You Gotta Dance

Sometimes in life things turn out for the good, and sometimes things turn out for the worst . How you decide to deal with it though will have more to do with the outcome than anything. In July of 2007, the CEO of CitiGroup – Chuck Prince made a comment at an investment bankers conference. The off the cuff comment has gone down in history and ended up defining Prince’s entire tenure at Citi. At the conference, Mr. Prince was asked about the deterioration in sub prime credit standards, falling house prices, and why Citi was still buying, selling, writing and trading swaps, CDO’s, junk rated mortgage bonds etc. In a comment that will live on in infamy he simply replied  “As long as the music is playing, you’ve got to get up and dance,” he said. “We’re still dancing”.

As it turns out though, the music Mr. Prince – and his entire board of directors was dancing to ended up being the music for the game of musical chairs. And, as one would suspect, eventually the music stopped. However, instead of removing just one chair, the entire foundation of the US financial system was taken away. As most of us know, what would come next was an event so powerful it almost bankrupted the entire world. If not for the largest government intervention since the great depression, the world as we know would have been bleak. In the dark days that followed the Great Financial Crisis ( GFC for short ) governments, regulators, and top business leaders met day after day, and into the wee hours of many mornings to try and stem the tide. In the end the make shift solutions worked – at least at the time and staved off a crisis that no one could afford to deal with. However, as is usually the case, solving one crisis laid the foundation for future problems.

Governments for all the smart consultants they pay for still have not figured out that for every action, there is an equal and opposite reaction. While the actions at the time seemed appropriate and worthwhile, those very same actions rolled out the red carpet for the next problem our economy would face. When all was said and done, the GFR caused the largest money printing experiment in the modern world. Trillions and trillions of dollars ( and dollar equivalents ) were printed around the globe to try and boost liquidity and restore confidence in the global financial systems. Now, it is easy in hindsight to say what should have been done, and what shouldn’t have been done. Only after something is done, can you go back in and deconstruct what you did and learn to improve upon it. Governments are famous for this. Everytime a massive hurricane rips through Florida, the Florida building code gets upgraded and changed to ensure it is robust and able to withstand the next set of storms. Every time there is a problem, governments have always done deep dives, paid billions to consultants, and tried to ensure the same problem doesn’t repeat itself. After all, the definition of insanity is doing the same thing over and over and expecting a different result.

Out of the GFR many things were done, many policies were implemented, and governments the world over took a hard look at why it happened, how it happened, and how to keep it from happening again. Although all of this research was done, billions spent, and the near collapse of the fiat currency system, no one asked the simple question ” Was it worth saving”? By it, I of course mean the financial system. Is a system that allowed us to teeter on the brink of collapse a system that was worth saving to begin with, especially after raking in billions and billions of dollars off of the same taxpayers that were expected to foot the bailout bill in the form of higher taxes.

When the US government decided to bail out everyone in 2008 and 2009, it created a condition known as moral hazard. Moral hazard is defined in finance as a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. By bailing out the financial system the governments created a system whereby the financial companies around the globe will continue on their merry way, adding more and more risk to the books as they go simply because they know if said risk becomes a problem – not too worry the government will prop us up. Why limit potential risk ( and potential profit ) when there is no downside if the risk goes awry?

Now, I have babbled on about the US side of things, and I am sure that people really wonder how this is relevant to you. Well, here we go:

Canada is not immune from moral hazard either, and in fact we have seen a large ramp up in moral hazard within the Canadian boundaries as of late. Let’s start with March of 2020. Of course the world shut down. Now, for the first 2 weeks of the COVID shutdown, everyone was panicked. Maybe about dying, but a lot of it was to do with money. All of a sudden people were clipping coupons again. As if by magic, people said “no” to a purchase. I saw people start to budget if you believe it? Then, a magical wand was waved, and everyone got $2,000.00 checks from the feds. All of a sudden all of the financial stressing that had been done went away. Housing went to the moon of course, especially if you were in cottage country. Interest rates dropped to rock bottom levels, and 50% of the population was convinced that rates were going to be negative. I said it then, and I will say it now : The bank is never going to PAY you to borrow money. Full stop. But hey, life was fucking great!!! Why not upsize the house, buy a fucking boat, take a trip, and buy 3 pre cons? Why the fuck not?? Don’t worry, the government will never let shit hit the fan. If we get into a problem again, they will drop interest rates. We can’t lose. Well, this shit has gone on for a couple years, and now the government is trying to put the moral hazard genie back in the bottle, but it ain’t working. Now, when you look around you may think that it is starting to work. You may see some house prices coming down, you may see people taking a second job, you may see less people upgrading, but the risk is still there.

