Interest Rates and 2014

The Canadian mortgage market favours five year fixed rate term renewals, and as such the prospects for those looking to renew mortgages in the coming year matters for inflation as well as credit growth. A borrower has a few options at renewal time, including continuing to amortize a loan on its original schedule, refinancing for a different loan amount, and changing between fixed and variable rate over various terms. Now-retired "Vancouver Housing Blogger" brought us the concept of the "renewal gap", the interest rate differential a borrower sees upon mortgage renewal, shown below for the 5 year fixed rate mortgage using the "average residential mortgage rate" as reported by CMHC, and the "posted" rate as reported by the Bank of Canada (note current rates are held as constant indefinitely into the future):

Extending this concept further, we can look in terms of change in payment, which depends upon whether a borrower refinances or re-amortizes. The four scenarios considered are:

• Borrower refinances a 5-year amortized $100,000 loan into another $100,000 25 year amortization loan (and pocketing the amortized amount) (blue line)
• Borrower refinances a 5-year amortized $100,000 loan into a $100,000 20 year amortization loan (and pocketing the amortized amount) (red line)
• Borrower continues a 5-year amortized $100,000 loan into a 25-year amortization loan (ie extends the amortization only) (yellow line)
• Borrower continues a 5-year amortized $100,000 loan into a 20-year amortization loan (ie continues the amortization schedule; this would be the scenario for a borrower who wants to continue with a government-insured policy loan) (green line)

The four scenarios are graphed below for the average lending rate, again assuming current rates are extended indefinitely into the future:

The blue and green lines overlap exactly. That is, a borrower deciding to refinance a $100,000 loan for 25 years or continuing to finance a loan five years into its 25 year amortization for 20 years is the same. If a borrower decides to refinance but not re-amortize, that results in a higher payment, and if a borrower decides not to refinance but to re-amortize, that results in the lowest payment in the scenarios considered.

Starting in 2012 and continuing all the way until today, all four scenarios resulted in lower mortgage payments compared to the previous five year term. Starting in early 2014, that scenario quickly changes, with only the re-amortization scenario offering any significant easing of payments. The sudden change in payment terms for borrowers will tend to reduce credit growth and yet be relatively inflationary through most of 2014 and all years hence, barring any significant drops in mortgage rates.

Canadian and US Bond Yields

The perpetual threat of rising bond yields that (one assumes) translate to higher mortgage rates are back in the news. Well, rising US yields are in the press, anyways, and we all know that Canadian yields are tightly linked to US bond yields.

The graph below shows the linear spread between Canadian and US 10 year bond yields (ie the Canadian 10Y bond yield minus the US 10Y bond yield) since 1955:

When we say Canadian and US yields track, it is in the statistical context.

Update on mortgage rates

Since the 5 year Government of Canada bond yield recently touched the psychological 2.0000% barrier I thought I'd update mortgage rates first from a historical perspective and second by looking at the "renewal gap" and relative payment ratios based on average mortgage rates to the end of July.

The 5 year Government of Canada bond yield:

Residential mortgage rates, using "posted" and "average" rates. Average rates through July 2013 have not increased significantly, meaning the spread to risk-free has dropped by about 70bps on the chart below.

The five-year "renewal gap" is the interest rate differential (IRD) an owner would receive renewing a mortgage at various points in time, with the most recent mortgage rate held constant into the future. After 5 years this would obviously mean a renewal gap of 0 bps. The renewal gap does not yet capture potential mortgage rate increases (since the last reported average rate is still low), nonetheless even with the most recent increase in rates, and assuming rates do not significantly increase further, the renewal gap will remain negative for the remainder of the year, with a near-zero renewal gap manifesting in May 2014.

The chart below holds income and debt-service ratio (DSR) constant and looks at how much loan a borrower can afford over time, aligned with changes to maximum amortization lengths. This assumes uninsured borrowers can still secure 30 year mortgages. If the predominant maximum offered amortization length becomes 25 years I will adjust this, which would kick the blue line down to about 155.

Even with the most recent increase in rates, households with five year fixed mortgages still have room to refinance at terms more favourable than five years ago.

