Psychological Stages of a RE Bubble Market

Cool chart on behavioural dynamics applied to real-estate

I have added Canada to Barry’s chart which shows the relative position of US housing

Source: The Big Picture via Irvine Housing Blog

via The Big Picture.

CMHC revises 2010 and 2011 Resale House price forecast… yet again

2010

CMHC released its quarterly housing forecast today and has changed for the 6th time, the forecast for 2010 average resale house prices!

Source: CMHC

Here is a chart showing the forecast for 2010 average resale price… the first forecast in Jan 2009 was for resale house prices in Canada to average $288100… compare that to the most recent forecast of $338900. (note the standard deviation of the forecast is $25500!)

CMHC expects resale house prices to increase in 2011

For 2011, the forecast hasn’t changed as the market conditions demand…CMHC still expects house prices to increase 1% in 2011… notwithstanding the fact that house prices have dropped about 5% the past 2 months…

Forecast Date	2011 Forecast Resale Price
01-Jan-10	$346700
01-Apr-10	$350800
31-Aug-10	$342200

Vacant Homes in U.S. = Canada Housing Stock x2

i.e. Total number of houses in Canada = Half the number of Vacant homes in US. 

 

 

 Vacant Homes in U.S. = Canada Housing Stock x2

.

Comparison of House prices in Vancouver and San Francisco since 1990

Source: Standard & Poors, Teranet House Price Index

What is the impact of new rules for lease accounting proposed by IASB & FASB?

(This article is applicable to CFA Level 1 Candidates but is a good review for Level 2 candidates as well.)

A lease (e.g. lease to rent a machine to make widgets) can be reported on the financial statement as a capital lease or an operating lease depending on the accounting standards & the lease classification.  The key difference between the two is that a Capital lease is recorded on the balance sheet but an Operating lease is not… hence liabilities are lower.

IFRS definition:

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.

FASB definition: If a lease meets one or more  of the following criteria, it is classified as a capital lease; otherwise it is classified as operating lease.

The [lease] agreement specifies that ownership of the asset transfers to the lessee.

The [lease] agreement contains a bargain purchase option.

The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset.

The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset.

What is the effect of choosing one lease classification type over another?

	CAPITAL LEASE	OPERATING LEASE	Which lease reflects better metrics?
EFFECTS ON FINANCIAL STATEMENTS
Assets	Higher	Lower	–
Liabilities	Higher	Lower	–
Net Income (earlier years)	Lower	Higher	Operating
Cash Flow from Operations	Higher	Lower	Capital
Cash Flow from Financing	Lower	Higher	Operating
Total Cash Flow	Same	Same	–
Tax Savings	Higher	Lower	Capital
BALANCE SHEET RATIOS
Current Ratio	Lower	Higher	Operating
Working Capital	Lower	Higher	Operating
Asset Turnover	Lower	Higher	Operating
Debt-to-Equity Ratio	Higher	Lower	Operating
PROFITABILITY RATIOS
Return on Assets (ROA)	Lower	Higher	Operating
Return on Equity (ROE)	Lower	Higher	Operating

In summary, there are very few benefits of classifying a lease as capital lease vs operating lease.  Operating lease acts a means of off-balance sheet financing and perhaps as a way to hide debt.

A good financial analyst should adjust the financial statements by reclassifying operating lease as a capital lease.

The Economist comments on the proposed rule which essentially wants to bring all leases on the balance sheet and eliminate operating leases:

WHEN you lease something—a boat, a warehouse, a machine for making ball-bearings—you agree to pay for it bit by bit over time. So it is like incurring a debt, say the International Accounting Standards Board (IASB) and America’s Financial Accounting Standards Board (FASB). Therefore, it should be on your balance-sheet. This new rule, proposed on August 17th by the two regulators, has shocked companies everywhere. It is up for public comment until December, but could be enacted as soon as June next year.

A survey by PricewaterhouseCoopers, an accounting firm, found that it would add about 58% to the average company’s interest-bearing debt. Not only new leases but also existing ones would immediately be subject to the new rules. On the other hand, since rents will no longer be a running expense, operating earnings could see a bump upwards. But since the downturn, many companies are close to their maximum debt limits, and the new rules could push them over the edge. Small wonder they are howling.

The new rules’ effects will vary widely. Retailers, who often lease prime property, will take a beating. Airlines, which seldom own their jets, will suffer too. Some businesses, such as utilities, will barely notice. But others will see their apparent return on capital plunge. Many firms will see their debt-to-equity ratio rise and their ability to borrow fall.

Bruce Krasting on ZeroHedge who asks How Much Debt Does the S&P 500 Have? via Mish:

The list of companies with Operating Leases is endless. I would imagine that most of the S&P 500 will be impacted one way or the other.

And here is Mish on whether Corporations are sittings on piles of cash?

Putting two-and-two together I cannot help but wonder if some of this recent corporate “cash raising” exercise is directly related to the proposed new accounting rules. Certainly rule #1 above applies, and for some corporations the window might close in a year.

Thus, it is highly likely some corporations are “raising cash” now, just to be safe, while they still can. That is one plausible explanation for at least a part of the massive corporate debt issuance as of late.

On the other hand, since when has there been any meaningful changes in accounting rules that were not discarded, ignored, or put on the back-burner for years or decades?

Did Mortgage Backed Securities boost Home Ownership Rates in Canada?

