – a 25-per-cent decline in housing prices nationally and a 30-per-cent decline in Ontario and British Columbia real estate values – that will put a chill into any homeowner's day. A hit to consumer wealth of this magnitude would cause a host of sticky economic problems, but where the banks are concerned, there is likely less to worry about than it first appears.
Losses of $12-billion spread across the banking sector would be very painful for industry balance sheets. But Canadians should remember that the banks are extraordinarily profitable. In the past 12 months, the combined profits for the sector were $34.41-billion, or almost three times the expected losses.
The banks, of course, are unlikely to maintain this level of profitability if the housing market implodes. But while a housing price decline could be swift, the financial fallout will be felt over time. The banks won't have to accept all the losses in a single quarter and can spread the pain out over time. In addition, current profit amounts offer a substantial cushion over expected losses.
There is also a very important difference between the pre-2007 U.S. housing bubble and the current state of the Canadian real estate industry. In simple terms, the entire U.S. financial system was playing hot potato with mortgage default liability before the crisis, but this is not the case in Canada.
In 2006, it was not uncommon for a subprime lender such as Countrywide Financial to issue mortgages to people when there was a greater than 50-per-cent chance the client would eventually default on the loan. The reason the underwriter would do this is because they could immediately sell the policy to an investment bank at a profit. The investment bank would then package the mortgage along with hundreds of others into a structured product called a collateralized debt obligation (CDO) that they would sell in units to their clients, again at a profit.
By early 2007, with the prevalence of NINJA mortgages (no income, no job or assets), we can safely assume that subprime lenders and CDO underwriters knew they were, to put it bluntly, acting like jackasses. But – and this is the important part – they were confident they were protected against losses because they had bought credit default swaps – insurance against mortgage defaults.
The financial crisis really kicked off when it became apparent that losses and mortgage defaults had reached the point where companies that sold default insurance policies would not be able to afford to make good on this insurance. At that point, nobody knew who was liable for what, and where the losses from mortgage defaults would fall. No bank would lend to any other bank because they were worried about insolvency, and the whole system froze.
In Canada, a housing correction would be painful but far more organized. Yes, private lenders would go bankrupt and their creditors would reluctantly own houses they didn't plan on, and mortgages would have to be renegotiated. But, by and large, the liabilities would be clearly defined. The banks would take their share, and the taxpayers would take theirs through the Canada Mortgage and Housing Corp.
It is also the case that any financial problems in Canada will be focused on very few organizations. This would make it easier for the Bank of Canada to support them. The United States had more than 8,000 banks in 2006, while Canadian liabilities lie predominantly in fewer than 10 institutions.
The primary dangers surrounding a severe housing market correction in Canada are more economic than financial. A drop in housing values would make households less wealthy and, perhaps more importantly, make them feel less wealthy and willing to spend. Consumption levels and economic activity would decline as households diverted savings to pay off debt, and unemployment would likely rise.
Canadians who fear that a domestic housing market correction will look like the U.S. in 2008 are suffering from a usually destructive psychological tendency called recency bias, in my opinion. Recency bias describes the inclination to expect a dramatic event from the recent past – like the financial crisis – to reoccur in the immediate future despite numerous facts pointing to different outcomes.
The evidence indicates that, while painful, a steep drop in real estate values – something that is not guaranteed, by the way – will have far different effects on Canadians and the domestic financial institutions than the Americans endured eight years ago. For that, we can be thankful.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.