More thoughts on real estate and the nature of Canadian banking

(Disclaimer:  Opinons are my own and don’t reflect in any way those of my employer)

There is a very good post (“Real Estate: Are High Prices a Bubble or New Normal“) from December 2013 by my colleague David Wishart that I had overlooked. It concentrates on banking and the nature of why banks lend, why they prefer to lend a certain way and how they hedge their risks. Read the whole thing here

Here is an excerpt:

As the banking industry has consolidated over time after periodic recession induced bank failures, management decision making has become more centralized. The era of the small independent savings and loan institution depicted in the movie It’s A Wonderful Life is largely over. The average branch manager has far less autonomy to make loans to local businessmen than in the past and must defer the credit approval process to formal adjudication centers. These centers rely mostly on standardized credit policies rather than personal relationship management (the character C of credit). As a result of regulatory pressure, competitive pressure to manage costs, and additional compliance to handle increased operational risk in a larger organization, differentiated small business loans with their own unique features become less feasible. What banks need for lending purposes is consistent, homogeneous collateral like real estate or an automobile. When collateral is similar and subject to a more straightforward legal framework than a small business loan, it means that these mortgages and auto loans can be securitized more easily in to Mortgage Backed Securities (MBS), Asset Backed Securities (ABS) and then further tranched in to Collateralized Mortgage or Loan Obligations (CMO or CLO). This kind of securitization at least at present isn’t available for small business lending. A combination of a bank’s own ability to shoulder risk and BASEL regulatory requirements like the liquidity coverage ratio (LCR) or the capital ratio’s risk weighted assets treatment (RWA) means that the modern global bank isn’t able to make numerous dissimilar small business loans and is naturally steered towards lending for real estate purchases. This is further exacerbated by government guarantees on high ratio mortgage loans that protect banks from losses in the higher risk portions of the housing market.

From a risk management perspective, private banks have to do the best they can to line up their liability cash flows with their asset cash flows. What this means is that if the bank has a lot of long dated loans on its books and many short dated deposits, it can either securitize the loans and sell them for short dated bank reserves (cash) or it can sell long dated bonds to the market and stretch out the term structure of its liabilities. Mortgage and auto loans more easily facilitate this process on either side of the balance sheet, especially as covered bonds (a debt of a bank that is typically collateralized by mortgages) become more popular as a bank funding instrument. (bold emphasis added)

Related to this I have made the point in some previous posts that for the macroeconomy to grow better in the long run it may require that banks become ‘less’ profitable in the short run. Now, as a bank employee, this may sound counterintuitive and against my interests and those of the many banking employees that make a living working in the Canadian financial sector –I am not referring to investment banking “Master of the Universe” or prop trading types, I am referring to the legion of middle class employees that have benefits, a pension and work diligently day in and day out– but upon closer examination it isn’t.

Currently, everything is structured towards pushing the banks toward areas such as residential mortgage lending as the David Wishart’s passage illustrates. This cannot continue indefinitely as the Canadian economy becomes less diversified and more concentrated in its reliance on resource extraction and real estate, there comes a time when the expanding balances sheets of Canadian households (driven by bigger liabilites of ever larger residential mortgages) meets the reality of stagnant incomes. To reprise the business analogy, it isn’t a great sign to have an ever larger balance sheet with no concomitant rise in income. Greater levearge entails less resilience.  This is what has been happening in Canada. Rather than a housing crash, which is in no one’s interest, we will arguably see slower growth as discretionary consumption by many is curtailed to support debt obligations. The low growth thesis also  relates to the cost of raising a child to adulthood which is reaching astonishing new heights according to Maclean’s magazine and means that the consumer, the driver of growth and the bastion of consumption, can only spend so much witout further access to credit in the absence of wage increases.

Back to the issue to bank lending and the supply of credit: clearly on the supply side we do need to refocus an emphasis on not only getting more lending to SMEs but also have policies that encourage those SMEs to become bigger and more productive. In financial parlance, this is termed credit for investment purposes rather then credit for speculative purposes (i.e. buyin a house, making cosmetic changes and then flipping it for substantially more after a few months). None of these problems have ready made solutions but we aren’t going to get there with speculative finance and hoping that real estate prices continue to skyrocket. Trees don’t grow to the sky and ultimatley the price of a place to call home has a limit.

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