Mortgage Rules Changing and Timing

News abounds of the impending changes to maximum amortization lengths for government-underwritten mortgage insurance. This announcement follows the general form of previous announcements affecting CMHC, "strengthening" the housing market, and comments by Minister of Finance Jim Flaherty on concerns particularly about overbuilding in Toronto.

What's different this time is the implementation period is, in business terms, immediate: only 13 days to complete a transaction and fill out an application for mortgage insurance under the old guidelines. This was in an effort to avoid the surge in activity witnessed last year when the rules were changed with 60 day notice. To recap the changes to all mortgages that are eligible for government-underwritten mortgage insurance are as follows:

• Maximum amortization falls from 30 years to 25 years
• Lower the maximum amount Canadians can borrow when refinancing to 80 per cent from 85 per cent of the value of their homes
• Fix the maximum gross debt service ratio at 39 per cent and the maximum total debt service ratio at 44 per cent
• Limit the availability of government-backed insured mortgages to homes with a purchase price of less than $1 million.

Certainly none of these moves can be considered stimulative for housing, and in total impact it's around 10% less total debt that can be withdrawn based on the 30-25 year move, even more for top-prime borrowers, and completely snuffed for loans above $1MM, though it's unclear how many loans are insured above this level. There has been some good commentary on the moves and the implications in the short term.

What I wanted to concentrate on are two things, first the implications at the high end of the market in the event of a significant bout of weakness, (houses in higher-end areas of Vancouver are seeing months of inventory well above 10, which all but guarantees subsequent price drops) second the timing of the announcement.

1) If prices do become weak, many borrowers will find their equity has been compromised and banks, due to upcoming guideline changes to how it must account for mortgages, will be loath to carry these loans and require mortgage insurance as a hedge. If the property is valued above $1MM that leaves fewer options for the borrower and rates will increase, in some cases significantly. It's hard to tell by how much, but if current weakness extends through the remainder of the year -- which is no sure thing -- the high end of the market will suffer from another solid blow to the midsection.

2) The timing of this announcement caught me off-guard. It was issued subsequent to the G20 meeting in Mexico and at a time where rumours of a renewed bout of stimuli and recapitalizations occurring in the Eurozone, the United States, and China. My guess is that discussions regarding coordinated and large stimulus efforts were discussed at this meeting, ahead of the EU summit occurring this weekend. If a renewed bout of stimulus is put forward, this can flow, and in the past has flowed, into speculative assets, further deteriorating earnings ratios. The changes to CMHC's rules, designed to dam against further increasing household debt, by themselves could destroy a housing market in the face of slowing jobs and wage growth in the normally slower second half of the year for housing transactions. But if paired with a significant global stimulus, the effects may be muted.

(It may also be that this was the last opportunity for the Department of Finance to shoot off a policy directive before the vacation season kicks off, so the timing may be one of practicality more than any global machinations.)

The changes directed at the high-end and high-quality borrowers are interesting in the context of a potential renewed bout of global stimulus coupled with what looks like an unsustainable investment boom in other parts of the world, particularly China. Given the Bank of Canada has hinted in the past about the relatively high level of foreign investment in Canada's property markets, I wouldn't be surprised if they are attempting to both divert capital inflows and ensure another foray of borrowing by Canadian residents is impossible.

CMHC Tightening

I have been calling for further loan tightening being ordained by the federal government. CBC seems to be able to easily quote Mr. Flaherty while he's on tour:

Finance Minister Jim Flaherty said he shares the concern of Canada's top banking regulator that lenders are loosening their mortgage standards too much, but said any problems in the system are being corrected...
"OSFI's concern arises out of some work that OSFI has done as part of the ordinary course of its business to look at some of the loans being made by financial institutions," he said. "I was informed of what their assessment showed with respect to a few financial institutions, which is a matter of concern."
"That is being corrected," Flaherty said.

As I have mentioned in the past, further tightening amounting to reduced access to loans or faster amortizations seemed to be a shoo-in, now we are getting hints that the government is very concerned about debt levels and systematic financial risks, and will ensure they do not become worse than they already are.

This is akin to the previous explicit announcements on CMHC mortgage insurance qualifications announced in previous years. This year, it appears, guidance from OSFI and implementation of Basel 3 accounting practices -- not to mention higher prices -- are going to act as a brake on housing activity in 2012.

Y U No Spend?

Bank of Canada governor Mark Carney is speaking again -- again -- this time to businesses, on how to pull Canada through what looks to be a period of uphill growth (emphasis mine):

Canadian households increased their borrowing significantly. Canadians have now collectively run a net financial deficit for more than a decade, in effect, demanding funds from the rest of the economy, rather than providing them, as had been the case since the Leafs last won the Cup. 

Developments since 2008 have reduced our margin of manoeuvre. In an environment of low interest rates and a well functioning financial system, household debt has risen by another 13 percentage points, relative to income. Canadians are now more indebted than the Americans or the British. Our current account has also returned to deficit, meaning that foreign debt has begun to creep back up...

In other words, households are chasing diminishing returns and the point at which this debt will be impossible to properly service is a looming risk.

Our strong position gives us a window of opportunity to make the adjustments needed to continue to prosper in a deleveraging world. But opportunities are only valuable if seized.
First and foremost, that means reducing our economy’s reliance on debt-fuelled household expenditures. To this end, since 2008, the federal government has taken a series of prudent and timely measures to tighten mortgage insurance requirements in order to support the long-term stability of the Canadian housing market. Banks are also raising capital to comply with new regulations. Canadian authorities are co-operating closely and will continue to monitor the financial situation of the household sector. 

To eliminate the household sector’s net financial deficit would leave a noticeable gap in the economy. Canadian households would need to reduce their net financing needs by about $37 billion per year, in aggregate. To compensate for such a reduction over two years could require an additional 3 percentage points of export growth, 4 percentage points of government spending growth or 7 percentage points of business investment growth. 

Any of these, in isolation, would be a tall order. Export markets will remain challenging. Government cannot be expected to fill the gap on a sustained basis. 

But Canadian companies, with their balance sheets in historically rude health, have the means to act—and the incentives. Canadian firms should recognize four realities: they are not as productive as they could be; they are under-exposed to fast-growing emerging markets; those in the commodity sector can expect relatively elevated prices for some time; and they can all benefit from one of the most resilient financial systems in the world. In a world where deleveraging holds back demand in our traditional foreign markets, the imperative is for Canadian companies to invest in improving their productivity and to access fast-growing emerging markets.

This would be good for Canadian companies and good for Canada. Indeed, it is the only sustainable option available. A virtuous circle of increased investment and increased productivity would increase the debt-carrying capacity of all, through higher wages, greater profits and higher government revenues. This should be our common focus.

Carney is pleading with businesses to invest to make up for what household spending has done in the past 3 years (and longer), in part by expanding enterprises away from Europe and the United States where growth prospects look anaemic. It appears that increases in -- or even the maintenance of -- the average household debt-to-income ratio will be a trigger for further tightening of credit availability.

