Pt. 2: Leverage in the System- 2017 Canada vs. 2007 USA

Part Two: Leverage in the System; USA vs Canada

Excessive leverage is one of the primary concerns that a market is in a precarious position, and leverage is directly tied to a market’s long-run volatility: by the way that leverage creates more extreme returns, housing markets that use more equity are less volatile and more stable over the long run. Their bubbles do not run as high and their crashes are not as severe. This is based on the fact that more leveraged investments will move with greater force in either direction, making them more susceptible to large swings.

Every individual housing market is different, and every city has different features that affect the growth and volatility of its housing prices. Different cities even have a different proportion of influence derived from local vs. national factors. What is almost universally true is that, since 1999, housing markets around the country have become more connected to the performance of the national housing market (and the stock market) and less volatile overall.

This change coincided with the availability of more advanced financial instruments that spread money through a wider housing market, and low interest rates that encouraged more leverage and more speculation. It produced less volatility over the short run, but it was deceptively fueled by debt over the long run.

This is what we saw in 2008. The simplified version is that, for years leading up to the 2008 financial crisis, homebuyers and amateur real estate investors were taking advantage of low interest rates to take out high leverage mortgage loans and buy properties near the market’s peak value. When home values began to decline, the drop was accelerated by leverage throughout the entire market. Homebuyers and investors were forced to hand their keys to the bank.

But it didn’t affect every area in the same way. The huge drop in home prices was a catastrophe for the United States, but it was only a minor bump in the road for Canada.

Canada’s economy also had a recession, but Canada didn’t experience the same steep decline in housing prices, and it successfully avoided any bank failures or bailouts. Economists attribute the stark difference in outcomes to a stronger regulatory structure that enforces better lending principles, but the part we’re curious about, in this case, is whether the Canadian market’s housing prices have been less volatile because it has been using less leverage.

There is certainly a case for believing that Canada benefitted from a stronger financial position. Using the household debt to GDP ratio as a crude proxy for leverage within the housing market (most household debt is made up of mortgage loans), we can see that, before 2008, Canada was much better prepared for a fall in housing prices. When everything started to go bad, the United States was forced to begin de-leveraging, while Canada could absorb it.

It’s not a perfect comparison, but other measures of debt and economic performance show similar trends, and it adds evidence to the assessment that lower leverage is at least partially connected to a more stable market.

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