Through raising interest rates, and implementing all of the policies that have been brought in over the last couple of years, it looks like things are calming down. Maybe from the outside they are, but there is a dirty little secret. There is still a crap tonne of risk in the market, we have just shifted it. Governments know 1 thing really really well – how to get re elected…..Well, that and ” rules for thee, but not for me”. Those are really the only 2 things the governments know. While it appears that prices are coming down, and people are maybe getting in line, the amount of risk has simply been transferred from the individual back onto the financial system. No dollars changed, we just moved the risk from one party to another. This party I speak of is of course the Canadian banks. Canadian banks are starting to see a risk problem on their books. The Canadian banks that make more money every quarter than every other business. Those banks.

Now, I am certainly not calling for a 2008 level meltdown. However, we are seeing some issues in Canadian banking that should raise some eyebrows. I have long contended that bank regulators are bullshit. Bank regulators in Canada are the definition of useless. OFSI which we all know and hate equally is the most useless regulator in the history of the world. OFSI is the classic tail of the fox watching the henhouse. OFSI makes people believe that they regulate the banks, when in fact all they do is make sure that the banks don’t blow themselves up. Banks are free to make as many billions as they desire off of Canadians, and when the risk becomes an issue, OFSI simply turns a blind eye. Case in point: Toronto Condo’s. Now, we all know that the condo market in Toronto is dog shit. Apparently people don’t want to pay half a million dollars for a dog crate. Well, all of the stupid speculators that tripped over each other to put deposits down are now facing market value drops upon completion of about 30%. So, every person who speculated on pre cons should take a bath now. But, if that happened, and the developer and builder didn’t get their money, then they could not pay back the financing on their big mortgage they took through TD, RBC, CIBC, BMO etc. So, now banks are allowed to do ‘ blanket appraisals’ and use the sale price for the market value. Even though the actual market value is probably 30% to 35% lower, banks can use the original sale price – even though we all know the value is lower. Talk about dogshit!! So why are the big banks allowed to do this through OFSI? Why can’t anyone else do it? Because OFSI protects banks at all costs. Can’t have RBC getting smoked on a few condo developments now can we? They might lose their 4 billion dollar quarterly profit for a few quarters….. Imagine the gong show that would be if all of a sudden this wasn’t allowed to happen? Imagine if the pre con speculators had to either pay up the difference, or get sued? It would devalue real estate, starting with condo’s, then leading to semi’s, then leading to single family and on and on. Every time you devalue the new build pre-con places, the existing stalk goes down in lock step. Every time we see a devaluation in home prices, banks get a little more nervous, as their risk level and average LTV goes up. Probably better to let people close a purchase now at 110% LTV right?

So, rather than have all that negative news, and people losing hundreds of thousands, let’s just ignore the rules for a bit, allow banks to do things they shouldn’t be able to do, and hope for the best. Risk didn’t go away, it simply got transferred to 5 or 6 banks rather than thousands of homeowners. It is easier to control risk on the bank balance sheet than it is in thousands of individuals hands. Thousands of people losing hundreds of thousands of dollars are unpredictable, and tend to cause problems. All that risk on the balance sheet of 6 banks? No problemo. Even if we see further deterioration of prices, and that risk on the bank balance sheets becomes an issue, the government will simply step in and “buy” that risky debt from the banks, and exchange it for government bonds which are rated AAA, and then the government will hold all of that crap risk on their books. Again, we didn’t eliminate the risk, we just keep moving it around. But, who is the government exactly? Well, it is all of us. It is the taxpayers. So bank risk, if it gets bad enough will be picked up by the government, and distributed right back to the taxpayers. And then the debt has gone full circle. It is like a game of hot potato whereby we just keep moving the risk around and no one wants to be caught with it.

Remember in 2021 when Trudeau made the comment ” We took on debt so Canadians wouldn’t have to?” Well, that was a pretty dumb comment since the government debt belongs to those exact Canadians he claims to have ‘ saved’. We didn’t save anyone, we just changed the address of where the tab gets sent. Now, so far in Canada the music is still playing, and risk is being controlled. However the same could well have been said for the US financial system in the summer of 2007. Everything is fine until all of a sudden it isn’t. Again, not predicting a 2008 level shit storm for Canada, but things are not as good as they would appear. Risk is higher than it has ever been in the financial system since it is actively being transferred from individuals, builders, developers and onto bank balance sheets. If those bank balance sheets become a problem we may see a swap program that will transfer the risk onto the taxpayer. It has already started to happen with CMHC insured mortgage debt now being swapped and guaranteed by Ottawa ie: the taxpayer.

Instead of making banks adhere to the rules, underwrite risk prudently, and ensure the rules are abided by, OFSI and the federal government is allowing banks to actively lend at 110% LTV, actively allowing them not to re confirm income after 3 years has gone by, and etc. etc. And for the banks, why the fuck wouldn’t they? They can rake in profits hand over fist, pay themselves huge fucking bonuses, and if shit hits the fan? No problem, the government will step in and fix it.

Risk may be only a 4 letter word and right now all appears calm, but much like the calm before the storm, risk is slowly building up like clouds on the horizon. Let’s just hope that when the storm hits the hydro doesn’t go out and kill the music.