Carney has also provided confirmation that banks are increasing their capital reserves for household loans, which means less credit will be available going forward and banks will need to be more selective in the loans they make. It is unclear what criteria banks will use to ration their loans but may involve regional considerations, as was done by HCG earlier this year.

The Bank of Canada is trying, with the limited tools it has available, everything it can to get businesses to spend. If businesses do not spend the burden will be borne by households and governments and this, in Carney's view, is the outcome most likely to lead to subpar (or negative) economic growth. The federal government has been attempting to facilitate private investment through tax breaks and other investment programs, but now Carney, at least, is appealing to patriotism. That is a wonderful stance in principle.

Bank of Canada Blows the Alarm on Housing Again

As the Eurozone crisis continues its slow impact with the current account iceberg, Canadian financiers, politicians, and technocrats (yes Canada has technocrats too) are planning for fallout (PDF). One key area of concern is the health of Canadian household finances. Below are excerpts from the risk analysis of Canada's housing market (emphasis mine):

The rising indebtedness of Canadian households in recent years has increased the possibility that a significant proportion of households would be unable to make debt payments in the event of an adverse economic shock. This growing vulnerability has heightened the risk that a deterioration in the credit quality of household loans would amplify the impact of the shock on the financial system. The resulting increase in loan-loss provisions for financial institutions and the reduced quality of the remaining loans would lead to tighter credit conditions and, in turn, to mutually reinforcing declines in real activity and in the overall health of the financial sector. 

The vulnerability to this risk remains elevated and is broadly unchanged since June. There are tentative signs that the sustained rise in the proportion of vulnerable households in recent years has moderated and credit growth has slowed noticeably over the past six months. Nonetheless, our simulation results suggest that household balance sheets remain vulnerable to adverse economic shocks... 

While the growth of household credit has slowed since early 2011, it has continued to increase more rapidly than income. As a result, the debt-to-income ratio of the Canadian household sector increased to a historical high of 149 per cent in the second quarter (Chart 23) and has been higher than the ratio in the United States since the start of 2011.

If recent trends persist, the ratio of household debt to income will continue to rise

Despite the rebound in the growth rate of mortgage credit in October, the Bank expects a gradual moderation in the underlying trend in household debt accumulation over the medium term as activity in the housing market slows and as lower commodity prices and heightened volatility in financial markets weigh on the wealth and confidence of Canadian households. Since the growth of personal disposable income is also projected to be moderate, the gap between credit and income growth is expected to narrow but remain positive, implying that further increases in the aggregate household debt-to-income ratio are likely. 

The overall financial situation of households remains strained  

Data for both individual households and the sector as a whole indicate that the financial situation of the household sector remains vulnerable. In particular, both the share of indebted households that have a debt-service ratio exceeding 40 per cent and the proportion of debt owed by these households remain above the 2000–2010 average.
The aggregate credit-to-GDP gap for Canada has fallen from its cyclical peak but remains high by historical standards, owing to the growth in household credit. International evidence has shown that this indicator is a useful guide for identifying a potential buildup of imbalances in the banking sector. 

Financial stress in the household sector has eased since the beginning of 2011, although it remains above pre-crisis levels: mortgage and consumer loans in arrears have moderated somewhat during 2011 but are nonetheless elevated. As well, the ratio of household debt to assets remains above its pre-crisis level, and household net worth declined modestly in the second quarter. Given negative returns across a broad range of assets since mid-year, net worth is expected to have declined further in the third quarter. 

Households are vulnerable to adverse shocks to the labour and housing markets 

Given the vulnerable state of their balance sheets, households would be less able to cope with the impact of significant adverse shocks. Two interrelated events to which Canadian household balance sheets are vulnerable are a significant decline in house prices and a sharp deterioration in labour  market conditions. 

Since high-ratio mortgages in Canada are insured, it is likely that a moderate fall in house prices would affect systemic risk primarily through the negative feedback loop with the real economy. In such a scenario, declines in house prices would lead to lower household net worth, reduced access to secured credit and lower employment in the housing-related sector. These factors would reduce consumer spending and increase strains on household balance sheets. 

Some measures of housing affordability suggest continued imbalances, owing to the robust performance of this market. In particular, house prices remain very high relative to income. Since the adverse impact of elevated residential property prices on affordability has been largely offset by low interest rates, affordability would be considerably curtailed if interest rates were closer to historical norms.

Certain areas of the national housing market may be more vulnerable to price declines, particularly the multiple-unit segment of the market, which is showing signs of disequilibrium: the supply of completed but unoccupied condominiums is elevated, which suggests a heightened risk of a correction in this market. 

A sharp and persistent increase in the unemployment rate would reduce aggregate income growth and make it more difficult for some households to make their debt payments. It would also have adverse knock-on effects on consumer confidence, the housing market and Canadian household net worth. 

The elevated debt loads of the household sector require continued vigilance

The Government of Canada has taken important measures in recent years to strengthen underwriting practices for government-backed insured mortgages. The most recent set of measures was implemented in March and April 2011, when the maximum amortization period was reduced from 35 to 30 years, the maximum loan-to-value ratio when refinancing a mortgage was lowered from 90 per cent to 85 per cent, and government-backed insurance on lines of credit secured by houses was withdrawn. These measures represented the continuation of a series of actions taken by the Government of Canada since 2008 to foster stability in the domestic mortgage market, and should help to moderate the future growth in household debt. Nonetheless, continued vigilance is warranted, since adverse debt dynamics remain in place. The Bank is co-operating closely with other federal authorities to continuously assess the risks arising from the financial situation of the household sector. 

Given the robust pace of mortgage credit growth in recent years, the Office of the Superintendent of Financial Institutions has conducted focused research on retail lending products over the past 18 months. An advisory was recently released noting that additional analysis is planned in the coming months. Where appropriate, this analysis will build on international mortgage underwriting principles being developed by the Financial Stability Board. OSFI has reiterated that mortgage lenders are expected to have an established policy for mortgage underwriting that is supported through appropriate risk-management practices and internal controls.

Key points and comments:

• Household balance sheets are likely to deteriorate further in coming months, and potentially years, with current controls in place.
• The Bank of Canada sees high house prices relative to incomes as unsustainable in the long run.
• OSFI is concerned about a disconnect between bank lending practices and long-term economic stability.
• Curbs on lending in terms of implementing risk management measures and countercyclical buffers on mortage loans are likely in the works.
• Usually announcements of further tightening of mortgage credit are announced in the first two months of the year to allow for proper implementation before the brunt of the peak of Canada's spring selling season.

If the Bank of Canada feels the need to lower interest rates in early 2012, this paper suggests that they are seriously considering additional curbs on mortgage lending to offset any additional monetary stimulus. This may mean, in particular overheated regional markets (like Vancouver's), that OSFI will start enforcing measures more closely tied to regional price-income metrics. This means Vancouver homeowners may find credit availability tougher than other regions of the country.

This is an important report. I have been surmising that further curbs in mortgage lending are coming, but am still unsure what form they will take. It is still possible that curbs going forward will start delving into the low-ratio mortgage market -- if prices do start falling banks who are lending on terms incompatible with government-backed mortgage insurance will create a significant liability for Her Majesty's Government.

