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How much higher can bonds go?

August 2, 2011 Leave a comment

In case you haven’t noticed, the TSX is down 5% YTD and 10% from April 2011 highs… which puts it squarely in a typical correction territory… while Bonds (as represented by XBB – DEX Universe Bond Index) are up 2.5% and 4.25% for the same period as illustrated by the TSX/XBB weekly charts

Here is look at the bond performance over the past decade… and today XBB gaped up!

The question is not how low can stocks go but rather how much higher can bonds go?

Bond prices are inversely related to interest rates i.e. if bonds are rising then interest rates/yields are falling… for all intents and purposes, XBB reflects all rates along the yield curve i.e. short and long term rates…

short term rates are above their record lows but 1% is still low historically

10 yr GOC yield is at 2.8%… which is ~10 bp higher than the most recent low of 2.68% from a year ago

So there is room for bonds to go up further especially considering the Euro area weakness… but will we see new lows in 10-year yields?

(in case you are wondering why the 10-year yields… the trend of 10-year yields is usually considered a good barometer of future economic growth)

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Toronto housing market – update

April 25, 2011 Leave a comment

I haven’t had much time to write since buying a house and selling my condo… if I can convince myself, I’m never going to move again, that means not buying another principal residence.

It has been over a month since the new mortgage rules took effect… is there any early effect on real-estate markets? Let’s look at the GTA housing numbers for March 2011…

  • Year-over-year Prices up 5%
  • Year-over-year Sales down 11%
  • Month-over-Month Prices up 0.4% vs 5-year average of 0%
  • Sales up 15% over 5-year average Sales

I don’t think there is anything to worry about yet but I think we need to keep an eye on Sales numbers… -11% sounds like a lot but 2008-2010 were outliers for Sales numbers

…and mid-April numbers are:

Greater Toronto REALTORS® reported 4,444 sales during the first two weeks of April 2011 – a three per cent decrease compared to the first two weeks of April 2010. The number of new listings was down by 21 per cent compared to the same period last year.

Again, nothing to worry about here either. 3%… however, average prices have shot up!

  • Year-over-year Prices up 10.4% vs a range of -3 to +13 % over the last 5 years!! (with that kind of variation, averages become meaningless)
  • Month-over-Month Prices up 6% vs 5-year average of 4% !

I have been saying for the last year that this kind of price increases is unsustainable and I reiterate it here.

Expect waterfall effect from new mortgage rules

March 19, 2011 4 comments

New mortgage rules kicked in yesterday… the two major rule changes are:

  • Maximum Amortization – 30 yrs (was 35yrs)
  • Maximum Refinancing – 85% of home value (was 90%) (remember, this is not applicable for new mortgages, only for refinances)

I think the rules will have a cascading waterfall effect on all but the upper end of the housing market…

Let’s say John is a marginal first time home buyer and he qualifies for a maximum monthly mortgage payment of $1000 with a 35 year amortization on a $300k mortgage. With the new rule of 30 year amortization, the maximum amount John qualifies for drops by about 7% to $930 and so the maximum mortgage John can qualify for is about $279k (roughly speaking).

If John was buying a resale home, there are two things that can happen:

  1. John would now have to look at homes listed at approximately 7% less than what John was willing to purchase earlier OR
  2. The seller – Ram – of the house has to reduce the house price by 7%.

If John chooses to look at smaller houses, the seller has to attract new buyers but because John is a marginal buyer i.e. a buyer on the fringe, Ram cannot find new buyers willing to pay the original price of $300k. What does Ram do?

Ram drops the price… how does that affect Ram?

Presumably Ram wants to buy a bigger house from seller X but because Ram received less money than expected for his current house, Ram will have less money for down payment and because of the rule change will have to settle for a smaller or a less pricey house. How much less? A lot more than 7%… around 11% because of the double whammy! See table for calculation.

Buyer Seller Before March 18 After March 18 Reduction in Affordability
John Ram $ 300,000 $ 279,000 7.00%
Ram X $ 500,000 $ 445,470* 10.91%

*445470 = (500000 – 21000) * 0.93 (because Ram received 21000 less, Ram has no choice but to buy a smaller house)

Now seller X wants to buy an even bigger house from seller Filthy Rich… you see where it’s going?

The cascading effect will continue all the way up to the housing market chain… except for maybe the high end/million dollar plus market… worry not, the recent stock market jitters might scare them away!

On the plus side though, banks reduced fixed rates by 10-20 bp recently, perhaps and coincidently in anticipation of slowing momentum in the housing market? (Note that bond rates have recently inched up, so not sure why rates have come down)

Going forward, I will be posting less about Canadian housing… I recently bought a house and I’m still bearish on Canadian housing.

Interest rates on bonds & mortgages

March 12, 2011 2 comments

Government of Canada (GOC) Bond Yields…slowly & surely creeping up…Notice the ‘U-shaped’ turnaround for terms longer than 1 year… noticeable in the 5yr term.