In the US, there is debate within government, media and blogosphere on the role of government in the housing market… primarily in response to the poor performance of Government Sponsored housing Entities (GSE) – Fannie & Freddie… The housing GSEs were established to promote home ownership… so to fix Fannie & Freddie, home ownership needs to be fixed.

Home ownership rate (HOR) is the proportion of households who own their home (either outright or with a mortgage).

What is the situation in Canada? Since Canada supposedly lags the US housing market by a couple years… I am going to try and analyze where Canada stands and how we got here…

The Canadian housing GSE – Canada Mortgage & Housing Corporation (CMHC) was established in 1946 to solve housing shortage after WWII. Today it plays a major role in promoting home ownership by providing mortgage loan insurance since 1954.

Source: US Census Bureau via Wikipedia, Statistics Canada

Note: Unlike the US, census in Canada is every 5 years, the next one in 2011.  We can perhaps expect home ownership rates to decline if Canada indeed lags US but given the recent frenzy (see here) in housing market I somehow doubt that home ownership rates will decline… just yet. Will Canada experience a housing crash like the US? I don’t think so… see earlier posts (here & here).

So what caused home ownership rates to rise dramatically from mid 1980s to 2006 in Canada? This chart tries to answer that…

Source: Statistics Canada & Bank of Canada

As mortgage rate decreased, home ownership rate increased… BUT the role of 2-key CMHC policy changes along the way is grossly understated…

• 1986 – Introduction of Mortgage Backed Securities – reduced the funding cost for mortgage providers by letting non-bank financiers enter the housing market, thereby increase competition and reduce the cost of mortgage for a home buyer… I do not know where we would be if there was no MBS (I believe securitization is a great financial innovation)!
• 1990– 5% Minimum Downpayment – this policy change provided a huge boost to housing demand…especially from first-time home buyers.
• 1999 – 0% Down payment & 40 year mortgage terms…lets not go there, we all know how it ended!

0% down and 40 year term mortgages are no longer “legal” and are not insured by CMHC since 2008. This policy change was introduced due to rampant speculation in the housing market and a precautionary effort by Jim Flaherty to avoid a US style housing collapse.

Note: 0% down mortgages are still available by working around government policy.

Canada’s housing inventory approaching prior highs… not good for prices

Housing inventory i.e. number of homes available for sale is increasing since the beginning of 2010. See chart below and excerpt of accompanying note from Scotia Capital Economics

…in a typical year, the non-seasonally adjusted line shows inventories peaking by the very end of the year and into the very beginning of the next year. Inventories are typically low during the summer months after the Spring market has settled down. But this time, the non-seasonally adjusted stock of outstanding listings on the open market is rising appreciably during the summer. More important is that the seasonally adjusted overhang that compensates for such distortions during the year has the overhang now pushing back up towards the range of late 2008 and early 2009. On a seasonally adjusted basis, it would take about eight months to clear out the total number of listings on the market at current selling rates assuming selling activity remains unchanged [emphasis mine]

Increasing inventory is not good… we are following the same trend from mid-2008 to Spring 2009 when inventories rose from 6 month to 10 months and prices fell about 15-20%… the economic outlook then was uncertain and it is now “unusually uncertain”…

Technical Analysis of US & Canadian stock index with charts

S&P 500 – technically doesn’t look good… fundamental bias to the downside after today’s unemployment claims

TSX – not so bad, holding support at crucial averages (50 & 200 day)

Canada’s leading indicator drops… mostly due to housing!

The previous two releases (May & June 2010) for this indicator also showed a substantial slowdown in housing activity.

Today’s release from Statistics Canada is no different:

The composite leading index slowed to a 0.4% increase in July, after a gain of 0.7% in June. Most of the slowdown originated in the household sector, where three components fell. None of the seven other components decreased.

The housing index continued to retreat from its recent highs, declining 4.1%. Both housing starts and sales contributed to the decline. The slump in house sales was reflected in a 0.6% drop in furniture and appliance sales. Demand for other durable goods posted a fifth straight decline.

This negative housing news combined with the recently released mid-month housing activity by CREA should clear all doubts about a slowdown in housing… housing slow is here and here to stay for another 12-18 months.

Back to the leading indicator… in case you are wondering what is the leading indicator supposed to lead? Well, again here is StatCan’s definition:

The Canadian Composite Leading Indicator is comprised of ten components which lead cyclical activity in the economy and together represent all major categories of Gross Domestic Product (GDP). It thus reflects the variety of mechanisms that can cause business cycles.

I wonder what is the lead time… i.e. by how many days/weeks/months/quarters/years does the leading indicator lead the economy? In other words, if the leading indicator rises in a given period, when is the economy expected to follow the leading indicator… Again, according to StatCan

Average lead times can be highly variable, and the leading index will always be more volatile than GDP since the components are specifically selected as representing very sensitive indicators of total demand and output.

That didn’t answer my question…anyone?

Greater Toronto Area Resale House Prices… drop again

Mid-month report out for GTA house prices drop again… on track to drop for 3rd consecutive drop for a total drop of 7.5% (412934/446593 -1) from the May 2010 peak:

	Aug 2010 (mid-month)		July	June	May	April	March	February	January
Average Price	$412,934	$420,482		$435,034	$446,593	$437,600	$434,696	$431,509	$409,058
Monthly Change	-1.80%	-3.35%		-2.59%	2.06%	0.67%	0.74%	5.49%	#DIV/0!

 watch out… negotiate hard before purchasing a house