Canada and Fiscal Stimulus Update November 2011

Back in a post in September I remarked it was relatively obvious that Europe was going to head into recession and that the Government of Canada was less likely to meet its "balanced budget in 2014" pledge; now Mark Carney is calling for a near certainty of a Eurozone recession and it looks like Canada will suffer lower GDP growth as a result. Recall my predictions of potential areas of stimulus should Canadian GDP growth falter:

Highly probable

• Accelerating capital cost allowance for businesses

• Slowing of public sector layoffs

• Lower corporate taxes

• Employment insurance hiring incentives

• R&D tax credits

• Extending employment insurance benefits

• Targeted but piecemeal government spending programs, geared towards non-residential infrastructure.

Somewhat probable

• A second "Canadian Action Plan"

• Energy efficiency upgrades

• Reducing Bank of Canada's overnight lending rate

Unlikely

• Reducing CMHC requirements for loans

Now today a fiscal update from the Department of Finance indicates more stimulus will be needed:

Flaherty also announced Tuesday the government is extending a work-sharing program that lets some employers hang onto skilled workers while they deal with money problems. Under the program, workers can drop to part-time hours and the government will top them up with Employment Insurance... 

Flaherty also cut in half the increase in EI premiums employees and employers are expected to pay starting Jan. 1, 2012. 

EI premiums were set to increase in the new year by up to 10 cents per $100 for employees and 14 cents per $100 for employers. Those increases will now be capped at five cents and seven cents respectively...

Border and trade talks with the U.S. will mean more spending on border infrastructure, Flaherty said after the speech.

So we have: corporate tax reductions (in the form of slowing EI premium increases), extending EI benefits, and non-residential infrastructure spending.

Though it would be unlikely to be announced, I expect there will be a slowing of public sector layoffs going forward. I'll have to wait until the new year to find out for sure about the R&D tax credit and grant prediction but I expect it won't be cut. I'm not sure about the CCA acceleration.

So far no major surprises. I am also anticipating that there may be further mortgage credit tightening announced in January, though I'm not certain if mortgage insurance will be the mode by which the government acts. Speculation has spread to the low-ratio loan market and, ultimately, the Government of Canada will be on the hook for many of these loans should prices retrench -- banks may not be aligning borrowers' ability to pay with longer-term rates in mind. Further curbs to mortgage lending may show up behind-the-scenes through OSFI decrees.

Central 1 B.C. Housing Forecast 2011-2013

Report available here (PDF). Excerpts (emphasis mine):

On the bifurcation of BC's real estate market:

A key characteristic of the post-recession housing market has been the divergent housing strength between the Lower Mainland and most other areas of the province. While the Lower Mainland-Southwest and, to a lesser extent, the Capital region had shown relatively stronger post-recession sales activity, most other regions remained at recessionary levels. The impact of low interest rates was more benefi cial for real estate markets in larger, diversifi ed economies with a higher proportion of local area buyers. In addition, employment growth was generally weaker outside of the Metro Vancouver region.

On overvaluation in the Lower Mainland:

It has become fashionable to suggest that price levels in Lower Mainland-Southwest region of the province, and particularly Greater Vancouver, are set to correct substantially due to the significant price gains in recent years and a de-linking of home prices relative to income and rental rates. Central 1 does not subscribe to this view, but does expect price gains to slow considerably over the forecast horizon. While price levels may turn lower in the near term, the annual Lower Mainland-Southwest median resale price level in 2012 is forecast to surpass 2011 by 1.4% to reach $497,000. A further gain of 3.6% is forecast in 2013 Central 1 deems a significant price correction in the Lower Mainland-Southwest to be unlikely for various reasons. First, much of the price growth in the region has been attributed to disproportionately strong demand for higher priced single-detached product in localized regions such as the west side of the City of Vancouver and Richmond. In contrast, price gains have been less substantial in other markets and product types, meaning this has not been a region-wide price surge. Moving forward, demand will likely remain stable as economic growth, albeit slow, persists and mortgage rates remain low.

In addition, speculative demand in the region remains low. The proportion of units re-sold within six months of purchase can be used a proxy for speculative activity. In theory, speculators look to gain through capital appreciation over a shorter time-frame relative to home-owner occupiers. In a period of higher speculation, which is generated by strong market activity and price gains, this proxy generally rises. However, this metric has exhibited a declining trend since early 2008, currently hovers near 2% and operates near normal levels. In contrast, this proxy surpassed 10% in the late 1980s, and was closer to 6% in 2006 when markets were overheated. The lack of excessive speculation suggests that we are unlikely to see a speculation-induced bust in pricing.

Meanwhile, price levels will be further supported by supply-side adjustments. Sales activity and the flow of new listings are positively correlated – when demand increases, new listings tend to follow in the months that follow. The opposite is also true. This reflects the tendency of sellers to capitalize on strong markets and rising prices, and sit tight when market conditions weaken. In the absence of any major shock in the economy such as a large and unexpected increase in interest rates or another recession, Central 1 expects the recent slowdown in demand to be met by declining listings activity, which will mitigate growth in standing inventory of resale product.

On population growth:

Weak population growth through 2013 will be a limiting factor for housing over the forecast horizon. The provincial population is forecast to expand at a lackluster rate of 1.1% this year, and fare only slightly better in 2012 and 2013 with 1.2% growth. The slow pace of growth will reflect a drop in the number of landed immigrants to B.C. from international markets this year and increased net outflow of residents to other provinces, primarily Alberta, in 2012 and 2013. This interprovincial net outflow reflects the stronger rebound in Alberta’s economy and improved labour market conditions.

On interest rates:

Mortgage rates will remain low and edge up beginning in the latter half of 2012 and through the remainder of the forecast horizon. This reflects a compression of bond yields, which have recently declined sharply in the U.S., Canada, and Germany during the latest round of market concerns and volatility. The U.S. central bank has stated that it expects no rate increase until mid-2013 and only then if conditions warrant.

I do not necessarily endorse this view in full; nonetheless the data presented are worthy of review. Personally I would give greater weight to price-rent ratios but to each his own. House purchases come with obligations lasting longer than to 2013. Place your bets.

Canada and Fiscal Stimulus Round 2 Fight!

Mark Carney is in Washington this week trying to convince 17 Europeans to agree. He was generous to take 20 minutes of his time to talk to The House's Evan Solomon on Europe's sovereign and banking debt crisis. Europe's woes are interesting -- Carney understands that to keep Greece and other countries a part of the common currency there will need to be large fiscal transfers to enable smooth transitions of these economies to lower their wages until they are competitive again. The more interesting part for Canada's housing market is Carney's comments (or lack of comments) on what Canada's government and central bank will do in case of a European-centred credit crunch giving the rest of the world a cold.

