A house! A house! My kingdom for a house!

I.
It's been a busy few weeks for those paying attention to the Canadian real estate market. First, BMO decided to sell mortgage-backed securities in a way that hadn't previously been done in Canada. Then Premier Wynne started taking notice of the chronically overheated Toronto real estate market, and brought in a series of proposals designed to make housing more affordable. And then, a mortgage lender ran into serious financial trouble due to allegations of impropriety from the regulator.

The combination of these three was to bring bubble talk to the front of mind for people who pay attention to this sort of thing, myself included. I'll go into that momentarily, but I think the first thing that needs to be addressed is much more basic - what a bubble is and how it works. Bubble psychology is a complex and misunderstood creature, and it's caused a lot of devastation historically, so getting it right is important.

Basically, bubbles are one of those wonderful phenomena that happen because the future in uncertain. Consider for a second how things would work in a market where the future was certain. An asset that is bought and sold in an efficient market with perfect future information would have a price that reflects its supply and its demand, and the future supply and demand will feed into future prices. Future prices will be limited by present prices, because you can always just buy it now and hold it until then to get a guaranteed profit. Nobody would be trying to time the market or guess at future prices, because they'd already know. You generally get a smooth price curve, growing at a flat interest rate, and that's it.

In reality, of course, we're flying blind. People disagree about what will happen, and some of them are wrong, but we don't know who's wrong until it's too late. As such, people act on incorrect predictions and make incorrect moves, ones that they'll later regret. One particular sort of error is the one that leads to the bubble - the idea that an asset will keep going up. Not even forever, necessarily, just for a while longer. If an asset goes up quickly for a while, there's two natural theories as to why - either it's random chance and it just had a good run, or there's a narrative as to why this happened, why it needed to happen, and why it will keep happening. And remember, we cannot tell in advance which one's right. History certainly has plenty of examples of both - yes, the dot-com bubble was kind of nutty, but Apple really did take over the world.

Thing is, people like narratives. The more mathematically inclined among us may sometimes poke fun at the habit, but it seems to be a very important part of how brains work - after all, a brain is mostly a tool for turning scattered observations into predictive theories so that we can understand the world around us. So people see a compelling narrative as to why a particular asset is sure to keep going up, and they'll believe it a bit more than they should. If that was the worst that happened, then it wouldn't be so bad. But the thing is that assets sold in a marketplace are prone to supply and demand, and the narrative creates demand. After all, if something is going to rise in price forever, I should really buy it now while it's cheap. This demand raises the price, which strengthens the narrative. Bam, you've got a positive feedback loop. And just like feedback into the microphone at a concert, it rapidly turns what was originally just a little bit too loud into a shattering squeal.

Many people like to blame bubbles on fiat money, or evil speculators, or the errors of a capitalist economy, or a hundred other politically motivated bogeymen, but they're all wrong. Bubbles come from people. They're a natural consequence of human psychology, and they will always be with us. People can be trained out of them, usually by seeing the ugly consequences of a burst bubble, but as people who've never seen one up close grow up and get into positions of power(even as simple a power as having enough money to buy into the bubble), they come back. As soon as you think "Oh, that can never happen", it happens. The problem is within us, and it will never go away. Sure, you can make them a bit smaller by getting rid of some of the incidental factors, but that doesn't eliminate them.

II. 
This understanding of bubbles makes a lot of political narratives look really ugly. For example, look at the biggest crash of our lifetimes, the 2008 real estate crash in the US. There's a few big narratives of what happened, but I don't think any of them hold up.

The pop-culture belief seems to be a belief that weird banking products let banks gamble all of our savings on mortgages like crazy people, tame regulators didn't do anything about it because they were incompetent and/or corrupt, ratings agencies gave AAA ratings to IOUs scrawled on dinner napkins, and it all blew up. There's a bit of truth to that, but not all that much. The banking products weren't that crazy, and the ratings agencies did do an honest job of rating them with the tools they had available.

