Mon Post #2: The Canadian Banking System - a myth built on quicksand?

Long time readers of this site know that on numerous occasions we have talked about the Canadian Banking System and the myth of it's stability.

It was on December 7th, 2009 that we quoted a Sprott Asset Management report and discussed how the Canadian banks escaped the 2008 meltdown unscathed.

Few realize all five Canadian banks are levered at an average of 31:1 and that if tangible assets were to drop by 3% in value, tangible common equity would effectively be wiped out.

Nor do many realize that Canadian Banks were bailed out by receiving $65 billion in liquidity injections from the Insured Mortgage Purchase Program (IMPP) in 2008 - Canada's version of TARP - whereby the CMHC purchased insured mortgages from Canadian banks to provide additional liquidity on the asset side of their balance sheets.

No one seems to be aware that the Bank of Canada then gave our Canadian Banks an additional $45 billion in temporary liquidity facilities or that the Canada Pension Plan, through the purchase of $4 billion in mortgages prior to the IMPP program, raised the total government bailout to $114 billion.

Back in 2009 we talked about how we have been fed almost daily fed propaganda that tells us that the dramatic performance of our nation's real estate during this worldwide economic crisis is all a result of the solid foundation of our nation's banks and the virtuous conservatism of the Canadian financial system.

And that's it is... propoganda.

Earlier today on of the contributors to our first Monday post left a link to an article titled "Canada's Housing Bubble Blow out amid Global Collapse".

The article provides an interesting analysis of the recent downgrading of Canada's banks by Moody's and the reasons behind the downgrade.

The move by Moody's marks the first of what will, no doubt, become widespread worldwide realization that the stability of Canada's Banks is more myth than fact.

The article is a great read and while the blog doesn't agree with all of it, it does articulate many of the points we have attempted to make in the past.

For your consideration:

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Canada’s Housing Bubble Blow Out Amid Global Collapse.

Sunday 24 June 2012, by Christiane

By Matthew Ehret-Kump

While this shouldn’t come as much of a surprise, the long-standing myth, proclaimed by official talebearers, that the Canadian banking system is the most “stable system in the world” due to its “conservative banking culture”, has been seriously undermined. Moody’s Investors Services recently spooked the Canadian banking community when it announced in a June 25 [1] report that the emergency “corrections” being made to the overblown Canadian real estate bubble to deleverage itself from oblivion, has come too late.

What happened?

In April of 2012, the Canadian Centre for Policy Alternatives (CCPA) issued a report called “Big Banks Big Secret” which demonstrated the sleight of hand $114 billion of bailouts of Canada’s five biggest “too big to fail” banks which had found themselves loaded with worthless assets from November 2008 until 2009 [2]. As the CCPA report documented, these bailouts were initiated by the Canadian government directly via the Canadian Mortgage and Housing Corporation (CMHC), which produced $67 billion to clear the books of private financial institutions of their toxic paper, followed up by the Federal Reserve’s 0% open discount window of 2011, which was tapped heavily by those same five banks who all the while maintained that they were in perfectly sound shape, and didn’t need any help yet took liquidity injections nonetheless. This Fed scheme, as well as a similar operation conducted by the Bank of Canada represented the remainder of the $114 billion bailout (figure 1).

Defenders of the bailout from all sides of the aisle in Canada, much like their American counterparts, will defend the scam by first calling it either a “liquidity injections” or “investment”, and then stating that they actually turned a profit after the initial capital was returned with interest! However, like in the United States, what tends to be avoided is the fact that those toxic assets covered by taxpayer revenue, represented magnitudes more than their nominal value due to infamous leveraging practices on the national and international derivatives scene. In the case of the USA, actual assets associated with those bailouts were in fact over $29 trillion [3]. This begs the question: how much fictitious speculative capital was actually represented by the underlying $114 billion?