I'll summarise Carney's comments on how Canada will react to a potential impending global downturn (feel free to listen; unfortunately I don't have time to transcribe the most interesting bits):

• Canada's banking system will remain solvent one way or another.
• The US and Europe look to be undergoing slow growth for some years to come.
• Canada's businesses have been investing in capital equipment and need to continue to invest, making up for a chronic productivity gap with other countries.
• Canada needs to start selling and investing in ventures in the developing world.
• Elements of the massive fiscal stimulus unleashed in 2008 and 2009 can be retooled for 2011-2012, however many of the measures were less "effective" than desired [By less effective not sure if he means with undesirable side effects].

What Carney didn't say:

• Household debt issues were not discussed or alluded to.

Even with a massive fiscal stimulus emanating from Europe, which is looking unlikely, we should fully expect another round of fiscal stimulus to aid the Canadian economy. Given Carney's comments over the past year on: high household debt levels , robust house prices and sales despite tightened credit conditions, plum corporate balance sheets, and his relative silence on government fiscal spending, I will formulate some guesses on what fiscal and monetary stimulus will be concentrated on:

Highly probable

• Accelerating capital cost allowance for businesses
• Slowing of public sector layoffs
• Lower corporate taxes
• Employment insurance hiring incentives
• R&D tax credits
• Extending employment insurance benefits
• Targeted but piecemeal government spending programs, geared towards non-residential infrastructure.

Somewhat probable

• A second "Canadian Action Plan"
• Energy efficiency upgrades
• Reducing Bank of Canada's overnight lending rate

Unlikely

• Reducing CMHC requirements for loans

When a stimulus of the magnitudes required to stave longer lasting effects of a second recession, my feeling is the government is aware that increasing household leverage risks tipping households into an unsustainable debt spiral similar to what Ireland experienced a few years ago. This does not mean Canada is the next Ireland or Spain but the effects of overleveraged households should be obvious to anyone who has read the literature on these countries' housing busts. It may even be the case that if a stimulus is unleashed that commensurate crimps on residential investment will be required to ensure investment money flows are properly targeted away from the overbought housing market, and instead concentrating more on consumption with broader wage growth.

In summary, I expect the chances of a second fiscal stimulus package from the federal government are high, and we should expect that household borrowing will be carefully watched -- even regimented -- to ensure their debt-to-income ratios are not increased further. This will likely mean higher federal deficits in the next one to two years, and a probability the government misses its "balanced budget in 2014" pledge.

Mr. Flaherty Replies to My Concerns

In January of this year I sent a letter to Jim Flaherty and my MP concerning Canada's debt load. A copy of the letter I sent is below

To

Hon. Jim Flaherty

Your MP's name here

Sirs,

I am writing you supporting potential changes to mortgage financing rules in the upcoming year. As you are undoubtedly aware, the average Canadian household debt to household income ratio has increased significantly in the past number of years and has now exceeded that of the United States. This was made possible by historically, and unsustainably, low interest rates on mortgages. As has been shown in other OECD countries, there is some evidence to suggest that households are primarily concerned with their short-term financial health -- the ability to service today's debt with low interest rates -- and less concerned with their long-term financial health -- the inability to service service tomorrow's debt with high interest rates. I have not seen any data or arguments to suggest that household debt will start decreasing in the coming year as long as interest rates remain low. My concern is that without further tightening of mortgage financing rules, Canadians will continue to take on debts that are unsustainable in the long-term.

While I am a believer in free markets, the growth in household debt is not sustainable when interest rates rise and I am not confident households will start saving while debt is so "cheap". If measures are not taken sooner rather than later, the resulting overhang of debt will put Canada at a distinct disadvantage relative to its trading partners, whose households have started to rebuild their balance sheets and will be in a much better position to weather the inevitable interest rate rises in the coming years.

Sincerely

Your Name

Your Address

In response, Mr. Flaherty sent me this response via Canada Post:

Dear (redacted):

Thank you for the correspondence of January 6, 2011 regarding Canada's housing market. Please excuse the delay in replying.

The economy remains our Government's top priority. Although Canada is still recovering from the impact of the global economic recession, we have emerged stronger than most other countries. We are helping to support both economic growth and job creation through Canada's Economic Action Plan and through important tax relief for Canadians. Furthermore, we are encouraging responsible home ownership through measures to help first-time home buyers.

Canada's strong housing sector, especially our traditionally prudent mortgage market and responsible lending practices, has also been important to our economic recovery. Unlike the citizens of other countries, such as the United States, Canadians did not face mass foreclosures on their homes, and our banks did not require taxpayer bailouts due to turmoil in the housing market.

A home is a family's most important investment, and a stable and secure housing market keeps our economy strong. That is why our Government continually monitors the housing market, ready to take careful steps to ensure its ongoing stability.

In 2008, and again in 2010, our Government took proactive steps to protect and strengthen the Canadian housing market. In 2008, we announced measures reducing the maximum amortization period for new government-backed mortgages to 35 years, requiring a 5-percent minimum down payment, bringing in new loan documentation standards, and requiring a consistent minimum credit score. In 2010, we introduced additional adjustments requiring buyers to meet a five-year, fixed-rate mortgage standard, lowering the home refinancing amount that financial institutions can offer from 95 percent to 90 percent, and requiring a 20-percent down payment to non-owner-occupied properties purchased for speculation.

Recently, we announced further important and prudent measures to encourage Canadian families to make sound investments in their homes. First, we reduced the maximum mortgage amortization period from 35 years to 30 years for new government-backed insured mortgage (that is, for mortgages with loan-to-value ratios of more than 80 percent). This measure will significantly reduce the total interest paid by Canadian families over the lifetime of their mortgages. It will also allow Canadians to build up equity in their homes more quickly and helps them pay off their mortgages before retirement.

Second, we lowered the maximum amount lenders can provide when refinancing insured mortgages from 90 percent to 85 percent of the value of the property. For example, for a home valued at $300,000, refinancing at 90 percent would allow the homeowner to access up to $270,000 whereas refinancing at 85 percent would provide the homeowner access up to $255,000. The lower refinancing limit means homeowners will keep an additional $15,000 in equity in their homes and limit the repackaging of consumer debt into mortgages guaranteed by taxpayers.

Third, we withdrew government insurance backing on home equity lines of credit (HELOCSs). Taxpayers should not bear any risk associated with such consumer credit products. These risks should be managed by the financial institutions that offer these products.

These measures underline our Government's continued action to protect the stability of the economy by ensuring lenders' practices are sustainable and the investments of Canadian families in their homes are secure. This will decrease the interest payments of Canadian families by tens of thousands of dollars over the life of a mortgage, helping to improve the financial well-being of Canadian households.

Our Government's ongoing monitoring and sound supervisory regime, along with the traditionally prudent approach taken by Canadian financial institutions to mortgage lending, has allowed Canada to maintain a strong and secure housing market.

Thank you for communicating your concerns.

Sincerely

James M. Flaherty

First, I thank the Honourable Minister for his long and detailed response. The views expressed below are my own and not necessarily those of other authors on this blog.