<digression>

To understand how these fancy products work, consider a simple example. Let's say I have a company that flips coins as a side business. Every time a coin comes up heads, I make $2, and every time one comes up tails I make nothing. I can choose to sell you the results of the coin-flip before we actually do the flip - perhaps I want a more certain income stream, or perhaps you're a gambler. So, how much should I sell a coin flip for? Well, a child could tell you that a fair price is $1. So I can sell you the flip for $1, you get your $2 or nothing, and statistically we're each equally well-off as we were before.

But let's say I've noticed that most people don't want to gamble, and they want something a bit more stable. So instead of selling flips one at a time, I bundle the week's flips into a "Flip-Backed Security"(FBS), with 10 flips in the pool. I sell 10 shares, and each share will get 1/10 of the total payout. Each share is still worth $1, but the payout is much more likely to be $1.20 or $0.90 or something like that - in order to lose all their money, I'd need 10 tails that week, and that's less than a 0.1% chance. Well the market likes that, and my FBS is selling way more quickly than single flips used to.

Still, some people feel like they're taking on too much risk. So I get clever. Instead of selling equal shares, I divide it up into three groups. FBS-A gets the first two payouts, no matter where they happen - if flips #3 and #7 are the only heads that week, owners of FBS-A will still get a 100% payout. On 10 flips, getting two payouts is almost guaranteed(~99% chances), so this one will sell for about 99% of a maximum payout - in this case, $1.99. Similarly, FBS-C gets the last two payouts. They need nine flips to get anything, and ten flips to get the full $2 per share. That's really unlikely, so it'll sell for about one cent - the real gamblers will buy those, or maybe I'll just hold them myself to avoid the hassle of marketing them for a penny each. The middle set, FBS-B, will get flips #3-8 - those are the tame normal ones, and they're still going to average a dollar each, they'll just be a bit swingier now because the sure things on both ends have been taken out of their pool. The whole set still has the same probability it started with - the average flip pays $1, the whole pool of 10 flips is worth $10, and we can expect five heads. But different people are getting different cuts of it.

If a rating agency thinks 99% payout is what a AAA rating requires, that FBS-A will be a genuine AAA security, even though the underlying investment is nothing but perfectly random coin flips. You've taken a gamble and called it AAA, and you are entirely correct to do so. It's not a scam, it's not a lie, it's just applied statistics.

This is actually a lot closer to how mortgage-backed securities worked in the real world than you might expect. Sure, a mortgage being paid back is more complex than a coin flip, but the broad statistical principles are the same, and the reasoning was pretty similar too. The problem was in one embedded assumption, one buried so deep that very few people ever thought to question it.

What if the coin is weighted?

What if, instead of the flips all being 50/50, they're all 60/40 or 80/20? If it's 80/20, that AAA-rated FBS-A security is now only worth $1.52/share, instead of $1.99 - it was rated as a sure thing, but it just lost almost a quarter of its value. Some pension fund was relying on it to pay people back, and it just tanked. And that was supposed to be the safe part of their portfolio! Worse yet, that $1.52 is an average - more than 10% of the time, there will be zero heads, and they'll get nothing at all. Once people see what's happening, they'll stampede out of the markets and the chaos will start destroying banks, so the stocks will do even worse. The AAA rating is looking a bit foolish now, isn't it?

All the models used to rate mortgage-backed securities made the assumption that each house stood alone. They figured that people would default, but they made no plans for a whole nation suddenly defaulting, for a few scattered failures caused by individuals overreaching or losing their jobs turning into millions of people walking away from their underwater houses and saddling the banks with the bill. As soon as the risks aren't random, but instead start moving the same way at the same time, the statistical principles used to turn lead into gold stop working. Whoops. It's not fraud, not even particular incompetence - they just got blindsided by something that was buried in the math.