Increasing Interest Rates

As interest rates threaten to increase it helps to realize that rising rates on amortizing loans affect borrowers in two ways. The first is that as rates rise, total payments increase. The second, and less talked-about, is that as rates rise, total principal paydown is delayed. To depict this I have graphed the percentage of principal paid down after five years of payments alongside the amount of interest paid over those five years:

A borrower will find that, after five years of payments with a higher mortgage rate, not only will they have paid more interest but also they will have paid less towards principal.

Macroprudential Mortgage Rates

A comment in this Financial Post article "Rising rates creating increasing dilemma for homeowners" piqued my interest:

Jim Murphy, chief executive of CAAMP, wonders about what the impact of higher rates will be for new buyers when stacked on top of tougher rules.
His groups pointed out this month that sales for homes under $400,000 in the greater Toronto area were down 18% in May from a year ago. For homes priced above that level, sales were down just 5%.
“All of these changes have impacted the first-time buyer,” said Mr. Murphy. “Now we are seeing rising rates and that will have an impact too.”
Vince Gaetano, a principal at monstermortgage.ca, said the gap has become wide enough to convince him to go variable now.
Strangely enough, banks have not moved quickly to change their 5.14% posted rate — the percentage nobody actually accepts but which everybody qualifies based on.
“What has gone on is the discounting has shrunk. It’s absolutely sneaky and it’s done on purpose because they don’t want to move people away from not qualifying at all,” said Mr. Gaetano.
Another reason the banks don’t want to change the posted rate is it’s used to calculate any penalty on your mortgage. A higher posted rate would shrink your penalty, said Mr. Gaetano.
“It’s a very cleaver way for the banks to keep the handcuffs on people,” he says. “I still see people just break their mortgages outright. Variable is attractive too because of all the games banks play with breaking mortgages and penalties. With a variable mortgage, it’s three-months straight and simple.”

"Strangely enough" banks have kept their posted rate locked at 5.14%. Conspiracy! Or... let's check the data. Below a graph of posted and discounted rates with their spread:

From 2011 or so, save the last two months, there has been a consistent widening of posted-discount spread. The posted rate has been kept artificially elevated. Public shots have been fired by Flaherty towards banks stepping out of holding the posted line. This is almost certainly due to government policy of macroprudential credit controls targeted directly at housing market credit excesses.

Calls for a bank conspiracy seem a bit premature to me; more likely recent closing of posted-discount spreads are tickling memories of the way we were, when economies ran near full capacity.

Changing Uninsured Amortizations to 25 Years

Some rumours abound of maximum amortization lengths for uninsured mortgages being set to 25 years as a form of macroprudential easing of relative excesses in the Canadian housing market. To quantify this change, and put it in recent historical perspective, I have graphed the change in affordability relative to 2000 for a fixed income and debt-service ratio, using prevailing average mortgage rates for both insured and uninsured mortgages. Currently 30-year amortizations for uninsured mortgages are possible, but if these were dialled back to 25 years, the effect on maximum loan affordability is evident:

It should be clear that the proposed changes are not announced or in force, but we can see in recent months the gap between uninsured and insured loan affordability has widened. If prices are to fall an uninsured mortgage can quickly become insured, hence, likely, the consternation in Ottawa of this gap. If amortizations were to change from 30 to 25 years this amounts to an affordability drop of 10%, and a halving of the insured-uninsured affordability spread from 24% to 12%.

The Effect of Overt Macroprudential Policy and Interest Rates on Borrowing

A quick and dirty gauge is to ask, given current interest rates and rates used for loan qualification requirements, what is the amount of loan a borrower can get via a conventional mortgage? To answer this, we can normalize for income level and debt-service ratio and look at the effects on maximum loan qualification for both insured and uninsured loans. I have normalized the results to January 2000:

The amount of loan has depended upon macroprudential policies relating to maximum amortization lengths and minimum downpayment ratios. These two have tracked well until 2010 when the government required using posted, not discounted, rates to qualify for government-insured loans. The most recent overt macroprudential measure was to reduce the maximum amortization for an insured loan to 25 years from 30 years. I have assumed uninsured loans can still get 30 year amortizations. 