There are many things about Canada's housing market for which the government can take some credit, namely that mortgages are generally more conservative than the filth that was promoted in the United States last decade. It should be stated, however, that the rule changes Mr. Flaherty cites as indication of his government's willingness to reduce debt loads are retrenchment of very rules his government brought in earlier last decade.

The government's "Economic Action Plan" -- "backfilling" spending when private demand was lacking -- was generally a reasonable response given the severity of the economic slowdown that started in late 2007 and continued into 2009. My concern with the implementation of this action plan, which involved heavy lending through CMHC-insured vehicles, is that it involved increasing debt loads on assets that were already showing signs of over-valuation before the recession. Unlike government debts that can be reduced through higher future taxation, consumer debts linger.

I am somewhat disappointed that the government sees "housing market stability" as a primary concern, yet certain regions of the country are, and have been, experiencing rapid house-price appreciation. Stability should not solely mean preventing price drops. The government does have at its disposal the ability to control prices on a region-by-region basis by changing CMHC policies, something it hasn't yet done (to my knowledge) for whatever reasons.

In any case, I am not expecting further changes to CMHC policy for the remainder of 2011, though I leave the door open to certain region-based measures aimed at cooling down credit hot spots more swiftly. There are a few ways by which this goal can be accomplished, including targeted capital flow restrictions, informal MOUs with big banks, and internal CMHC policy directives.

Global Rebalancing

Concerted discussions by G20 countries to formulate a cohesive monetary policy are slowly at work. Recent comments by Bank of Canada Mark Carney on high levels of capital flows, a demand-driven commodity boom, emerging market inflation, and the transfer of such inflation to developed markets like Canada's, supposedly gave stock markets a reason to take pause earlier this week.

An interesting article by Manoj Pradhan and Alan M. Taylor of Morgan Stanley argues that the "global savings glut", where capital flows to emerging markets (EMs) return "uphill" to developed markets (DMs) in the form of asset purchases, are unlikely to continue at previous pace.

Capital flowed “uphill” from poor to rich countries — EMs saved more than they invested, the excess showing up as current account surpluses (net exports of EM goods) and financial outflows (net acquisition of DM assets). But digging deeper exposed a crucial fact: private capital still flowed “downhill” to EM economies in line with intuition, but offset by even larger “uphill” official flows, the reserves bought by EM central banks and sovereign wealth funds.

...

While EM reserves might still grow gradually to track EM expansion, a continued aggressive step-change to augment reserves relative to GDP seems unlikely, as current war chests are evidently large enough to cope with severe macroeconomic disasters.

Why is this important for Canadian housing? It's not a coincidence that low interest rates have been helped by increasing demand for treasuries by those abroad who have saved. If their saving patterns look to be shifting into investment, that should produce higher interest rates for government debt.

The article concludes:

...we see lasting consequences beyond those unfolding in the immediate aftermath of the financial crisis:

• A huge rise in demand for capital in EMs with a more moderate increase in DMs. Talk of a savings glut or an investment drought may recede. The global real interest rate is likely to rise.
• Less saving flows out of EM economies. Growth prospects are the main driver but risk premia for newly resilient EMs may fall. If investment demand is muted in DMs, and saving flat, the shift is weaker in DMs. Global imbalances moderate, reinforcing the trends after the crisis.
• These current account shifts cannot be an “immaculate transfer” without real exchange rate adjustment. Recent real appreciation of EMs took the form of relative inflation and managed currencies (the latter creating political distractions). But EMs are likely to absorb further adjustment through nominal appreciation, given a triple whammy of cyclical reflation, growth differentials pushing nontradable inflation and oil/commodity price shocks.

Despite ongoing developed world unemployment issues, high commodity prices, and serial developed world sovereign debt crises, it's useful for us to remember the global economy will eventually start to recover in earnest and pay more attention to productive investment, and this can happen relatively quickly.

TD Bank Predicting House Prices to Drop

From TD Economics.

Our existing home sales and average price forecast for 2010 is largely unchanged since December 2009. We still expect 475K transactions to take place, with an average annual price
nearing $350K, an increase of 9% over 2009.

However, this hides an underlying shift occurring over the course of this year. While we anticipated sales and prices to be strong in the first half and to cool in the second half, we now expect this contrast between the two halves will be sharper.

A surprisingly robust economic recovery provides some offset in the form of higher employment and income, but a combination of factors suggests a weaker handoff to 2011 than previously expected.

One crucial factor is the supply side response (listings) to higher home prices. While it was slow to appear, it is now stronger than had been expected. Housing starts have also been slightly higher than anticipated at 200K units in Q1/2010.

While we previously expected the average home price to gain a modest 1.6% in 2011 (stagnating in real, or inflation-adjusted terms), we now expect a modest pullback of 2.7% at the national level, with 7 out of 10 provinces experiencing lower prices.

REBGV Sales are the Story

The local real estate market has been goosed this spring by the super low interest rates available to your average home buyer.

Sales in the REBGV jurisdiction were very high at 4259 for the month of June.

Active Listings fell to 13,252 units.


Consequently the Months of Inventory fell to a mere 3.11 for the month of June. A dramatic fall from January's levels.

As sales have risen and inventory has fallen, prices have gone up.

The correlation between Months of Inventory and Price Changes is still very strong.

It will be very interesting to see how future price changes play out. We will see if this spring market is a temporary phenomenon like so many other spring markets around North America.

Unemployment levels, interest rates, and many other factors play a big part in the local market and it will be interesting to see which way things turn.

Hoorah for 2008 and Predictions for 2009

2008 in Review

2008 was the year that the entire world woke up to the fact that houses don't go up in value forever and the entire mess of a year that 2008 was can be summarized in that fact.  Stock, bond, and commodity markets all reacted to the spectre of a long and protracted recession with no quick turnaround in sight.  It is truly amazing to see how consumption and borrowing against the value of a home had an impact at inflating the US and Canadian economies.

Locally, house prices fell dramatically starting in May and benchmark prices are now down nearly 14% in the REBGV area and just over 9% in the FVREB area.  The pundits are still calling for a spring turnaround and many real estate agents will likely be disappointed with their incomes during 2009.  They had better learn how to get sellers to drop the price fast or no paycheques will be forthcoming in 2009.  I fully expect that many real estate agents and mortgage brokers will try to find other work during 2009.

Prediction Time

I was 2 for 3 on my predictions for 2008 but I missed a big one as I didn't see how bad the stock, bond, and commodity markets would turn out.  

Predictions make fools of us all unless we are lucky enough to guess correctly.  Sometimes an educated guess is better than nothing however and it is kind of fun to toss around what we think is coming during the next year.

Here are my thoughts:

1) Real estate prices in the Metro Vancouver area will fall by 20% or more during 2009 from current levels.  The fall in prices will be worst for apartments and will be best for moderately priced suburban detached homes.

2) BC will enter recession sometime in 2009.  Canada and the US will continue in their recessions throughout most, if not all of 2009.

3) The Vancouver construction industry will be decimated during 2009 with many more projects hitting the completion phase and the need for labour dries up.  See historical employement statistics here.  The Metro Vancouver area will probably see a loss of 50,000+ jobs in 2009 from the construction, retail, finance, and real estate professions.