</digression>

Of course, today, nobody has any desire to repeat those mistakes - the financial industry knows what happened, and normal people won't touch MBSes with a ten-foot pole. We're safe from the same thing happening again for at least a generation, until the people who remember the lessons of 2008 are a minority. (Something else may happen, of course, but that's a risk with literally everything)

The left's belief is that problem was deregulation. According to them, the biggest error was laws like Gramm-Leach-Biley, which allowed commercial banks and investment banks to exist under the same roof, when previously they'd been kept apart. (More well-read commentators will discuss other examples of deregulation, but this one example gets about 90% of the headspace in discussions of this topic).

The right's belief is that the problem was over-regulation. According to them, the biggest error was laws like the Community Reinvestment Act, which forced banks to give more loans to people in poor neighbourhoods(who are less desirable as credit risks, or so the narrative goes).

Both of these can be dealt with by the same sentence: The first bank to fail was British, the worst-hit housing market was Spain's, the worst-hit banking system was Iceland's, and the country that got hurt most overall was probably Greece. Why on earth are we blaming this on American laws?

Everyone looks for a scapegoat. The left blames the right, the right blames the left, and society blames bankers. Nobody thinks to look in a mirror. The housing market went crazy because we let it - we kept buying, telling ourselves things like "I had no choice!" or "It's a sure thing!", and we bid prices up to unsustainable levels because we wanted to believe we were getting a bargain. Bubbles come from people, and I don't mean all those icky people over there. Regular people, like you and me. We suck sometimes.

III.
So, is it happening again? Is Toronto real estate a bubble? Well, herein lies the rub - if it was a sure thing, we'd already be past it. If it was 100% sure to be a bubble, then everyone would know it and it'd be popping. If it was 100% sure to be sustainable, who would ever be selling their house before it hit the new normal price of $firstborn for a semi in Regent Park? So I don't offer a definite answer here, just the arguments on both sides.

On the side of no, or possibly the side of "paying in kidneys will be the usual thing for a while yet", the fundamentals pushing these price increases are stronger than a lot of people give them credit for. See, for example, my Globe and Mail piece from last year on the role of interest rates - long story short, we would expect house prices to roughly double, over and above the effects of inflation, simply from the gigantic fall in interest rates over the past few decades.

And of course, that's not the only fundamental. Toronto is growing at a ridiculous pace. It's both by far the largest destination for immigrants in the country(and Canada accepts a very high number of immigrants by global standards), and it's also the hot spot for Canadians who want to move to the big city. The era of cities being ugly, crime-riddled hellholes like they were in the 70s is long over, and people are moving back. Toronto is by far the most popular destination for this crowd as well. It's a rich, growing, vibrant city that is massively appealing to the diversity-loving young professional, and so they're moving in like crazy too.

Toronto proper is growing by 23,000 people per year, and the GTA is growing by 73,000 per year. That means that every week, 500 people are moving to the city and another 1000 to the surrounding suburbs. That's a gigantic growth rate, and every single person in that group needs somewhere to live. An average household is 2.8 people, so that means 26,000 new housing units a year are required to keep up with demand.

A lot of that demand can be met with condo towers. Toronto's condo boom is legendary, and justly so. A few years back Toronto had significantly more high-rises under construction than the entire United States, and for all I know that may still be true - there's certainly enough cranes around. Problem is, most people don't want a condo. It's a good way to build some equity and get a starter home, but most of us grew up in a detached house. Whether you're from a Canadian suburb or a Filipino village, owning your own land is a convenience(particularly when you have kids), a status symbol, and a solid investment.

