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The financial and housing sector correction in Canada and Europe: Why so different? What does this mean for recovery? March 9, 2009 Millan L. B. Mulraine Economics Strategist Key takeaways • The spark for the global financial and economic crises was the sudden and dramatic correction in the U.S. housing sector • Seeds of the crises were sown in the post-tech bubble era of easy credit • It could be argued that the European housing market bubble was much bigger than in the U.S. • Exposure to the Central and Eastern European economies (CEEE) has added another dimension to the European banking system crisis • The Canadian banking and housing sectors have been spared the sudden correction that has plagued their European counterparts U.S. housing bubble • Housing – NINJA (No verification of INcome, Job status, or Assets) loans – High risk borrowers offered exotic loans – Speculation in home prices • Financial alchemy – Old mortgage lending model discarded – Mortgages bundled and sold – The securitization of mortgages led to loose lending standards • The bottom fell off – Mortgage defaults and foreclosures skyrocketed (jingle mail) – Value of mortgage-backed securities (MBS) plunged – MBS went from exotic to toxic The bursting of the bubble U.S. Home Prices 20 15 10 5 0 -5 -10 -15 -20 70 74 78 82 86 90 94 98 02 Median Price of Existing Single-Family Homes (y/y % chg.) 06 Banks take it on the chin Writedowns Due To U.S. Housing Crisis US$ 'billion 1,000 900 $850B 800 700 600 $494B 500 400 $327B 300 200 100 $29B $12B Asia Canada 0 Worldwide Source: Americas Europe Why no Canadian banking crisis? • Market structure – Deposit-oriented – Conservative lending practices – Captive market (oligopolistic in nature) – Competition vs stability • Regulatory environment – No allowance for domestic mergers (or foreign takeovers) – Deposit and mortgage insurance helpful • Hit from subprime crisis manageable – Limited exposure to U.S. MBS – Modest domestic housing correction Canadian Housing Price Correction Remains Modest 2005:6 = 100 135 125 115 105 95 85 75 65 Feb-99 Apr-00 Jun-01 Aug-02 Source: Teranet, National Bank Oct-03 Dec-04 Feb-06 Apr-07 Jun-08 Canadian Mortgage Arrears Remain Low % 0.75 0.65 0.55 0.45 0.35 0.25 0.15 Jan-90 Feb-92 Source: CBA Mar-94 Apr-96 May-98 Jun-00 Jul-02 Aug-04 Sep-06 Oct-08 The bursting of the bubble Canadian Home Sales Crash ' 000 45 40 35 30 25 20 15 Jan-90 Feb-92 Source: CREA Mar-94 Apr-96 May-98 Jun-00 Jul-02 Aug-04 Sep-06 Oct-08 European banks being squeezed US Housing Crisis European Banks’ Pain CEE Economic Crisis Domestic Housing Crisis European housing crisis • Housing boom – Housing sector bubble bigger than the U.S – Deregulation in the 1980s and 1990s, and Euro introduction • Non-banks were able to issue mortgages • Application procedure loosened • Low interest rates – Ireland, Spain and the U.K. main culprits – Spain built more homes in 2006, than Germany, France and (combined) • Credit-powered growth – Credit binge bolstered economic growth – Banks were more leverage than their U.S. counterparts – EU lacks institutional framework to handle banking crisis UK 1983 Source: IMF 1990 N Jap et he an rl an d N s or w ay S pa i U ni S w n te d ede K in n U ni gd te om d S ta te s Ita ly tr al i A a us tr B ia el gi um C an a D da en m ar Fi k nl an d Fr an G ce er m an y Ir el an d A us Mortgage Debt to GDP % 120 100 80 60 40 20 0 2006 European Real Home Prices 1997 = 100 300 Ireland 250 France Spain 200 150 United Kingdom Euro Area 100 50 1995Q1 Source: IMF 1997Q3 2000Q1 2002Q3 United States 2005Q1 2007Q3 Source: IMF U ni Ita ly n ed e w in pa Ja te pa n d S ta te Fi s nl a G nd er m an C y an ad A a us tr ia S S Ir N ela e U th nd ni e te rla d n K ds in gd om A us tr al ia Fr an c N e or w D ay en m a B rk el gi um House Price Gap % 35 30 25 20 15 10 5 0 -5 -10 Economic contagion • CEE growth opportunity – Credit-starved economies seen as “green pastures” – Credit binge: credit flowed like water (over US$1.7T borrowed) – Housing sector boom ensued – Unhedged foreign currency loans soared (Euro or SWF popular) • The hangover – CEE economies slowed – Domestic currencies plummeted – Debt-ridden consumers default – Impact on Western Europe is expected to be profound Liabilities To Foreign Banks % of GDP 160 140 120 Others 100 Italian Austrian 80 German Scandinavian 60 40 20 Source: IMF Tu rk ey bi a Se r d Po la n ia en Sl ov an ia R om ria Bu lg a R ep . . C ze ch ak R ep ia Sl ov ua n Li th ga ry H un ia La tv at ia C ro Es t on ia 0 Response betrays crisis • Fiscal response to CEE crisis – Support for CEE economies an imperative – Political vs economic costs – Fortunes of East and West intertwined • National response to financial crisis inadequate to resolving a Euroean problem – Exposes soft under-belly of the EU financial sector – May be a factor in exacerbating the problem – Small countries suffer from inadequate scale and resources The way forward • Coordinated fiscal response required • Canadian model has virtues that may be relevant • Unified regulatory/supervisory framework a necessity – Financial sector supervisory and regulatory functions remain fragmented and need to be consolidated – “Beggar thy neighbour policies” will lead to “race to bottom” • European financial stability fund? – A number of countries has similar funding vehicles The bottom line • Canadian housing and financial sector correction is expected to be modest • Mitigating the adverse impact of the economic crisis in the CEE will require significant financial resources • Despite the aggressive actions so far, further losses and bank failures remain likely • The way forward for Europe will be increased coordination in both fiscal and prudential policies • A turning point in the financial crisis will come about when home prices begin rising