Credit Crisis: The Worst May be Behind Us (for now)

Several indicators, like the TED spread, have now reversed direction this week and are now getting better not worse after hitting ridiculously elevated levels last Friday.

See Calculated Risk for more on the Credit Crisis.

The local media has really glommed onto the idea that house prices have fallen and are falling more.  The facts, which were clear to many of us 2 years ago, become more obvious by the day to the average Vancouverite - house prices got too high and now they need to come back down.  Articles in the Georgia Straight, Vancouver Sun, Province, and Globe and Mail all pointing to further weakness in the local housing market.  It is improbable that there will be any material improvement in this situation for at least 18 months.

Several projects have now hit the skids with the overly ambitious Infinity Project in Surrey making the headlines this week.  More to come on further project cancellations.

I had a nice time off.  What are you seeing out there right now?

Bank Raises Rates on Variable Rate Mortgages

LORI MCLEOD, Globe and Mail Update, October 6, 2008 at 8:46 PM EDT

The latest victims of the growing financial crisis could be the standard discount available to consumers on variable mortgages, and home equity loans at prime.

In a move expected to be followed by other banks, all of which have been stung by higher funding costs, TD Canada Trust is raising rates on both types of loans, effective Oct. 7.

Rates on these products will rise to 5.75 per cent, a percentage point above the prime rate. Only last week, TD eliminated the discount on its variable rate mortgages, offering them at the prime rate of 4.75 per cent. During the housing boom of the past several years, consumers could often get their bank to drop the rate by half or even up to a full percentage point.

“While TD Canada Trust has endeavoured to not pass on the increases in rates to its consumers, this change reflects steadily increasing costs of funds in the current economic environment,” the bank said in a statement.

The percentage point increase raises the term interest cost on a $250,000 variable rate mortgage by $12,247.22 over five years, according to Royal Bank of Canada's online mortgage calculator. The difference is based on a 25-year amortization, a variable rate mortgage with a five-year term and bi-weekly payments. On that basis, the bi-weekly payment amount rises to $725.90 from $657.83.

The credit crisis and economic uncertainty have caused banks to stockpile their cash. That's driving up their short-term cost of borrowing from one another, and means margins on variable rate mortgage products are shrinking.

Rates on fixed-term mortgages went up last week too, as banks have passed on fewer of their savings from falling bond yields to consumers to consumers.

“The deterioration of global credit markets is beginning to squeeze the ability of even the strongest of financial institutions to raise longer-term funds, which could limit the provision of longer-term credit in Canada to businesses and households,” federal Finance Minister Jim Flaherty said in a statement Monday.

“Hopefully this isn't a permanent shift, but a short-term reaction to conditions the likes of which we really haven't seen before,” said Gary Siegle, regional manager at mortgage broker Invis.

With a discount, some customers can still get five-year, fixed-rate mortgages at 5.55 per cent, meaning a bi-weekly payment of $707.66 on a $250,000 mortgage amortized over 25 years. This means those looking for peace of mind in the current market turmoil aren't paying a premium to lock in, Mr. Siegle said.

Canada faces housing bust: Shiller

Jacqueline Thorpe, Financial Post Published: Wednesday, October 01, 2008

The Canadian housing market could face a similar housing bust to the United States, particularly in more bubbly markets as Vancouver and Calgary, said Robert Shiller, the University of Yale professor who predicted both the 1990s stock market boom and bust and the US housing slump.

Mr. Shiller, co-founder of the S&P Case/Shiller Home Price Index, said psychology is the primary driver of bubbles and it appears that Canada has been caught up with home buying fever just as the United States and other countries around the world.

Asked whether that meant Canada could face a similar bust Mr. Shiller said: "Yes, especially in places that went up a lot like Vancouver and Calgary. I don't think Toronto has been quite as extreme."

Mr. Shiller said there was a natural connection between the United States and Canada.

"I would be surprised that the bubble that appeared in the United States and elsewhere didn't appear in Canada," he said in an interview with the Financial Post. "It's psychology, I think that drives it.

Mr. Shiller, whose book Irrational Exuberance came out in March 2000 just as the tech bubble peaked, said it was essential for the U.S. government to pass a financial bailout, though he believes the United States is facing a "severe recession," regardless.

"I'm concerned problems are deeper than can be handled by the bailout but that doesn't mean the bailout doesn't do some good," he said.

He said a bailout might help restore some confidence to the stressed financial system.

"What creates a crisis is a lack of confidence," he said.

He said the housing crisis was primarily a policy failure by U.S. authorities.

The U.S. government was "totally blind" to it, regulators failed to monitor the mortgage industry properly and the U.S. Federal Reserve had very low interest rates at a time of the greatest housing bubble of all time.

While homeowners should take some personal responsibility for the debacle, they were being goaded into the fevour by an establishment that endlessly pushed an ownership society.

"They were doing what was considered right at the time," Mr. Shiller said.

Mr. Shiller said human nature seems to predispose people to spectacular excess, fanned by a voracious news media.

"Until we had newsapers and other media we had no bublbles, he said.

While ups and downs in the market can lead to creative destruction the current housing crisis has morphed into a system problem.

"The problem is that perfectly good firms are in trouble," he told the Financial Post in an interview at the Ontario Economic Summit.

A bailout may not be palatable, government assistance is required when the system fails.

The trick is to reduce conditions that fan bubbles.

In his current book, "The Subprime Solution," Mr. Shiller proposes several measures to reduce bubble conditions in the housing market including better information for prospective buyers and broader markets that trade risk better, such as the housing futures he has developed on the Chicago Mercantile Exchange.

There should also be new retail products such as "continuous workout mortgages," that go up and down with the value of the home equity and mortgage equity insurance.

Mr. Shiller, who would not give a precise forecast on the outlook for U.S. home prices, nevertheless said futures markets are predicting more price declines of 10% or more. His Case/Shiller index earlier this week showed home prices down 16.3% year-over-year this summer.

He expects things to get worse for the U.S. economy in the short-term.

"We're going to have a severe recession, most likely," he said. How quickly the economy recovers depends on policy.

"Unfortunately the bailout has hit a snag," he said. "There is resentment of rich Wall Street people. I am worried that the sense of trust, in confidence of each other is being damaged."

Mr. Shiller said he does not have another bubble in his sights as the U.S. economy will be "damaged for years."

"The housing bubble was of record proportions," he said. "Maybe the next big bubble will be your children's or grandchildrens...The excitement we had in the 1990s and in 2000 in the housing market is a fragile thing and it won't come back for some time."

Housing Problems Brewing in Canada

From the Financial Post. Read the actual report here (pdf).

Most of Bay Street has argued there is little risk Canada could suffer the same kind of housing-led credit crunch that is now hammering the United States and to a lesser degree the U.K. but one economist argues all the ingredients are there.

David Wolf, Canadian economist at Merrill Lynch, said Canadians are just as personally indebted as their other Anglo Saxon cousins.