The problem with giving everyone their own detached house is math. Everyone wants a detached house in a pleasant neighbourhood where getting around by foot, car, and transit are all viable options and you can have a bit of quiet while keeping easy access to downtown. In a small town, that can be done. In a big city, it can't possibly work that way. Downtown is physically small, and you can't have more than a certain number of detached houses close to it. Sure, you can sprawl forever in principle, but people want a detached house in the Annex, not in Aurora. Occasional neighbourhoods fitting that description exist, but they're roughly synonymous with "where the rich people live" - Rosedale and Forest Hill and Hogg's Hollow are all fairly secluded, easy to get around for locals, spacious, quiet, and reasonably accessible to downtown, but not coincidentally they're all places where $5M houses don't raise any eyebrows. And unless somebody starts paving Lake Ontario, they're not making any other land that's equally desirable anywhere.

It's important to emphasize this - this isn't politics, this isn't foreign buyers, and this isn't a trick of developers. This is math. If we wanted to give a detached house downtown to everyone who wanted one, we'd need about 20 times as much land as actually exists downtown. It is not physically possible to give everyone what they want. The limited supply of downtown land will be rationed by some means or another, and in our economy that usually means the people with money get it. That means higher prices, until only as many people can afford to move in as can actually fit.

So we're a bit stuck. We have tens of thousands of people moving here every year who want to live in desirable neighbourhoods as much as the locals do, and no more space in those neighbourhoods. What happens is that every neighbourhood will move up the income scale. If 50% of the city could live in detached houses in Toronto proper before, and the population of the city doubles, now only 25% of the city can live there, and the houses will go up in value from what a median household can afford to what a top-quartile household can afford. (This is an oversimplified analysis, of course - desirability is not just a single number that people try to maximize, and some will prefer condos/semi-rural living/whatever - but the point stands)

Supply and demand is real. We have a mountain of demand and virtually zero new supply in the most desirable sector of the market, and even in less-desirable sectors it's looking like we have shortages. On top of that, everyone can afford more than twice the prices my parents could when they were my age without needing to make any higher a mortgage payment. Is it any surprise that prices are shooting upwards?

On the side of yes, there's some definite bubble psychology going on. Every anecdote about home sales I've heard is that buyers have turned into a ravenous mass of raw demand, and they haven't done it for fun - they feel like it's the only way to get a place to call their own. Tales of sellers getting 40 bids, all of them above the asking price, within an hour of bids opening are common. In that market, you only have the choice of playing crazy or not playing at all, and that's exactly what a late-stage bubble always looks like. Prices are going up by north of 30% a year in some segments of the market, and that is of course grossly unsustainable. A 30% annual rise in prices for another decade will leave average house prices north of $10M, which clearly can't be afforded by more than a few thousand people in the whole city no matter what interest rates are. The city is growing, but not so fast that we should expect a couple million Conrad Blacks to move here in the next decade.

On the whole, I think the 30% growth rate is a bubble in action, but I don't think that bubble popping is going to look like the wastelands of empty developments we saw in Florida a decade ago. Prices will stop shooting up like crazy, and they'll correct a bit, but I don't think we're going to see Toronto turn into Detroit unless a meteor hits the city. As long as people want to live here, it'll cost a fair bit of money to buy your way in.

IV.
So, prices are going up like mad, and even if it's a bubble, the fundamentals underpinning it are real and worthy of some notice. So, what do we do? Well, if the problem is supply and demand, the solution is to fix one or both of those.

The demand side is fairly easy to solve, in some sense - if people don't want to move to the city, housing prices will drop. So all we need to do is tear up the roads, shut down the subway, ban banking and movie shoots, and release a few thousand rabid skunks downtown. Housing prices would drop right away!

...Yeah, no. The right solution is to embrace Toronto's desirability, and build it into a city worthy of that desire. That means letting people live here. The problem there is that everyone always has a reason why development is bad and we need to oppose it. "It'll change the character of the neighbourhood!" or "It's too tall, it'll cast shadows!" or "It's being built on land that's green, and Canada has a desperate shortage of greenery!" or whatever.