Figure 1,

Canada’s Real Estate Crisis

Canadians have swallowed hook, line and sinker the story that ours is “the finest banking system in the world”. As a by-product of such a delusion, a great number of citizens have allowed themselves to get caught up in a gigantic real estate bubble where prices have doubled on average since 2002, although countless cases of quintupling or sextupling prices over the same interval exist (figure 2*). This bubble has resulted in average real estate values having surpassed even those of the United States at its peak as of June 2011 (see figure 3). When this is combined with the personal debt to GDP ratio of $1.50 to $1.00 as one of the highest of all Western countries, the image of Canada’s “conservative” financial culture no longer holds, and in its place, the dark shadow of a predatory banking system is expressed in the great northern dominion of the British Empire.

It now stands that total assets associated with securitized mortgages have stretched beyond $1.1 trillion dollars, and it is important to keep in mind that this is happening, not within a vacuum but within the context of the hyperinflationary meltdown of the trans-Atlantic monetary system.

Figure 2.

Figure 3.

What has kept this bubble growing?

In the immediate maelstrom now at hand, the chewing gum holding the hull of the Canadian financial system together is to be found in a few key factors, but not least among them is the ultra low interest rates being maintained by the Bank of Canada. These low interest rates of nearly 0% (figure 4) make borrowing cheap; attract international speculative agencies resulting in an ever stretched bubble. Insiders in the Canadian government have revealed to this author that during internal briefings, Mark Carney himself has pointed out that should even a small increase in interest rates occur, an immediate 10% default of houses across the board would follow resulting in a vacuum much greater than its $110 billion dollar nominal value.

These interest rates have been kept artificially low primarily as a function of the unprecedented taxpayer-backed insurance scheme provided by the Canadian Mortgage and Housing Corporation which was created in 1946 as a federal insurance agency modelled on the American Fannie Mae and Freddy Mac, but which under the current liberalized order, now behaves as a monster used only to prop up a dying system, evidenced by its astronomical insurance cap of $600 Billion dollars (a ceiling that had been increased several times by the Harper government in recent years from its $350 billion limit in 2007, and $50 billion in 1988 (see figure 5)). The other major mortgage insurer Genworth Canada, while remaining private, also has a cap of $250 billion, 90% of which would be covered by the Canadian government were it to go under.

Figure 4.

Figure 5.

To restate the formula: risky assets are guaranteed by the government on the condition that interest rates are kept nearly nil by the government such that exponential profits may occur as out of thin air. For this scheme to function, however, a highly centralized top down meshing of government and private finance must occur. As historian Tom Taylor wrote in 1976; “The political power of the larger banks and of the Bankers’ Association can hardly be exaggerated. The bank acts were written largely by the very banks supposedly regulated by them [4] .”

While it is important to understand the current chewing gum holding the ship of Canadian finance together, it is vital to keep one’s mind on the more important question “who designed the ship, and sailed it into the maelstrom?”

For this to be understood, it is necessary to look back a little farther into history and recognize the treacherous effects of the Mulroney governments’ destruction of three of the four pillars of banking in 1987. It is demonstrable that those speculative practices underlying the current bubble which Canadian financial cartels have been complicit in creating, both at home and internationally alike, could not have occurred were it not for the repeal of those laws which forced the separation of commercial banking, trusts (which were the sole issuers of mortgages), securities dealers, insurance companies and which had been maintained for decades following World War II, otherwise known as the “Four Pillars”. After the repeal of those pillars all of the above financial institutions could all mingle under one roof and waves of mergers of the already cartelized financial institutions during the 1990s resulted in a new type of beast which could take legitimate deposits and create the means of leveraging risky securitized debts (as well as other insured liabilities) as “universal banks”, much of which would be now backed by tax guarantees. To re-emphasize, mortgage related securities could not have existed had the Four Pillars not been repealed.

This was the Canadian experience of the same essential process which lead up to the repeal of the Glass-Steagall under the Gramm-Leach-Bliley Act in the United States in 1999 orchestrated by the City of London centred oligarchy around Lord Jacob Rothschild’s Inter-Alpha Group of banks.