"We believe that markets remain overly sanguine with respect to the prospects for the Canadian housing market, the financial sector and the overall economy," Mr. Wolf said in a note.

Mr. Wolf said the underlying source of U.S. troubles stemmed from the simple fact banks lent people too much money to go out and buy houses but there were obvious danger signs in the data.

For example, every year from 1952 to 1999, U.S. households were net savers, but by 2005 household net borrowing had swelled to 7% of disposable income, which the credit curnch is now reversing.

In the U.K. net borrowing reached a peak of 6.1% early this year.

But Canadian numbers are easily comparable. Canadian households moved into sustained deficit in 2002. The deficit grew to an average 6.3% in 2007 and in the first quarter of this year it reached 6.4%.

Judging from the massive outperformance of Canadian bank shares through the global crisis the market view is that that Canadian housing and credit markets are not going to crack, that somehow household overextention is somehow more sustainable in Canada, Mr. Wolf said.

"We fear, however, it may simply be a matter of time," he said.

The tipping point in the United States was the emergence of falling house prices in the summer of 2006, kicking off the "vicious" circles that have brought the financial system to the brink.

Canadian house prices are now beginning to fall, yet mortgage debt continues to grow at a double-digit pace.

"From this perspective, the absence of a Canadian credit crunch to date may be cause for concern, not comfort," Mr. Wolf said.

Yes, it is true. Canadians are in hock up to their eyeballs and we are no different from most of our counterparts in the rest of the western world. We have plenty of problems here in Canada so we need not try to pick out the specks in other people's eyes until we remove the log in our own.

don't PANIC

Well folks we are certainly in the middle of it now.

There is no denying that the fancy financial shenanigans of the past few years have now fully culminated in the fecal matter hitting the overhead rotational device.

Bring it on is all I have to say. Let's get this over with. Me and my clients are positioned decently to weather this storm but not without a concern for the broader societal impacts.

Investment banks - done.
Sketchy lending joints - done.
Poorly capitalized banks and insurance companies - done.
Hedge funds - done.

Fortunately, life will go on without these companies and hopefully it will result in less speculative mentality and behavior. Let's focus on doing productive things like designing and building stuff that works well. Providing valuable services with pride and honesty. Supplying the world with items of real utility and value.

Phinance for Physicists #1

Thanks to jesse for putting this together and doing some legwork.

I had a brief email conversation with Dr. Somerville on his recent paper regarding proper valuations of residential houses in different Canadian cities. He and I agreed that the life of an economist involves a bit more than plugging numbers into equations. However economics is a science so, having no significant formal finance/economics training but a bit more physics training, I thought I would bridge the divide with some much touted but rarely practiced cross-disciplinary legwork. Scientist to scientist.

A good friend of mine opined about physics education that the number of lies told during one's schooling slowly decreases. In many ways, in my current view, economics is like this. We use simple formulas, supply-demand curves, etc. in an attempt to understand the world around us.

With my limited understanding of finance, here starteth the lies.

Net Present value

The concept of The Net Present Value (NPV for short) is determining fundamental value for an asset, such a car, a boat, a stock, a pair of droids, a sail barge, or a house. The concept is simple: that the purchasing of this asset ties up one's money that cannot be used for other things, that people generally want to maximize their wealth, and that there is risk in tying up money in an asset.

Rule#1: The Net Present Value (NPV) of an asset is the sum of a series of expected discounted future cash flows.

What it means is that rational investors, given all other available choices with what to do with their money (opportunity cost), the risks involved, the expected revenue, expenses, and a little something for their trouble, will look at an asset and determine what the maximum they would be willing to pay to produce a fair return.

We can derive a rough formula for the net present value of, say, a condominium that is rented out. We assume the condo is rented out forever, which is a reasonable approximation (forever and 30 years produce about the same number). Returns and inflation compound so the series of cash flows increases geometrically but are discounted:

(1)

where i is the expected inflation of rent and expenses (say, 2% per year), and r is the so-called discount rate that is a combination of the long term bond rate (that includes expected inflation), a risk premium, and depreciation. The discount rate is a method of combining risk, inflation, and opportunity cost into one number. Rent is gross annual rent, and Expenses are annual maintenance, tax, and insurance costs (et cetera). Financing costs are not included here as the decision to buy is based upon having cash in hand, though more advanced analysis can explicitly include them. (Financing costs are, to a degree, implicit in the above formula) Note depreciation could be abstracted in Expenses or as part of the discount rate r.

Note that some condos will have more problems with tenants than others. How this is handled in the calculation is typically by having a higher risk premium included in "r" though in essence it could also be handled by using the expected value of rent, not nominal rent. The same principle applies for expenses, like the probability and expense of a condo being leaky for example.

This is in fact the formula mohican used to calculate fundamental value. He chose to use r-i (also known as the "cap rate") as the 5 year mortgage rate as a rough approximation. In his words, "The bond market and the banks are particularly efficient at determining the risk premium and adequately price that in to the 5 year mortgage rate. This is why I use it." Mohican also clarified to me that he assumes land appreciation and structure depreciation are roughly equivalent. It's also worth noting that mohican has chosen to use a relatively simple formula to estimate fundamental price and not spend too much time in details. In general there is nothing wrong with this but in certain situations it helps to know what to do if there are significant deviations.

The working paper Dr. Somerville et al published uses a formula similar to this but in a different form. It can be derived from the same basic principle, resulting in:

(2)

Where k is the long term mortgage rate, t is tax rate, m is maintenance, d is depreciation, (the last 3 are as % of property value) and E(DP/P) is expected capital appreciation.

Without going into the details, both mohican's and Dr. Somerville et al's chosen formulas can be construed to have been derived from Equation 1 above, from a strict financial, not economic, perspective.

Example

Let us use mohican's chosen formula in a simple example. A condo rents for $1000 per month, just sold for $220,000 and has expenses that are 20% of rent. The mortgage rate is 6%. NPV = 1000*12*0.8/0.06 = $160,000. This means that a rational investor who is looking only at future cash flows will be willing to pay $160,000 for this condo, according to mohican's formula.

Now, let us use Dr. Somerville et al's chosen formula for the same condo. We will assume that this condo will "conservatively" appreciate at E(DP/P) = 3% per year, k is 6%, t is $1200/year, or 0.5%, m is 0.5%, and d is about 1%. According to this formula a rational investor will pay 12000/(0.06+0.005+0.005+0.01-0.03) = $240,000

Analysis

Why the difference? There are two reasons. The main reason is contained in E(DP/P). It turns out, according to first principle derivations, that E(DP/P) is equal to the expected appreciation of future cash flows. In other words, a value of E(DP/P) increasing faster than cash flows are increasing from the current asset is expecting to either sell the asset to someone in the future for a price inflated by E(DP/P) (selling an asset is a cash flow), or that cash flows can increase more sometime in the future by using the asset more productively. Assuming 3% annual appreciation is more than what was implicitly assumed by mohican.

