A smart way to cushion Canada's economy from future housing bubbles involves nothing more than re-engineering our mortgages.
In their new book, House of Debt, Atif Mian and Amir Sufi argue that out-of-control housing prices tend to inflict long-lasting pain on a country's economy, but much of that distress can be avoided. The key? Forcing banks and other lenders to share in the ups-and-downs of the real estate cycle by requiring them to bear part of the cost if a housing boom implodes.
The authors, who teach at Princeton and the University of Chicago, respectively, are mostly concerned with the U.S. housing debacle, but their work deserves attention in any country that suspects it, too, may be suffering from real estate dementia.
Canadians, in particular, may want to lend an ear. The soaring sales volumes and steadily rising prices reported by the Canadian Real Association on Tuesday indicate that consumers here are still wildly optimistic about the outlook for residential real real estate. Observers outside the country are far less sanguine, however. Both investment research firm Morningstar and credit rater Fitch published reports in the past few days that argue Canadian home prices are at least 20 per cent overvalued.
Many housing skeptics believe Canadian regulators should dial down the real estate euphoria by further raising down payment requirements and imposing more severe financial tests on mortgage applicants. But previous fiddling has failed to rein in the general bullishness about housing.
The two professors propose an idea with far more teeth. They suggest rewriting mortgage contracts so that a homeowner's payments and principal shrink if an index of local home prices declines. In effect, their system would shove part of the losses onto the shoulders of the mortgage holder. (Yes, in Canada that would be mostly you, Big Six banks.) In return, the lender would get a 5-per-cent slice of any capital gains on the house when it is sold or refinanced.
Notice how this changes, well, everything. Suddenly lenders would no longer be just dispensers of cash, but active participants in the housing market. Since they would now feel the pain if home prices fall, they have a compelling reason to cut back on lending to home buyers if they figure a market is growing overheated.
On the other hands, banks have every reason to lend in situations where home prices seem to be lagging behind income growth or other fundamentals. If the Canadian banks' generally rah-rah attitude toward the real estate market is justified, they should do very well under a re-engineered mortgage system because they'll be able to grab a modest chunk of the capital gains when homes are sold.
Profs. Mian and Sufi acknowledge that forcing banks to eat part of a housing downturn might be seen as a get-out-of-jail-free card for consumers who foolishly take on too much debt. But they argue that it creates powerful incentives for lenders not to give money to those spendthrifts in the first place. And, they say, it is more than justified by the potential savings from avoiding a home-price collapse.
The authors of House of Debt make a persuasive case that a housing bubble is nearly always poisonous for a country. Unlike a stock market crash, a plunge in home prices hits hardest at young families and working-class people. It wipes out the modest equity they have built up in their residences and prevents them from spending for years to come.
A general rush to sell real estate also drags down property prices in general and so hurts even people who are financially stable and prosperous. As their net worth falls, they, too, cut back on spending.
For all those reasons, history shows that housing bubbles are usually followed by extremely long periods of slow economic growth. Revamping our mortgage system seems a small price to pay for protection from that calamity.
Ian McGugan