Today, this system has inflated itself beyond all containable limits. The Canadian Council of Chief Executives has implemented a veritable coup over the past several decades for their London masters. The time has come to decide whether Canada will move with the LaRouche three-step program of a Glass-Steagall-like bank separation, the adoption of a public credit system and the North American Water and Power Alliance (NAWAPA) or abandon all remnants of national sovereignty as it follows the City’s crazed British financial empire faction into hell.

*Graphs 1, 3 and 4 were taken from www.theeconomicanalyst.com and Figure 2 was taken from www.mjperry.blogspot.com

Footnotes

[1] “Moody’s Warns on Mortgage Debt” June 25 2012, www.globeandmail.ca

[2] “Big Banks Big Secret: Estimating Government Support for Canadian Banks During the Financial Crisis”, by David Macdonald, Apr 2012. www.policyalternatives.ca

[3] “$29,000,000,000,000: A Detailed Look at the Fed’s Bail-out by Funding Facility and Recipient” by James Felkerson Dec 2011. www.levyinstitute.org/

[4] History of Canadian Business: 1867-1914, 1976

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How can we be so blind?

Yesterday I mentioned that I had an encounter with James, a casual acquaintance of mine who happens to be Scottish (he's a tolerable guy though, so we overlook that).

I've known James for almost 20 years, but yesterday was the first time we had ever talked about real estate... and it was an intense 15 minute conversation in which he hit on just about every stereotypical defense for real estate.

'Real Estate never goes down, you can't ever go wrong buying and our solid Canadian banking system won't facilitate any sort of collapse here.'

It was almost a surreal encounter.

But it speaks volumes.

Mainstream Canada is still completely unaware. They have bought into the 'official' line that everything is alright.

And perhaps it is just as well. Can you imagine the panic to dump real estate were it any different?

The average Canadian is blissfully ignorant about what has happened... about what is happening... about what is about to happen.

They are completely unaware about how our Canadian banks barely escaped their own meltdown in 2008.

Few realize all five Canadian banks are levered at an average of 31:1 and that if tangible assets were to drop by 3% in value, tangible common equity would effectively be wiped out.

Nor do many realize that Canadian Banks were bailed out by receiving $65 billion in liquidity injections from the Insured Mortgage Purchase Program (IMPP) in 2008 - Canada's version of TARP - whereby the CMHC purchased insured mortgages from Canadian banks to provide additional liquidity on the asset side of their balance sheets.

No one seems to be aware that the Bank of Canada then gave our Canadian Banks an additional $45 billion in temporary liquidity facilities or that the Canada Pension Plan, through the purchase of $4 billion in mortgages prior to the IMPP program, raised the total government bailout to $114 billion.

And what about the CMHC being ordered by the Federal Government to approve as many high risk borrowers as possible to prop up the housing market (with entry level buyers) and keep credit flowing?

• In 2008 some 42% of all high risk applications were approved, a 33% increase over 2007.
• Between the beginning of 2007 and 2009 Canadian Banks increased their total mortgage credit outstanding listed on their books by only 0.01% - possibly the smallest amount of change in post WWII history - which was the only way we managed to keep credit flowing in our country while it dried up in the USA.

Canadians are oblivious.

They can't see how this all impacted the debt orgy. Aren't aware of how CMHC's obligation has grown from $100 Billion in 2006 to $776 Billion in 2010.

Last year the Conservative Government, after our nation spent 10 years digging ourselves out of a $45 Billion deficit with onerous taxes like the GST and years of cutbacks in government services, replunged us back into hock with a record breaking $50 Billion deficit.

If CMHC is forced to pay out on a mere 10% of that guaranteed $776 Billion, that amount would more that double that historic $50 Billion debt.

But the average Canadian is completely oblivious.

They sincerely believe that our secure, non-bailed out Canadian banks don't lend to 'risky borrowers'.

They are wilfully blinded to the ads all around them whereby someone with no money can go out and, courtesy of bank initiatives like this one that offers them 7% back, can get their 5% downpayment covered and actually get PAID 2% of the mortgage value to make that purchase.

Nothing down and get PAID to buy a house!!!

No... we don't see it.

We tell ourselves we aren't making the same mistakes the Americans did. And we do it with blatant ignorance.