People have a status quo bias, and they're suspicious of people who want to change the status quo just to make a buck. To be fair, developers have a long history of trying to get around anti-development laws, and they're doing it to make money in large quantities, which makes a lot of people deeply suspicious. Of course, everyone who has laws passed against them tries to work around those laws, and everyone tries to make money, but developers get a special dose of ire nonetheless. Like I said above, the problem is math, but there's a lot of people who would rather find a scapegoat for this math than understand it.

And hey, scapegoats aren't hard to find. Just go to China, they have about 1.4 billion of them. If Canadians are moving to a city and starting families en masse, and the cities aren't building enough houses for them, it must be the fault of non-resident Chinese billionaires trying to hide money offshore by buying houses to get in on the 30% growth rates. Only they clearly don't care about money, because legend would have it that they're allegedly sitting vacant in a market where you can rent a used refrigerator box for $1200/mo, so I'm not sure what the plan is. But damn it, it must be their fault - stats say that non-residents are about 3% of the market, and clearly those 3% matter way more than the other 97% of us.

Blame CanadaChina, shame on CanadaChina
The smut we must cut, the trash we must smash
Laughter and fun must all be undone
We must blame them and cause a fuss
Before someone thinks of blaming us!

Some people call me cynical, but they're just bitter.

V.
So, we want to let Toronto grow. Let's see what our provincial government came up with to help with prices.

1) A non-resident speculation tax, like Vancouver's. "Speculators" are always blamed for price movements that people don't want(as if "Quick, buy now before the price goes up!" isn't speculation), but if the stats are wrong and there is actually some secret epidemic of Chinese billionaires taking all the new supply off the market, then this might help a bit. If they're as price-insensitive as people suggest then a 15% tax won't make a huge difference, but maybe it'll do something. Of course, Vancouver's didn't, and they have about twice as many foreign buyers, but it's worth a shot I guess?

2) Expanding rent control. This has some knee-jerk appeal, because a few renters really might get pushed out by huge increases, but I think they went way too far. Rent control has long proven itself to be a bit of a mirage - it helps the politically connected, and it helps people who can afford to spend $100,000 to buy a key for a $400/mo apartment, but it doesn't actually drop the price of housing overall. It picks a bunch of people to get cheaper rent, and a bunch of people to get totally boned. Making it a worse idea to build new housing, especially high-density housing, is going to make things worse, not better.

3) Standardized leases, and similar admin changes. These seem inoffensive, though they don't help with prices at all.

4) Opening province-owned land in the city up for development. Big thumbs-up here - this will help for sure. It's not a lot of land, so it won't solve things itself, but it's a concrete action that will make it better to some extent.

5) Allow cities to charge a vacant homes tax. Much like #1, this will help a bit if the problem is real, and not have much impact if it's not, so that's fine.

6) Synchronizing property tax rates between rental buildings and owner-occupied buildings. This makes good sense, and I know that Toronto(and possibly other places) have been moving this way for a while, because it got way out of whack. It's odd to see this as a provincial program, but I don't know the procedures here well enough to comment much.

7) Spending $125M to rebate development fees on rental buildings, As should be expected of Liberals, they're rebating fees with a new program, and not merely lowering the fees for everyone, but this is okay, I guess?

8) Giving municipalities more flexibility to create incentives for development via property taxes. Inoffensive, but really microscopic.

9) A "Housing Supply Team" with a multi-ministry work group to identify barriers. When you're hip-deep in buzzwords like that, you know they're just padding the list.

10) Working to understand and tackle speculative and tax avoidance practices. See #9.

11) Updating the rules around realtors, in particular ending the right of realtors to represent both sides of the same home sale. Makes sense, but it has nothing to do with prices.

12) Establish a Housing Advisory Group, which is somehow different from the Housing Supply Team and the unnamed investigators of #10. This is straight out of Dilbert.

13) Educating consumers on their rights. Again, cool I guess, but meaningless when it comes to prices.

14) Working with the CRA on tax reporting. This doesn't make anything better for home buyers.

15) Creating more rules for elevator repair timelines. I can see the appeal, but this isn't supply-related.

