A dramatic example of the pro-cyclical nature of the lending business comes from the last Canadian real estate crash, which occurred around 1990. A large private company known as Olympia and York, headed by Paul Reichmann and based in Toronto, went on a building and buying spree of real estate assets and publicly-traded companies. They built First Canadian Place in Toronto, the World Financial Center in New York City, and they bought non-real estate companies such as Gulf Canada Resources and Abitibi-Price. They invested billions of dollars, almost all of it borrowed from banks. O&Y started a real estate development in London, England, called Canary Wharf. When the slowdown came, O&Y went into bankruptcy, leaving billions of dollars of debt unpaid. Banks had lent massive amounts of money to O&Y, falling over each other to compete to provide more credit at the height of the boom. It came out after the fact that O&Y had convinced some banks to lend without even seeing the company books!
Of course, nothing like that would ever happen in a period of tight credit when bankers are being careful in their lending. Lending without careful auditing beforehand only happens in overheated markets when banks are fearful of missing out on new business. So the cycle gets exaggerated at a peak by reckless bankers who lend more money than they should to people that are taking too much risk. And this causes the excesses of the highs and lows in the cycle to become even more stretched. The preferred ideal way of managing things would be “counter-cyclical” where lenders would lean against a booming market by saying no more often when things are overheated. But that just doesn’t happen.
Speculative tendencies and pro-cyclical fluctuations have had an impact repeatedly in history, in many different decades and geographic locations. Canada is part of this worldwide trend. Think tulip bulbs and dot-com stock market bubbles as parallels for this boom, rather than real demand driven by income growth, household formation, and immigration.
Figure 2.2 [4] shows how Canadian households added more debt from 2005 to 2009 at a rate that has no historical parallel.
In his book, The Next Economic Disaster: Why It’s Coming and How to Avoid It, Richard Vague describes the danger of a rapid expansion of private sector debt. He suggests that the doubling of U.S. mortgage debt from $5.3 trillion in 2001 to $10.6 trillion was the “immediate cause of the 2008 crisis.”[5]
The U.S. mortgage market, just prior to the 2008 crisis, was the largest market of any credit instrument in the world. Their mortgage market was twice as large as their total federal debt. Canada’s mortgage market grew to $1.2 trillion in 2014, expanding rapidly since the 2009 crisis making the Canadian mortgage market twice the size of Canada’s federal government debt. On an adjusted basis, using a 10-1 conversion for the relative size of the two countries, Canada’s mortgage market is the same size as the U.S. market was just prior to their crisis.
Vague postulates that any “major economy” that has “growth in private debt to GDP of at least 18 percent in five years combined with an overall private debt to GDP ratio of 150 percent or more means that a crisis is likely.” We can see from Figures 2.1 and 2.2 that Canada meets both criteria with room to spare with an increase of more than 30 percentage points from 2004–09 and a total private sector debt of almost 200 percent. Vague points out that other analysts tend to focus on government debt while ignoring private sector debt. But it is the “over lending” to the private sector, both household and non-financial corporate borrowers, that caused the crisis, not the stock market crash or subprime mortgage collapse that incorrectly gets the blame.
At some point Canadians will shift, voluntarily or involuntarily, from piling on more and more debt to trying to reduce their debt obligations.
If Vague is right, there will be an economic crisis, followed by a period of painful debt reduction or deleveraging.
It is going to be a very tough slog for Canadians and the economy once consumers stop adding to their pile of debt and start focusing on paying it back. This change from adding debt to trying to reduce debt obligations will happen but there will need to be a catalyst event. It will happen when one of these trigger events occur: first, if interest rates rise by enough to squeeze the monthly payment cushion; second, if there is a recession and people lose a job or worry about losing a job; or third, if the housing bubble bursts and people lose their enthusiasm for speculation in the housing market. Or perhaps the inflection point will be a Minsky moment, as described below.
Financial Instability and the Minsky Moment
Hyman Minsky (1919–1996) was an economist who studied the credit cycle and booms and busts in asset prices. Minsky believed that the credit cycle made the booms and the busts worse, because lenders become more willing to extend credit near the top of the cycle and try to withdraw it at the bottom of the cycle.[6] The boom phase that Minsky described portrays what has happened in the last fifteen years in Canada, with the cooperation of eager borrowers, speculators, the Canadian banks and other lenders, the Canada Mortgage and Housing Corporation (CMHC), private mortgage insurers, and two successive Canadian governments, all of which have combined to exacerbate the normal housing cycle into an overheated housing boom. The late finance minister James Flaherty had introduced some restrictions during his tenure designed to slow the growth rate of debt but those measures were not, by themselves, bold enough to reverse the boom phase. Minsky described this type of euphoria state that precedes a collapse in asset prices, withdrawal of credit, and significant damage to bank balance sheets.
The lending cycle, as outlined by Minsky, grows slowly at first, developing gradually as increased borrowing by businesses and households continues to be supported by rising asset prices, incomes, and expanding balance sheets. This he called “hedge finance.” As the cycle continues banks are seduced into expanding their lending business by the rising values on the collateral side (houses are collateral) and the very low level of defaults. Borrowers are comforted by their ability to borrow more and more, often borrowing enough in new loans to pay off previous loans and the interest on those loans too. This second phase he called “speculative finance.” As long as borrowers have sufficient cash flow to pay off the interest and qualify for new loans when it comes time to rollover existing loans, the cycle continues. Often governments and central banks contribute to the growth and add to complacency by relaxing the standards for bank loans and leverage ratios for banks. Financial innovation becomes rampant with clever participants finding ways around any rules that put limits on the amount of borrowing.
The irony is that the longer the lending cycle and the related boom in asset prices continue the more comfortable, complacent, and confident the participants become. Individuals who were originally reluctant to borrow large amounts become willing to take on larger loans; the ease with which the interest payments are covered, and the loans are rolled over into new loans, convince them that there is no danger. Lenders, who should know better, are also lulled into complacency by the feeling that there is a permanent upward trend in asset prices. This last phase, when eventually receipts are insufficient to cover interest payments, he called “Ponzi finance.”
Minsky called his ideas the “financial instability hypothesis.” In lay terms, his theory suggests that the financial system swings between robustness and fragility – swings that are in tune with the business cycle and the credit cycle. Instead of trending towards equilibrium, the system swings between boom and bust. His theory did not gain a large following in the beginning, as he was in the shadow of more famous economists and defenders of free market ideology (such as Milton Friedman) who argued that markets, if left alone, would tend to equilibrium.
Minsky pointed out that the longer a trend continues without interruption and without a significant negative shock the more convinced people become that it will continue forever. In the current period in Canada, which extends back to the early 1990s without a major crisis, real estate speculators, foreign investors, and most Canadians have come to believe that house and condominium prices will continue on an upward trajectory indefinitely. This belief, as odd as it seems to some of us, is widespread among speculators, homeowners, and especially young adults. I can imagine asking a hundred people on a busy