But Americans can see it.

When I spoke to two tourists from Minnesota in August, they asked what the interest rate was on a 30 year mortgage here. When they found out virtually no Canadians have long term mortgages... that the vast majority have 5 year terms or less that reset at whatever the going interest rate is... they recoiled in shock. They instantly recognizing that all Canadian mortgages are set up exactly like American subprime mortgages: 2-5 year low teaser rates that reset higher once the teaser term is over.

But the average Canadian is oblivious.

We bailed out our Banks.

We allow people with no money to buy houses (which has driven up the price of our real estate exponentially).

We have a vastly higher percentage of Canadians juiced on teaser rate mortgages, mortgages they can afford now but for which the vast majority will not be able to afford when rates reset higher.

And when interest rates do climb higher, our real estate market will implode just as spectacularly as California, Phoenix or Florida.

That collapse has already started. As I have shown you in posts this month

• Okanagan Real Estate has stagnated and properties are down 50%,
• Victoria Real Estate, after three previous months of sales down by over 40% from the same month last year, are on target for a 75% decline this month,
• Vancouver is on track for a fourth consecutive month where sales are 40% down from the same month last year,
• Bob Rennie is selling luxury condos downtown at the Fairmont Estates for 40% off their March prices, and
• in Surrey developers are offering units for 35% off their 2006 pre-sale price.

We are like the people in South East Asia who, on Boxing Day 2004, witnessed the sea drain from their shores.

Not sensing the danger, they ventured out to check out the tidal flats in wide-eyed wonderment only to realize, too late, the danger as they tried to flee for their lives from the crushing Tsunami barreling down on them.

The only difference is that the South East Asians didn't witness a neighbour go through the same situation 3 years earlier and then make the same mistakes.

Canadians saw the Housing Tsunami strike America, the UK and Europe. We have no excuse for not seeing this coming.

Yesterday my friend James revelled in calling me a doomer.

I perfer the term 'rational realist', myself.

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The Great Reckoning (... what'd I do?)

In April of 2009, Statistics Canada conducted a survey on financial capability.

The survey found that more than 1/3 of Canadians said they were either struggling or unable to keep up with their finances.

And you can bet your bottom dollar, dear blog reader, that a good portion of the other 2/3's (the ones that said they were not struggling to keep up with their finances) are probably in the blissfully ignorant camp.

Self-assessment scales need to be taken with a grain of salt. Most of us will report that we are good drivers. Not all of us are.

As I have said time and time before, the story of Canadian Real Estate is going to be the story of interest rates. And those rates are going to be going up. The only question is... how high are they going to go?

Over the past week I have tried show that the current economic 'recovery' is all based on massive amounts of government stimulus. That western governments were within hours of a complete meltdown of the world's financial system and - in a desperate attempt to prevent a nuclear meltdown - the braintrusts of our national finances responded with knee-jerk reactions to halt a complete financial collapse.

Now they are struggling with the repercussions of those moves.

Worse... key members of that braintrust now admit that they made key mistakes that lead us to this precipice in the first place.

This is important since the 'emergency measures' taken in September/October 2008 were based on the those very flawed strategies, strategies which were once again drawn upon and taken to the extreme in the heat of potential disaster.

In Canada our own 'braintrust' made several catasrophic moves that are going to wreak havoc on our country in the years ahead.

When the 2007 real estate crash swept across the United States, Canadians smugly looked down at their noses at our American cousins and exalted in the superiority of our Canadian banking system.

But as we would come to learn, our Canadian banks barely escaped their own meltdown in 2008.

All five Canadian banks are levered at an average of 31:1. According to a report by Sprott Asset Management this implies that, if the Canadian banks’ tangible assets were to drop by 3%, their tangible common equity would effectively be wiped out.

When the recession started to appear in Canada, and real estate values began dropping here; government moved quickly to intercede.

If asset prices could be protected, it was rationalized, our nation could weather the recession and minimize the fallout.