This is for a generic "prime" borrower; DSR and other qualification limits will be imposed based on lenders' internal risk management policies (that have notably changed of late) that will not show up in this graph above.

Nonetheless it is stark how accommodative uninsured loans are in the current environment, and how stiff the "posted" rate has been since mid-2012 despite the significant pressures on yields. Finance Minister Jim Flaherty recently took to strong-arming banks to ensure they did not change their posted five-year rates. If banks were allowed to lower the posted rate the red line on the graph would be higher.

As it stands in the current environment an insured borrower can qualify for about 33% more loan than was the case in 2000, income-adjusted. An uninsured borrower can now qualify for an impressive 65% more loan.

Upper Body Work on the Five Year

Here are some graphs on the Canadian five year mortgage rates. The first graph is the "posted" and "average" mortgage rates since around 2000:

The components of the mortgage rate are comprised of future inflation expectations (I used the long real return bond and the long bond to estimate future inflation expectations), the real rate of interest on "risk free" (the five year Government of Canada bond yield subtracting inflation expectations), and the residual which we abstract to be the "spread".

The real rate of interest on the five year GoC bond has been negative for over a year now. For the most part this has materialized as increased spreads to mortgage lenders and securitizations. The negative real rate on the five-year bond has been causing consternation with the government and the Bank of Canada and is a major reason why they have been leaning so heavily on mortgage lending over the past year.

The posted and average mortgage rates have diverged over the past few years:

Finally there is the "renewal gap" that takes rates from five years ago and asks the question, what interest rate differential (IRD) will a borrower see upon renewing a five-year mortgage, all else equal? I have estimated the forward-looking renewal gap by keeping current rates constant out until 2018 (five years from now). If that occurs the renewal gap in five years will be exactly zero.

The five-year renewal gap is heavily negative and will remain so until the end of 2013. This will provide some refinance tailwind for housing activity. That tailwind hits a proverbial brick wall in 2014 even if rates remain low. (Note the absolute magnitude, not just the gap, matters for payments. That is, a renewal gap of -1% pre-2008 and post-2008 will have a different effect on changes in absolute payments.) In terms of setting macroprudential policy, I expect the government is considering upcoming renewal IRDs.

Comparing Canadian and US House Prices

To compare Canadian and US house prices we can use the US-based Case-Shiller house price indexes overlaid with the Canadian-based Teranet house price indexes. The two share comparable methodologies, using same-sales pairs with extraneous discards. Since the house price indexes are referenced to a point in time, and not a specific valuation, we will need to re-scale the results to some value for an apples-apples measure. I produced these results about a year ago and have updated the values to the latest data. The incongruity between US and Canadian HPIs is evident:

The Case-Shiller  uses a baseline of January 2000 = 100, the Teranet is June 2005. If, for example, Canada was in the midst of a speculative bubble in 2005 and the US were more fairly-valued in 2000, it means the scaling factor for Canadian cities will under-report gains. One method to compensate for this is to re-scale the indexes and align the troughs:

This graph finds the minimum indexes in the 1990s and rescales those values to be 100. Then the data are time-shifted to align these minima. I have CPI-deflated the results. Based on this measure, for what it's worth, while Vancouver is currently more overvalued than any US city, index gains over the past year have vaulted cities like San Francisco and San Diego to be rather close to Vancouver. As a sidenote, Jim Sutherland, a local reporter, opined to me last Wednesday that some coastal US cities are showing valuations approaching those of Canadian cities, even Vancouver. This simple analysis would tend to support this view.

Some Thoughts on Bank of Canada and House Prices

Deputy Governor of the Bank of Canada John Murray gave a speech to a crowd in New York on global rebalancing. I'm certainly not learned enough to comment meaningfully on his arguments and rationale but he did mention something in subsequent commentary about Canadian housing:

Canada's heated housing market appears to be cooling as desired, a senior Bank of Canada official said on Tuesday, although he noted that housing starts remain unusually high.

