Some thoughts on Canada’s housing market

By Edward Harrison On May 16, 2013

This is a more in-depth follow-up piece to the free article I wrote yesterday. In the wake of the recent Ira Sohn conference and the revelation that hedge funds are starting to short housing-related Canadian stocks, there is a lot of bubble talk in the press. I believe this talk is well-founded. I have predicted the bubble starts to burst this year. Canadian house prices are overvalued both in relation to rent and to property income. The question is not whether these price variables will revert to mean, it is about how violently and how much the denominators rise or the numerators fall. And this is significant because the Canadian economy has become one big housing bet.

This is a long-form version of the daily commentary. So I am not going to take a strong view per se. However, I am going to identify a number of issues to think about in the context of the Canadian property market.

Let’s remember how we got here first. If you recall, at the height of the housing bubble, Canada was not one of the markets that had exhibited breathtaking house price inflation. According to the economist, in mid-1995 Canada’s house prices had appreciated 47% over the past 8 years, whereas a number of markets saw their markets more than double in price – Ireland had seen 192% appreciation, Britain 154%, Spain 145% and Australia 114%. Other notably frothy markets like France, Sweden, the Netherlands and the US appreciated 87, 84, 76 and 73% respectively. Only Sweden and France have not had a housing bust yet. I chronicled this in 2008.

After the bubbles had begun to burst, Merrill Lynch warned on Canada in September 2008. Canada too was pulled down in tow. House prices did decline there. Toronto house prices were in freefall, by the end of the year for example. But, as I indicated in mid-2008, “Canada is looking a lot better than some other Anglo-Saxon economies.” And ultimately this helped Canada and Australia both pull through. By the time the global recovery was in full swing again, bubblicious mortgage deals started to proliferate in Canada. We’re talking 100% financing, cash back, 40-year mortgage type stuff. I said at the time, the “great thing about the recession in Canada is that it cooled down an overheating market, especially for condos in places like Vancouver and Toronto. But, prices are marching higher again… This will end badly.” And I believe this is what we are beginning to see.

The prices turned into a bubble. In March 2011, the Economist magazine pegged Canada as only modestly overvalued unlike other bubble markets in Sweden, France and Australia that had yet to pop. But by April of last year, the Bank of Canada cautioned that house price to income was 35% above mean levels. By this January the Economist gauged Canada as extremely overvalued, 34% on price to income basis and a massive 78% on a price to rent basis. Basically, you could rent and be 78% better off than buying. That’s a bubble – a bubble that had started to leak air in Vancouver by July of last year.

This bubble is the result of cheap and easy money. The Bank of Canada lowered rates to record low levels during the financial crisis. And although the Bank of Canada is still the only central bank in a major industrialised currency area with a tightening bias, the benchmark rate has been at 1% since September 2010. That’s cheap money. I talked a bit about the easy part as well with the dodgy loans that I saw being advertised everywhere. But most of this has been stopped. Last year, the regulators tightened the screws and put an end to these practices.

One easy money practice that I do want to discuss a bit more in depth is financing purchases through home equity lines of credit (HELOCs). I think this is significant because it threatens bank balance sheets as these vehicles have no government guarantees like most standard Canadian mortgages and are generally unsecured credit. The first I heard of this problem was in August when Macleans talked about why Canadian homeowners were just as vulnerable as Americans were. In October, Macleans also chronicled how Canadians were buying US properties in housing bust market Phoenix, where Canadians represented 95% of all foreign buyers. Macleans called it the attack of the snowbirds. Another Canadian blog mentioned that many of these buyers were using HELOCs to finance their purchases, something this blog believed was going to end badly.

Then I started to hear more about the use of HELOCs in the Canadian domestic market. In April, Humble Student of the Markets wrote the following about unaffordable Canadian homes:

Using a standard mortgage calculator, assuming a 3% mortgage rate for mortgage with a 25 year amortization, I got a monthly payment of $7571, or roughly 91K a year. How could a couple with 200K pre-tax income manage with those kinds of numbers? How would they eat? Even assuming a 2% mortgage rate, I got mortgage payment of 81K a year – still a bit of a stretch for our hypothetical couple with 200K pretax income.

HELOCs to the rescue

After chatting with a couple of realtors, they revealed to me the answer: These people aren’t financing their purchases with mortgages. They are financing their entire debt load with Home Equity Lines of Credits (HELOCs), which offer the “flexibility” of being secured, floating rate, interest-only loans!