To achieve this 'asset protection', Canadian Banks received $65 billion in liquidity injections from the Insured Mortgage Purchase Program. This is the official way of saying the Canadian Government, through CMHC, purchased insured mortgages from Canadian banks to provide additional liquidity on the asset side of their balance sheets.

The Bank of Canada then our Canadian Banks with an additional $45 billion in temporary liquidity facilities and there was also assistance from the Canada Pension Plan through the purchase of $4 billion in mortgages prior to the IMPP program for a total government expenditure of $114 billion.

But real estate values in Canada were plunging nothwithstanding. Que the next phase of the 'asset protection' strategy.

The CMHC was ordered by the Federal Government to approve as many high risk borrowers as possible to prop up the housing market (with entry level buyers) and keep credit flowing.

• In 2008 some 42% of all high risk applications were approved, a 33% increase over 2007.
• Between the beginning of 2007 and 2009 Canadian Banks increased their total mortgage credit outstanding listed on their books by only 0.01% -- possibly the smallest amount of change in post WWII history.

This bit of financial magic to securitized all these mortgages by the CMHC is the only reason credit continues to flow to our real estate industry.

And it worked. Canadians jumped on the cheap, easy money and continued with a debt orgy that started in 2001.

• The Canadian mortgage securitizaton market has grown from $100 billion in 2006 to $295 billion by mid-June 2009.
• CHMC plans to expand securitization of debt to $370 billion by the end of 2009 as per the conservative government request.
• CMHC indicates in its plan that it will insure $813 billion via a combination of mortgage insurance and mortgage-backed securities (MBS) by the end of 2009.
• According to CHMC figures from 2008 and 2007 it is clear that CMHC has drastically exceeded their planned figures. It is expected that $812 billion is more than likely to be a minimum target.
• At these rates of progression the Government of Canada will in effect be insuring well over $500 billion in securitized mortgages and lines of credit by the end of 2010. The Canadian Government will also have issued over $600 billion in outstanding mortgage insurance.

Make no mistake, the moves that the Canadian Federal Government took in 2008 forestalled the US financial meltdown from spreading to Canada.

By preventing the collapse of our real estate market; our financial system did not follow the path of our American cousins.

But at what cost?

Last Thursday we outlined the gigantic hole that Canadian households have plunged themselves into.

Debt held by Canadians is at an all-time high. Especially mortgage debt.

The policy of emergency interest rates and the moves to 'support' the Canadian banks can only succeed it there is a dramatic increase in the economic fortunes of the world economy.

But as I have outlined before, in order for the world economy to properly restructure we must still undergo a tremendous amount of deleveraging.

This will be a drag on any economic rebound for years to come.

Meanwhile, when the central banks start tightening monetary policy to mop up excess liquidity and stave off inflationary expectations and when capital markets start pushing back against massive government deficit funding and corporate debt rollovers, interest rates will have nowhere to go but up.

And, with it, will go mortgage servicing costs.

This process will not fully play out for 15 - 20 years, which means we will see very high interest rates for most of that period.

Since 2001 Canadians have been like the kids in the movie Ferris Bueller's Day Off. We have skipped class and finacially partied, having a grand old time.

At the end of that classic movie, Cameron Fry is left to deal with the ultimate reckoning from the reckless adventures of our heroes.

And while the movie glosses over that reckoning for Fry, that won't be the case for the 1/3 of Canadians say they are either struggling or unable to keep up with their finances when interest rates are at the lowest point in our nation's history.

Will Canada become a nation of Cameron Fry's?

When interest rates shoot up, Canadians are going to be caught in a debt vice of historic proportions. If 1/3 of Canadians are either struggling or unable to keep up with their finances now, what's it going to be like when the posted 5 year bank rate sits at 15%?

I distinctly remember a family friend, in the early 1970s, declaring that "the government will never allow mortgage rates to go over 10% because it would inflict too much financial harm on the people!"

By the end of the decade that family friend (as well as my parents) had to renew their home mortgages at 19% and 22% respectively.

How many are rationalizing in a similar delusional way today?

How many will be wiped out trying to service debt at interest rates at half of those 1980s levels?

How many will be uttering that infamous line... "what'd I do?"

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