The second difference is more subtle. Remember in Equation 2 the expense costs were as a percentage of value. If capital appreciation continually outpaces rent inflation, these percentages perpetually drop; in other words the cost of capital perpetually decreases. This works mathematically but one must realize that the capital appreciation inherently includes productivity increases above what the current structure can support. The potential flaw in this is that the expenses must include construction costs for the productivity enhancements and would boost the percentages higher than what was calculated. Furthermore, and more importantly, one must think hard about what value to use in the denominator of the percentages. For this reason it may (must) be preferable to pull m, t, and d and make them nominal, not as a % of an arbitrary pre-calculated value.

Remember Equation 1 assumes an infinite series of geometrically increasing cash flows. If at some point in the future rents increase faster than expected or the land can be further sub-divided and used to produce more rent (say turning a 5 story condo into a 20 story condo 15 years from now), the NPV could be higher than what current cash flows suggest. One can approximate this by adjusting upwards the exponent on the geometric series. Expenses, too, can be nonlinear if there are major renovations or redevelopments in the future. If, however, the cash flows spike up (or down) too far in the future, their present values are diminished so as not to significantly change the expected capital appreciation rate. For example 1000 years from now a giant space tower with 6000 floors is likely to be built in a detached residential neighbourhood. This will have close to no impact on NPV, even if it were a certainty.

We can of course solve for E(DP/P) to figure out, if the condo just sold for $220,000, what the rational investor expects for capital appreciation.

Another measure thrown around local blogs is the 100X-125X monthly rent multiplier for condos. This would put our example condo at $100,000-$125,000. There is historical precedent for this occurring, though just as prices can be above one's calculated NPV, they can drop below as well. It IS reasonably possible to calculate NPV equal to 100X rent in Vancouver; in fact I think there is a good chance of select condo sale prices equaling this someday soon.

Regardless of which formula, mohican's, Dr. Somerville's, or some other fundamental asset formula, you may choose to use, remember that their roots are the same but their assumptions can be different.

The next (lesser) lie to discuss is looking at E(DP/P) -- capital appreciation -- in more detail; naturally, with housing in mind of course.

US Financials Falling Like Dominoes

Sept. 14 (Bloomberg) -- Lehman Brothers Holdings Inc. prepared to file for bankruptcy after Barclays Plc and Bank of America Corp. abandoned talks to buy the U.S. securities firm and Wall Street prepared for its possible liquidation.

Lehman and its lawyers are getting ready to file the documents for bankruptcy protection tonight, said a person with direct knowledge of the firm's plans. A final decision hasn't been made, though none of the other options being considered appeared likely, the person said, declining to be identified because the discussions haven't been made public.

Sept. 14 (Bloomberg) -- Bank of America Corp. agreed to buy Merrill Lynch & Co. for about $44 billion, a person with knowledge of the deal said, after shares of the third-biggest U.S. securities firm fell by more than 35 percent last week and smaller rival Lehman Brothers Holdings Inc. neared bankruptcy.

Bank of America and Merrill reached a deal in principle, according to the person, who declined to be identified because the deliberations were private. A final merger agreement hasn't been signed yet, the person said. The boards of Merrill and Bank of America approved the transaction this evening, the Wall Street Journal reported, citing unidentified people familiar with the matter.

Sept. 14 (Bloomberg) -- American International Group Inc., the insurer struggling to avoid credit downgrades, is seeking a $40 billion bridge loan from the Federal Reserve as it tries to sell assets, the New York Times reported.

The insurer has turned down a private-equity investment because it would have meant handing over control of the company, the Wall Street Journal said on its Web site, citing unnamed people. AIG may get access to the Fed's borrowing window in an ``extreme liquidity scare,'' Citigroup Inc. analyst Joshua Shanker said in a Sept. 12 research note.

The Undercover Economist

The Wisdom of Crowds?

A single economic forecast is usually wrong. But groups of economic forecasts are often just as mistaken. Why?

By Tim Harford
Posted Saturday, Aug. 9, 2008, at 6:44 AM ET

When people discover that I am an economist, they rarely ask me for my views on subjects that economists know a bit about—such as how to respond to climate change or pay less at a supermarket. Instead, they ask me what will happen to the economy.

Why is it that people won't take "I don't really know" for an answer? People often chuckle about the forecasting skills of economists, but after the snickers die down, they keep demanding more forecasts. Is there any reason to believe that economists can deliver?

One answer can be gleaned from previous forecasts. Back in 1995, economist and Financial Times columnist John Kay examined the record of 34 British forecasters from 1987 to 1994, and he concluded that they were birds of a feather. They tended to make similar forecasts, and then the economy disobligingly did something else, with economic growth usually falling outside the range of all 34 forecasters.

Perhaps forecasting technology has moved on since then, or the British economy is unusually unpredictable? To find out, I repeated John's exercise with forecasts for economic growth for the United Kingdom, United States, and Eurozone over the years 2002-08, diligently collected at the end of each previous year by Consensus Economics.

The results are an eerie echo of John Kay's: For 2004, for example, 20 out of 21 nongovernmental forecasts made in December 2003 were too pessimistic about economic growth in the United Kingdom. The Pollyannas of the U.K. treasury were more optimistic than almost any commercial forecaster and closer getting their forecast right. So, one might suspect that systematic pessimism is to blame.

But, no, in 2005, the economy grew more slowly than 19 out of 21 forecasters had expected at the end of the previous year. The Pollyannas of the U.K. treasury were yet again more optimistic than anyone and thus more wrong than anyone. A year later, all but one of the forecasters were too pessimistic again. Yet at the end of 2001, three-quarters of the forecasters were too optimistic about 2002.

2003 is an interesting anomaly: the one year for which the average U.K. forecast turned out to be close to reality but also the year where the spread between highest and lowest forecast was widest. The rare occasion that the forecasters couldn't agree happened to be the occasion on which they were (on average) right.

Recent U.S. forecasters have done a little better: The spread of forecasts is tighter, and the outcome sometimes falls within that spread. Still, five out of six were too pessimistic about 2003, almost everyone was too pessimistic about 2002, three-quarters were too optimistic about 2005, and nearly nine-tenths too optimistic about 2006. Perversely, the best quantitative end-of-year forecasts were made in December 2006, despite the fact that the credit crunch materialized eight months later to the surprise of almost everybody.

In the Eurozone, forecasting over the past few years has been so wayward that it is kindest to say no more.

The new data seem to confirm Kay's original finding that economic forecasters all tend to be wrong in the same way. Their incentives to flock together are obvious enough.

What is less clear is why the flight of the flock is so often thought to augur much—but then, some astrologers are also profitably employed.

The curious thing is that forecasters often have something useful to say, but it is rarely conveyed in the numerical forecast itself on which so much attention is lavished. For instance, in December 2006, forecasters were warning of the risks of an oil price spike, a sharp rise in the cost of credit, and a dollar crash. The quantitative forecasts are usually wrong and not terribly helpful when right, but forecasters do say things worth hearing, if only you can work out when to listen.Tim Harford is a columnist for the Financial Times. He is the author of The Undercover Economist, and his latest book is The Logic of Life.

Article URL: http://www.slate.com/id/2196827/