With an interest only loan, a couple with 200K pretax income and a $1.6 million mortgage HELOC has payments of only $56K a year – which is well within the guideline of 40% of pretax income for housing related costs. Of course, the homeowner has the “flexibility” of paying more than the minimum interest payment each month in order to reduce principal. This financing “innovation” not only gets around the federal government’s rules around mortgages, but creates a entire new profit opportunity for lenders.

Also consider the attractiveness of the HELOC business for the lender. These are secured, floating rate demand loans. Current HELOC rates are about 3.5%. Given their near-zero cost of funding, it’s a great business (until it isn’t). Now lever up those spreads up a “conservative” 20 to 1, imagine the profit potential!

It’s a can’t lose proposition, right?

Read the whole thing. It’s enlightening. The gist here is that a lack of affordability has caused many people to leg into their property purchases in innovative ways. Here’s the thing; Ben Rabidoux, a Canadian market analyst quoted in the August Macleans piece thinks the exposure here is huge. Macleans wrote quoting his numbers:

Most importantly, the size of outstanding HELOC debt compared to GDP in Canada dwarfs that in the U.S. Data from the Office of the Superintendent of Financial Institutions indicates that chartered financial institutions in Canada hold $206 billion in HELOC debt. (And note that this does not include credit unions and other lenders that are not federally regulated financial institutions.) This amounts to roughly 12 per cent of Canadian GDP. By contrast, in 2010 a report by consumer reporting agency Equifax estimated that there were about $649 billions worth of HELOC debt outstanding in the U.S., or only about four per cent of GDP.

This leaves them and lenders exposed if the market tumbles, meaning there is more risk for lenders and Canada than one might think. And let’s remember that big Canadian banks are securitizing machines now. This lowers the average quality of loans in my view. Marshall Auerback noted in November that the average amount of traditional interest rate spread product Canadian banks offered in lending practices dropped from 90% in the early 1990s to less than 50% today. As in the US, someone is holding that securitized risk – and probably much of it is with the same banks which originated the product. Bottom line: Canadian banks are more exposed to a residential bust than one might think.

How does this end?

Well, the Canadian household has a record average 165% debt to GDP. That means that Canadians, while not necessarily maxed out – households in Denmark and the Netherlands have more debt, are constrained. In an economic downturn they are more likely to become sensitive to paying down debt. If house prices were to fall, this sensitivity to debt service would rise even more. I believe this means that affordability becomes a problem in a generalized economic downturn in which jobs, income, and wages are impacted at the same time that house prices decline. This has not yet happened but transaction volumes are declining and prices have begun to wilt in Toronto, Vancouver and Victoria in particular.

So, from a macro perspective, we should be looking at wage and job growth as well as GDP growth. But we should also be looking at the average length of the fixed rate in mortgage terms because mortgage resets may be a factor as they were in the US.

One other thing to note, about the residential property side is that full recourse is not a saving grace for Canada. A lot of people feel that full recourse mortgages make Canada a better bet to avoid a bust than the US. Not so. The following are Case-Shiller full recourse mortgage cities with peak declines over 20%: Atlanta, Chicago, Detroit, Las Vegas, Miami, Tampa, New York, and Washington DC. In the US, Florida and Nevada had some of the largest housing busts and both are full recourse states. As CNBC’s John Carney noted recently, a “study found no major difference when a mortgage has become unaffordable“. Why? If Canada’s price declines become large and mortgages also are unaffordable – as we saw they already are in places like Vancouver, then, as in Ireland or Nevada or Florida, full recourse will not save the economy. John Carney says, “it seems obvious, of course. Recourse laws only prevent discretionary defaults. If you can’t afford yer loan, no use at all“. Clearly, if you lose your job, you could always sell your home to stop servicing the mortgage. But if you’re underwater, that’s not going to work.

That tells me that, despite the tightening bias, the Bank of Canada is going to be on hold. A former aid to the BoC is saying that they should hike. But hiking now given what I have laid out would be disastrous as it would accelerate price declines and create debt distress. I don’t see it happening.

The hedgies are out in force shorting mortgage lenders. Fine. I think it’s difficult to find ways to profit from a house price decline in Canada. There’s really no Big Short-type trade here. As for the industry guys lending the money, some of these guys are claiming they don’t see the bubble. Bollocks. The bubble is all around. And it is going to pop. The question now is about how bad things get.

As always, relevant links below

P.S. – I don’t know how exposed to commercial property the Canadian banks are but it is interesting that a lot of the property being built in high rises in places like Toronto are for commercial use. That tells me that we have to be thinking about what happens when commercial rents turn down or when businesses default. In a generalized rececession this will definitely be a big factor.