16) Updating the growth plan for the GTA, but explicitly refusing to allow for any changes to the Greenbelt. So basically, this is a null.

For those of you keeping track at home, that's one small but sensible improvement, five small things that could hypothetically help but probably won't do much. one fairly major harm to supply, four pieces of bureaucratic nonsense, and five things totally irrelevant to house prices. The end result, I suspect, is a difference of about three housing units in the next decade, and a new $300M/year bureaucracy to take credit for it. Ugggh.

The province wants to take credit for throwing money around, encouraging affordable housing, and all that, but they totally miss the point. People need to live somewhere. If a bunch of people want to move somewhere and there's nowhere for them to go, you will have serious issues with a hot housing market and ridiculous levels of demand. Throwing money at home buyers just bids up the prices, giving units to people who need affordable housing means they don't go to someone else, and the problem never improves. To solve an overheated market, you need supply.

What kind of supply you get doesn't even really matter in the end. Let's say 10,000 new luxury units come on the market tomorrow. Well, who's moving in there? Probably people who live in nice, but less luxurious, places in the city, and will move out of them into the new building composed of nothing but penthouse suites. That'll free up units one tier down from the new places, and the people moving into those will probably be the ones two tiers down. This process will continue all the way down - at some point, a new unit will be occupied by somebody, and unless Kenneth Thompson decides he wants another 10,000 condos, those people will be moving out of somewhere to make the space. A new unit means another person who's out of the market and no longer getting into bidding wars. I want poor people to have places to live, of course, but we should build units first and distribute them second. If nobody has a place to live, the poor won't be helped by the process.

Here's my proposal, and it's one that might actually help.

1) Kill the Greenbelt. It was a stupid idea from day one, and it's caused a non-trivial part of this problem. Protecting farmland, seriously? Canada has no shortage of land that can be farmed, but a severe shortage of land where people can work in Toronto.

2) Allow as-of-right construction of all development projects. If the land is zoned for a 40-storey tower, you can build a 40-storey tower with no further say on the part of City Hall. Their job is to set zoning rules, developers can take those rules and build accordingly any time they want.

3) To prevent abuse of #2, zoning must be defined on areas of a certain minimum size. Perhaps 100 metres in each direction would be the smallest area you can zone. Developers would also be allowed to complete any project where ground has been broken, even if zoning laws were changed thereafter. Cities have a role to play in defining how the city is going to look, encouraging density near mass transit, and the like, but they should not be allowed to cater to NIMBY nonsense and tie up developments for years. (Edit: A friend showed me this article on Japanese zoning rules, which seems quite relevant.)

4) Give new-build rental properties an exemption from rent control for 20 years, instead of the flat 1991 cutoff, and then cap rent growth at inflation+5% thereafter, and require perhaps 90 days notice for increases. That gives room for prices to adjust reasonably to changing market conditions, but prevents people from being kicked out of their homes by ludicrous increases hitting them out of the blue. Rent doubling with no warning is a real problem, but going fully draconian on rent control is not the solution.

5) Change rules to allow for smaller units in more places. Affordable housing in a city where land is worth a million bucks per square foot means small housing, and builders might be less inclined to aim at the top of the market if 150 square foot bachelor condos were more saleable. Likewise "laneway houses", basement apartments, and so on. Turning the same amount of land into more units is a good thing.

6) Throw in some of that small-fry stuff from above. Couldn't hurt.

VI.
Oh, and as for the bank failure? They're talked about as a big player, because people are only looking at a tiny portion of the market. The bank's total balance sheet is about $15B. Royal Bank's is about $1200B. The only thing interesting about this is that they were foolish enough to name themselves after one of Canada's few bank failures, and that it's pretty funny to watch what happens when a bank goes scrambling for funding(22.5% on a line of credit? Yikes). If it was because of market conditions I'd be worried, but when it's a fraud scandal, it's probably a one-off. This isn't a big deal.