If you prefer the yield curve… which is a subset of the above data but presented differently

Fixed Mortgage Rates are based off of the respective GOC bond yields…(figure 1). The solid lines (right axis) in the figure below is the difference between the GOC bond yield and the corresponding term mortgage rate. This chart illustrates that mortgage rates don’t change as frequently as bond yields do. Look at the difference between the 3yr bond yield and the 3yr mortgage rate, it is sloping down or in other words hasn’t risen as much as the 3yr bond yields.

Is Canadian Housing the Next Domino?

March 7, 2011 1 comment

Canada’s Housing Market received plenty of international attention last week from the revered The Economist and Australia’s Business Spectator… with that kind of attention, is it time to short Canadian real-estate?

Similarities between Canada & Australia:

  • net commodity exporters
  • have similar net immigration rates
  • largely avoided the 2008-2010 financial crisis
  • have highly rated banking systems
  • housing market in a potential bubble or is it sound fundamentals

From Business Spectator [emphasis mine]:

Canadian home values have risen strongly relative to incomes and rents over the past ten years on the back of sharply rising debt levels. The key charts pertaining to the Canadian housing market are below, taken from Capital Economics’ recent Canadian housing and economic updates.

The house price growth of Canada’s major cities compared to Australia’s capital cities is shown below (chart courtesy of World Housing Bubble, here and here).

As you can see, there are some striking similarities between the two countries’ housing markets. First, the two mineral rich cities of Perth and Calgary experienced their own unique house price booms during the 2006/07 commodities bubble. Second, both countries’ governments and central banks were highly successful in reflating their respective housing markets after brief falls during the onset of the global recession.

In Australia’s case, the housing market was reflated by a combination of significantly reduced interest rates, the temporary increase in the first home owners’ grant, cash handouts to households, and the temporary relaxation of foreign ownership rules.

Canada’s central bank and government also provided significant stimulus to the housing market. In addition to the Bank of Canada lowering interest rates to record lows (click to view chart), the government significantly loosened mortgage eligibility criteria, culminating in the introduction of the zero-deposit, 40-year mortgage in 2007. Further, the amount that Canadians could borrow was increased, with many individuals in 2009 being granted loans in the $C500,000 to $C800,000 range, provided their household income ranged from $C110,000 to $C170,000.

One of the many reasons cited for the US housing bubble was low interest rates for a long period, during Alan Greenspan’s era, circa 2005… In Canada, interest rates were at their lowest ever (BOC overnight target rate of 0.25%) from April 2009 to June 2010…During this period, house prices rose about 20%… and presumably a greater than normal share of new mortgages were variable rate mortgages…

Not only was the monetary incentive high but the government loosened the qualifying standards…

Finally, in an effort to support the housing market in 2008 (when affordability fell sharply and the economy stalled), the Canadian government directed the Canadian Mortgage and Housing Corporation – the government-owned guarantor of high loan-to-value-ratio mortgages (explained here) – to approve as many high-risk borrowers as possible in order to keep credit flowing. As a result, the approval rate for these risky loans went from 33 per cent in 2007 to 42 per cent in 2008. By mid-2007, the average Canadian home buyer who took out a mortgage had only 6 per cent equity in their home, suggesting the risk of negative equity is high even if there is only a moderate correction.

This is the key….if the government did not step-in to stimulate the housing market during the throes of the recession, either Canada would have had the necessary downward adjustment to house prices, due to the negative feedback loop and possibly throw the economy in to deflation or was the government’s decision to stimulate and incentivize Canadians to buy real-estate now and worry about potential accelerated house price inflation later? Was the government in a Catch 22?

The Canadian government has since raised the mortgage eligibility criteria. In October 2008, it discontinued the zero down, 40-year mortgage, reverting back to the 5 per cent down, 35-year mortgage requirement that was in place prior to the global recession. Then, last month, the Canadian government announced that it would reduce the maximum amortisation period for mortgages to 30 years from March, adding around $100 in extra loan repayments to the average mortgage. The government also reduced the maximum amount that Canadians could borrow against the value of their homes – called a Home Equity Line of Credit (HELOC) – from 90 per cent to 85 per cent.

Perhaps, the government was in a Catch 22… and that is why it intervened to tighten mortgage rules twice in less than 1 year… The big question is: Are these changes enough or is it too little too late to control the animal spirits? And will Canadian real-estate slow down after March 18?

…Capital Economics released its Canada Economic Outlook Report (Q1 2010), which predicts sharp falls in Canadian house prices, household deleveraging, and anaemic economic growth into the future.

The report warns that Canadians’ belief that their economy is somehow invincible after emerging from the crisis relatively unscathed is “disconcerting” as house prices lose touch with fundamentals.

This is certainly true at the ground level… how much can be attributed to wealth effect from house prices increases?

“Relative to incomes, our calculations suggest that Canadian housing is now just under 40 per cent over-valued, which is about the same level of excess that the US market reached before it collapsed. We have pencilled in a 25 per cent cumulative decline in house prices over three years, mirroring what happened south of the border.

