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TSX trading near 2-year low… 11000 next downside target?
Daily Chart:
Weekly chart:
Expect waterfall effect from new mortgage rules
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:
- John would now have to look at homes listed at approximately 7% less than what John was willing to purchase earlier OR
- 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.
XBB and correlation between Canadian Stocks & Canadian Bonds
XBB – Conflicting technical signals
- XBB broke out of recent downtrend line but… not above the previously broken long-term uptrend line
- RSI & MACD are rising but price is declining
- Also death cross signal – 50 day SMA crossed 200 day SMA from above
Fundamentally, Canadian interest rates are bound to rise in the near future which is not good for bonds.
Conclusion…keep a close watch for the next couple weeks
What is the correlation between returns on Canadian stocks and Canadian bonds?
I’m going to use the bond ETF, XBB to represent the DEX Universe Bond Index and S&P TSX Composite to represent stocks.
Correlation of Daily Returns is:
- fairly volatile for smaller samples i.e. less than 3 months. (blue & green lines)
- low and positive from 2001 to March 2010
- -0.2 since March 2010 i.e. when one goes up, the other goes down.
Lets look at the correlation of monthly returns… partly because the daily volatility has been much higher since the financial crisis and that might bias the results. Again, it is a similar story, the smaller the sample, the greater tha
Correlation of monthly returns is similar to daily returns except:
- 12 month rolling correlation deviates between 0.5 and -0.5 which is on the high side.
- 3 yr correlation has been positive and low, around 0.1 since Jan 2009.
Is Canadian Housing the Next Domino?
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?
Canadian Interest Rates & Fixed Mortgage Rates
Fixed mortgage rates are no longer “historically low” … 1, 3 & 5 year fixed rates increased by 15, 20 & 25 basis points in the 2nd week of Feb 2011… this is the beginning of a trend that might pick up pace given that the Canadian economy (& global economy) is performing better than forecast.
BOC is scheduled to announce interest rate decision tomorrow and market expects no change to the BOC rate, currently at 1% …
The bond markets expect the BOC rates to rise 25 basis points in the next 3 months… look at the steepening yield curve.
Pouring cold water on ‘improved’ housing activity
Canadian real-estate has received more than its fair share of coverage in main stream media lately…
The quacks at CREA say housing activity “improved” …
Seasonally adjusted national home sales activity rose 4.5 per cent in January 2011 compared to the previous month, reaching the highest level since April 2010. Led by Vancouver and Toronto…
…
Actual (not seasonally adjusted) national sales activity via the Multiple Listing Service® (MLS®) Systems of Canadian real estate Boards came in 6.6 per cent below levels in January 2010. This was the smallest year-over-year decline since May 2010.
…
Now if it hadn’t been for Flaherty’s tinkering with mortgage rules and pulling demand forward and creating a buying panic, sales activity would be lower…agree? I will explain why…Lets look at GTA since it accounts for the biggest share of Canadian housing activity and it led the “improvement”…
The Toronto Real Estate Board publishes mid-month & monthly sales figures;
Mid-month figures for January 2011
January 19, 2011 — Greater Toronto REALTORS® reported 1,563 sales during the first two weeks of January 2011 – an 11 per cent decrease compared to the first two weeks of January 2010. See details.
Until 15-Jan-2011, sales in GTA were 11% lower than Jan 2010… then on 17-Jan-2011… The federal government acts prudently (in my opinion) and announces new mortgage lending rules… How did those changes affect sales for the rest of Jan 2011?
Monthly figures for January 2011
February 4, 2011 — Greater Toronto REALTORS® reported 4,337 transactions through the TorontoMLS® system in January 2011. This result was 13 per cent lower than the record result reported in January 2010. See details.
So even after taking some heat of the housing market and creating an apparent demand pull, January 2011 sales were 13% lower than Jan 2010… Perhaps 2010 was a record so maybe not a good year to compare?… Sales were 3.5% lower compared to the average sales from 2006-2010… even when including the paltry 2670 units in 2009!! (it is a clear outlier)
Moving on to Feb…
February 17, 2011 — Greater Toronto REALTORS® reported 3,084 sales during the first two weeks of February 2011 – a 13 per cent decrease compared to the first two weeks of February 2010. See details.
One month since the announcement and sales are lower than last year… if there was no government intervention, logic dictates that sales would be even higher because people (first time home buyers) would rush to buy a home on more favourable terms.
Admittedly though, compared to average Feb sales between 2006-2010, mid-month Feb 2011 sales were 6.2% higher.
Will Canadian real-estate slow down after March 18?
I have spoken to a couple mortgage brokers and agents in the last week and:
Mortgage brokers are expecting reduced liquidity after March 18 which will affect first-time home buyers and pull demand forward…like last year’s implementation of HST.
There has been little in mainstream media regarding the proportion of mortgages with 35 year amortization…
30% of new mortgages were 35 year amortizations last year vs 8% of existing mortgages.
via CMT
As of November, 42% of new purchase financing over the prior 12 months had amortizations over 25 years. Two years ago it was 47%.
The bulk of those were 35-year amz but I don’t have the exact ratio or the breakdown by home price.
From a real-estate agent who works with 2 mortgage brokers
“90% of our deals were high ratio, and approximately 70% were both high ratio and 35yr amortization.”
Via another broker I spoke to on Saturday
95% of her first-time home buyers have chosen 35-yr amoritzations
Will this round of tightening be enough to slow down the real-estate market in Canada? Or is something radical like prohibiting real-estate agents from fostering false confidence (prices always go up), using scare tactics (not many homes in the market), creating bidding wars (this is the worst, because there is no transparency, i would like to dedicate a post to this at some point)
open discussion… your thoughts?
Possible Black Holes to Canadian Outlook
Housing related highlights from BMO’s North American outlook. BMO expects Bank of Canada to increase rates starting in spring and end the year at 2% from the current 1%
The Good
Canada’s housing market has stabilized.
After slowing from record highs to more normal levels in the summer, existing home sales picked up in the fall, and prices have reclaimed their peaks. Low mortgage rates and rising personal incomes have kept housing reasonably affordable (at least at current rates) for the typical buyer. As long as prices do not outrun incomes in coming years, housing should remain within reach of buyers, reducing the risk of a correction when rates normalize. Still, higher interest rates and possibly stricter mortgage rules in the federal budget should restrain home sales in 2011.
Not so good
Canadian house prices rise sharply.
Witnessing the bust in other housing markets, Canadians should understand that house prices can’t outrun incomes forever. Thus, it would be irrational for buyers to bid prices sharply higher in coming years, especially since prices have already climbed twice as fast as personal income in the past decade. But irrational doesn’t mean impossible.
Definitely not impossible primarily because:
- Mortgage rates are still affordable
- Realtors continue talking up the housing market (Less than 10% of agents I have met think housing will soften)
Canadian household debt mounts.
Canada’s household debt-to-income ratio, though above the current U.S. ratio, is still meaningfully below the peak U.S. ratio in 2007. Still, Canadians could hit a similar debt wall if they can’t resist the lure of cheap money.
Canada’s housing market: then and now
Nice chart from Globe and Mail showing conflicting signs of housing bubble in Canada.
Canada’s housing market: then and now – The Globe and Mail.
simple financial analysis 
