This new way to buy and sell risk in Canada’s hot housing markets might help cool them off
Special to Financial Post | April 24, 2017
The housing market in Canada is seasonal and at its hottest in spring. Hence, it is no surprise that politicians are getting jittery and looking for scapegoats over a lack of affordability that, for some reason, many 
Canadians believe is an entitlement. But to the extent that speculators may be a problem in Canadian housing markets, the Bank of Montreal (BMO) may have taken a giant step towards solving it.
Speculators have long been a favourite target of politicians. In recent years, they have been blamed for events such as the financial collapse of Greece, high oil prices and people starving in Africa. Now speculators, or scalpers in the language of the Ontario minister of finance, are being blamed for turning middle-class Torontonians and Vancouverites into millionaires and filling government coffers with land-transfer tax revenue, which at least seems on the surface to be less of a moral indictment than making Africans starve.
“Foreign” speculators are now in a class of their own, as if they possess stronger demon genes than domestic speculators. They have now been singled out by the Ontario government, which has announced a “Non-Resident Speculation Tax” of 15 per cent on residential properties purchased in the Greater Golden Horseshoe. But do speculators, whether Canadian or foreign, really deserve such a bad rap?
The truth is that speculators play a vital role in markets. By taking on the risk of future price fluctuations to gain a profit, they are integral to market completeness, liquidity and price discovery. Markets are complete when there is a buyer for every seller of risk. In liquid markets, participants can transact with a minimum effect on price. Price discovery is the determination of the price for a security through the interaction of supply and demand factors. Consider a farmer who wishes to ensure financial security by locking in a future price for his next crop. The farmer can execute this with a transaction in the commodity futures market and a speculator will likely be on the other end of the trade. Many Canadians living in Toronto in rented condominiums right now can thank speculators for expanding the supply of rental units on the market.
If speculators are contributing to high house prices, it is because of limitations in the ability of investors to directly take short positions, thus reducing their contribution to price discovery. Speculators can short-sell equities and bonds that they do not own by borrowing them through an investment dealer. The same is not true when it comes to houses. There are limited options for betting housing prices will decline. Investors can indirectly take positions such as shorting Canadian banks or Gemworth, a private mortgage insurer. But Canadian banks are diversified and enjoy some protection from government-backed mortgage insurance, and Gemworth is one small insurer with a limited market capitalization. When it comes to direct investment through buying and selling property, investors can only bet on prices rising.
Now, BMO has announced that it will bundle uninsured residential mortgages into bonds, selling debt of $2 billion backed by uninsured mortgages. In contrast, mortgage bonds offered in the Canadian market have traditionally been backed by CMHC and a government guarantee, leaving investors with no risk exposure to the Canadian market. Investors in the new BMO bonds will acquire risk but will be paid a premium for doing so.
If the BMO product is successful, it could be the start of a new market in Canada in which investors can buy and sell housing price risk, although it won’t be an exact substitute for transactions in the physical market. But speculators will have an alternative to acquiring physical property, with more liquidity and lower transaction costs. CMHC will be able to explore innovative ways of offloading risk now borne by taxpayers through products such as Freddie Mac’s structured agency credit risk notes.
If new exchange-traded funds emerge to acquire these securities and market them to the retail market, some homebuyers entering the real estate market may choose to manage the risk of a price decline by taking a short position. Homeowners, potential homeowners and taxpayers will benefit if this market is successful, and speculators will deserve a lot of the credit.
Neil Mohindra is a public policy consultant based in Toronto.
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