“The biggest downside risk is that an adverse feedback loop could develop, as it did in the US, with rapidly falling house prices leading to a contraction in both output and employment, which puts even more downward pressure on house prices.”

Capital Economics also warns that the government-owned CMHC could be exposed to significant losses should house prices fall significantly.

“According to our reading of CMHC financial statements, insured mortgages and securitised mortgage guarantees total an amount close to $C800 billion. The total equity of CMHC is $C10 billion.

“If house prices collapse further than we predict, say by 35 per cent, with a default rate of 10 per cent and average home equity of 10 per cent, then the potential capital loss amounts to $C20 billion.

“Even if we assume that half of this amount is eventually recovered, that still leaves an expected loss of around $C10 billion. Under the same assumptions, the 25 per cent decline in house prices that we expect over the next few years would still result in a considerable loss of around $C6 billion.”

Only a year ago, the mainstream view in Canada was that the housing market was bullet-proof and that a US-style meltdown was highly improbable. Now sentiment appears to have changed following a collapse of sales, a build-up of inventory, and three consecutive months of price falls between September and November (December recorded a 0.3 per cent rise).

Have we Canadians taken comfort in the wide-spread belief that because Canada avoided the global recession that started in the US housing sector , Canadian housing cannot slowdown or experience a US/UK/Ireland like crash?

Affordability, GDS, TDS, personal income – gross vs disposable

March 1, 2011 Leave a comment

All financial institutions and creditors use Gross Debt Service & Total Debt Service (GDS & TDS) ratios when evaluating a potential borrower for a mortgage… and at least use the TDS for all other personal loans i.e. personal line of credit, credit card, an auto-loan, a mortgage, and the kitchen sink, etc (except student loans)

Here is a short definition of GDS & TDS:

Gross Debt Service (GDS): The percentage of the borrower’s gross monthly income that is needed to pay all required monthly housing costs (mortgage payments, property taxes, heat and 50% of condo fees).

Total Debt Service (TDS): The percentage of the borrower’s gross monthly income that is needed to cover housing costs (GDS) plus any other monthly obligations that an individual has, such as credit card payments and car payments.

According to personal finance rules of thumb, courtesy of CMHC:

  • Max GDS = 32%
  • Max TDS = 40%

What is my point?

Why do creditors use gross personal income and not your after tax income or your take home pay? After all, the cost of borrowed money i.e. interest is not tax deductible in Canada (with a few exceptions)… which means that you service your debt payments from your after tax salary i.e. your take home pay and not your gross salary!

Perhaps there is a simple answer…?

Why does it matter? Because…

Using gross income in any affordability measure overstates the affordability by the tax rate… and gives the false perception that that debt is affordable when it reality it is not. The government is not going to reduce your tax so you can pay your debt (unless you are a bank)!

After every new housing affordability report in the last year, CREA has been quick to announce that housing in Canada is more affordable than ever? Really? If you believe you the horn tooting dimwits at CREA, I don’t know who can help you!…I have talked about housing affordability measure before

On to greener pastures

A recent household debt report from TD squarely puts things into perspective… I have put together a chart of Debt-to-Income & House Price-to-Income ratio vs Bank of Canada rate using the TD data…

Source: Bank of Canada, TD Bank

 

Note that TD uses personal disposable income in both the ratios above…

See the trend… inverse correlation between Debt-to-income/House Price-to-Income and Interest Rates? Here is the correlation matrix:

BOC Rate (left) Debt-to-Income (right) Home Price-to-Income Ratio (left)
BOC Rate (left) 1
Debt-to-Income (right) -0.57808 1
Home Price-to-Income Ratio (left) -0.49056 0.809653 1

As debt becomes cheaper (lower interest rates), demand for debt increases (green line)… isn’t that econ 101? Not sure how ugly it will be when it debt becomes expensive… relatively

As it becomes easier to get debt, debt financed assets i.e. homes increase in demand & price (purple line)

Resale house prices gone parabolic in York Region – view from G0

March 1, 2011 3 comments

I have seen 3 houses in the last 2 weeks and every single one went over asking… this is in Markham/Richmond Hill area.

# List Sale Price
1 699900 705000
2 699900 725000
3 745000 758000

Couple Observations:

1. Similar houses in the area sold for under 635k just 6 months ago… that is more than 10% increase in less than 6 months!… If the trend continues, resale house prices will be up more than 20% in 2011!

2. Every single house had more than 3 offers clean offers – no financing, no inspection!

3. And all of them sold in less than 3 days of listing…

3 houses is nowhere near a constituent sample even if they are all in a small city block BUT this is the trend… I have spoken to a few realtors over the last month and that is what they say…

In contrast New Home prices have increased close to the inflation rate… around 2-3%

If you are in real-estate… or not… what are you seeing on ground zero?

Hysteria…Mania? Herding like donkeys? Sensible investors? Speculators? Pent-up demand? No Supply?…