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family formation.

      Family Formation and the Bubble

      Economists that examined the bubble and collapse in the United States noted that a substantial drop in household formation after the financial crisis of 2009 hurt the demand for housing and contributed to the housing crash there. Analysts estimate that as much as one-third of the U.S. male population between the ages of eighteen and thirty-five lives at home with parents, highlighting the dramatic drop in family formation. Perhaps that’s why sales of the computer-based game Grand Theft Auto have never been better.

      So what has happened with young people born in Canada who have reached adulthood over the last decade? As you would expect, their experience is very similar to that of their contemporaries in the United States. In Canada, these young people, known as Generation Y (or millennials), are very slow to leave home and establish independent living quarters, especially compared to previous generations.

      Forty-eight percent of the so-called late baby boomers (those born between 1957 and 1966) were married during their twenties, compared to only 33 percent of millennials born between 1981 and 1990 (who were twenty-five to thirty-four years old in 2015). This represents a huge drop in the rate of family formation, with more than 67 percent of millennials remaining single. Although single people might be homeowners and couples might live together but not get married, they are much less likely to buy a home than are their married cohorts.

      An even more important trend regarding these young people as potential home buyers is this: a remarkable 51 percent of those aged 20 to 29 live at home with their parents (based on 2010 data), compared to just 28 percent of the late boomers at a similar stage in their lives.

      Obviously two well-paying jobs are a prerequisite to buying a house and moving out of the parents’ basement. But as was shown at the beginning of the chapter, Canadian income growth and employment surpassed that of the United States by a wide margin, primarily because of commodity demand and prices. So it’s a puzzle why so few young Canadians have taken the leap to move out on their own. Perhaps the high cost of housing is making it impossible for these young people to get started on the homeownership ladder, even when their parents might like to give them a push.

      In fact, under closer examination, we see that while median income growth has been good, it has been relatively poor for the millennials who would normally be forming families and buying entry-level housing. While gains for the top 1.0 percent have been spectacular, for the rest of the population (the 99 percent who make less than $200,000 per annum), income increases have been very modest in Canada even with resource wealth, and especially after adjusting for inflation. This trend goes back several decades. For millennials, that job as a Starbucks barista isn’t providing enough income to rent an apartment much less buy a home or condo.

      According a study by the U.S.-based Pew Research Center, millennials are the first generation in the modern era to have “higher levels of student loan debt, poverty and unemployment, and lower levels of wealth and personal income than their two immediate predecessor generations ... at the same stage of their life cycles.”[14]

      We can conclude that factors such as household formation, immigration, foreign investors, and income growth, even when taken together, cannot explain the amazing surge in house prices. This lack of support for house prices makes the appearance of this bubble even more unusual — and much more precarious. We now turn our attention to the one major contributor that did drive the bubble’s formation and housing price increases; one that will play the leading role in the ensuing crash in Canadian real estate.

      Chapter 2

      The Elephant in the Room

      It thus seems likely that the rise in private sector debt was the fundamental cause of both the great depression of the 1930s and the recent great recession.

      — Andrew Smithers, The Road to Recovery[1]

      How does one explain the boom in Canadian home ownership and housing construction and the nation’s top world ranking in housing prices? In a word: debt. Lots of it, in fact, provided under generous terms allowing total private debt to grow at an unprecedented and unsustainable rate. Private debt is made up of household debt and nonfinancial business debt, split about evenly between the two types.

      The total amount of household debt grew at a breathtaking pace, made possible by eager cooperation from banks that provided credit on easy terms at lower and lower interest rates. In the short-term, speculation using cheap credit can overwhelm income and household formation as drivers of demand for housing — and that is what’s happened in Canada; the exponential growth in credit has overwhelmed the normal housing cycle. We can see from Figure 2.1 [2] that total private sector debt went from about 100 percent of GDP to 200 percent of GDP, a doubling of debt enabled by a bubble in house prices and government-sponsored insurance for lenders.

      Homes are bought with credit or borrowed money, in the form of mortgage loans from banks or other lenders. If house builders had to wait for first-time house buyers to save the entire purchase price before buying, they would all be out of business and the housing market would be mostly for renters. As collateral for the loan, the lender takes a mortgage that contains a repayment schedule and lodges a caveat against the title of the property. The lender — in Canada it’s often a bank — collects a monthly payment for the term of the mortgage. As the owner-occupant makes payments the principal gradually declines and the equity or level of ownership grows and the mortgage value shrinks. With rising house prices growth in the owner’s equity is the rule. But occasionally a borrower gets into trouble after losing a job and fails to pay the mortgage payments for a couple of months. Then the lender can initiate a process to seize the property known as foreclosure. The debt is written off and the title for the property is transferred to the bank.

      As the housing market continues to inflate over the credit cycle, bankers become more and more comfortable with the mortgage-lending business. They compete to make mortgage loans, and they relax their standards when calculating who qualifies for these loans. Two examples of relaxed standards are the inclusion of two incomes in the household when calculating qualifying income for the mortgage debt servicing ratio and the adjustment to 20 percent (down from 25 percent) for the minimum down payment to avoid buying insurance from CMHC. While these changes were made years ago they exemplify how banks become less worried about potential defaults as the cycle progresses. Economists categorize this process of loosening and tightening credit over the real estate cycle as pro-cyclical (meaning, factors such as the credit cycle tend to exaggerate the highs and the lows of the housing cycle, turning up the heat on housing prices near the top and causing an even deeper downturn during the lows). Pro-cyclical swings during the cycle happen because humans make the decisions to extend credit (approve a loan) or to deny credit. While it would seem plausible that bankers would make clear choices based only on hard and fast rules regarding the amount of risk involved in a loan, it doesn’t work that way. Bankers become optimistic about the economy near the top of the cycle and approve loans that they should deny during the frothy periods. And at the bottom of the cycle, when business is slow, bankers become very cautious and fearful of making a mistake that might cost them their job, at a time when jobs are scarce. So during those times, bankers are reluctant to approve loans even when all the proper collateral and income support is there. Bankers get too optimistic during the good times and too pessimistic during difficult times. So the bankers contribute to the excesses, both at the top and at the bottom of the cycle. In a perfect world, bankers and government leaders would know enough (and have the will) to restrain the credit cycle at the top to resist the formation of bubbles. As we shall see, we live in a world that is far from perfect.

      As David Graeber describes in Debt: The First 5,000 Years, the cyclical nature of lending has been with us for millennia. He details the problems in feudal society when farmers got into too much debt and a downturn in the economy arrives, “…especially in years of bad harvests, the poor became indebted to rich neighbours or to wealthy moneylenders in the towns, they would begin to lose title to their fields and to become tenants on what had been their own land, and their sons and daughters would be removed to serve as servants in their creditors’

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