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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?

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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)

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

August 31, 2010 1 comment

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

Did Mortgage Backed Securities boost Home Ownership Rates in Canada?

August 21, 2010 Leave a comment

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…

Chart of Home Ownership Rates vs Mortgage Rates

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.

A tale of two Housing Forecasts – CMHC vs CREA

July 30, 2010 2 comments

Couple housing related news releases this morning… the quarterly Housing Forecast by Canada Mortgage & Housing Corp (CMHC) and a Revised Housing Activity update from Canadian Real-Estate Association (CREA)

I have summarized the house price forecasts for 2010 and 2011 in table below

Forecast Period Canada Mortgage & Housing Corp (CMHC) Canadian Real-Estate Association (CREA)
Average MLS Resale House Price Forecast
2008 Actual 304986
2009 Actual 320362
2010 345500 331600
2011 350800 328600
Annual Percent Change Forecast
2009 Actual 5%
2010 7.80% 3.50%
2011 1.50% -0.90%

CREA President Georges Pahud…

The Bank of Canada recognizes that inflation remains well contained and that economic growth will soften, so interest rates will rise slowly and at a measured pace, which will keep home financing within reach for many homebuyers,” said Georges Pahud, CREA President

What is he drinking? Interest rates have gone up by 50bp (0.5%) on variable mortgages. Bank of Canada (BOC) has not control over fixed rates…I think BOC is responding to avert a potential US style housing bubble not to make housing more affordable…

It is obvious from data that future demand was pulled forward in anticipation of higher interest rates and introduction of HST on new homes.

CMHC maintains its balanced housing outlook for the rest of 2010 and 2011

For non-Canadian  readers:

CMHC is the Equivalent of Fannie/Freddie/Ginnie i.e. buys insured mortgages from from lenders in the form of Mortgage Backed Securities.

How accurate is CMHC Forecast on Canada’s housing market?

July 7, 2010 Leave a comment

… not very good, at least for 2009… it has been bang on for the first quarter of 2010!

CMHC – Canada Mortgage & Housing Corporation publishes its Housing Market Outlook quarterly with forecasts of housing starts, house prices, resales, etc. For 2009, it changed the forecast every quarter starting from Q3 2008 to Q4 of 2009 and… still got it wrong!

Accuracy of forecast housing outlook by CMHC

Source: CMHC

CMHC is Canada government owned National Housing Agency & currently holds about 30% of outstanding residential mortgages…