Housing prices and construction in Canada roared higher in 2011 amid low interest rates, sparking fears of a U.S.-style bubble. The market started to slow after the government tightened rules on mortgage lending in July, and policy makers hope to see a gradual softening rather than a crash.

"It's still early days. But we're certainly seeing evidence of movement and acceleration in the right direction," Murray told a business audience after giving a speech in New York.

"Some sort of smooth transition, at least on the housing side, is what we're looking for," he said.

An interesting comment for a "housing analysis" blogger! Murray is commenting that transitioning housing to a more sustainable level is something the Bank is looking for, and on which is likely advising the government to form fiscal policy. So we can play some guessing games as to what the Bank of Canada would like to see for a "smooth transition" and what that means.

What are the risks of high house prices and debts? Currently there is some risk of external economic shock to incomes, but absent that, with real rates depressed, debt-service ratios are currently for the most part manageable. If rates increase, however, this poses a significant headwind for the Canadian economy and worse could be almost impossible for policymakers to contain the fallout. Luckily, based on the yield curve, it looks as if rates have a good chance of staying low for a prolonged period, perhaps for the rest of the decade. The question then is what does Canada need to do in the coming years to ensure that when interest rates do rise she will not be caught out with excessive debt levels and overinflated asset prices.

Based on Murray's comments we have a smidgen of a clue what the Bank's and government's strategy is on the front of asset price reversion. It looks as if they are trying to pull of a "smooth transition" of prices back to levels that are able to be carried with historical interest rates. If prices continue at current levels (or increase) they will not have reverted quickly enough to stave off a big shock when rates rise. If prices fall too quickly this will lead to situations where a large swathe of owners are in negative equity situations, something that has knock-on effects to the broader economy. Given the assumption the Bank wants to control the band in which prices revert, we can do a quick calculation what that would mean for prices.

Say prices as a ratio to incomes are 40% above their long-term average. To revert prices to this range will require a 30% drop. To do this in seven years requires a -5% annual drop in the price-income ratio. Assuming incomes rise by 2% per year that means national prices need to drop at -3% per year for seven years to revert. If markets like Vancouver are, say, 50% overvalued, that will require prices dropping at -5% per year with 2% annual income gains to revert.

Prices do not often move in a straight line, rather we should expect that price drops will be more severe near the middle of the reversion and less severe near the ends. We can approximate this trajectory as a raised-cosine profile, say

P=(Pi-Pf)/2*cos(π*x/L) + (Pi+Pf)/2

where P is the price, Pi is the initial price, Pf is the final price, x is the year from start of correction, and L is the duration of the reversion target. Below are the year-on-year price change results for a 20% and 30% decline in prices:

Assuming the Bank of Canada is serious about price targeting we have some rough estimates of the level of annualized price drops required to pull off this delicate manoeuvre. As a reference, Vancouver looks to be on track for between -4% and -6% annualized price drops in the late winter of 2013.

But here's the thing -- if prices are to revert in a controlled manner, as regular readers of this blog know, this necessarily requires a certain ratio of for-sale inventory to prices. In other words, to ensure prices drop at a defined rate it will likely mean the government will need to control the level of sales. The only ways I can see them accomplishing such a feat are through controlling immigration intake -- not easy since they don't have much control on where immigrants settle -- and through credit availability.

In short, if the Bank of Canada is indeed "price targeting" so as to attempt to revert housing valuations to their long-term averages in the advent of future interest rate hikes, I believe we can expect further adjustments to controls of credit availability, both looser and tighter, over the coming years. It will remain to be seen how much capacity is left to accumulate additional credit, and where it can be stuffed!

You Can Still Get A Lot Of Loan

Canadian Finance Minister Jim Flaherty was quoted recently:

"Speaking on CBC Radio, Flaherty said he had no plans to take further action to take froth out of the housing market, after a series of moves to tighten conditions for mortgage lending. The most recent change was in July.
“We’ve done enough, I do not intend to do any more,” Flaherty said, adding that he was pleased at signs of a slowdown in key sectors of the market, like the condo market in the big cities of Toronto and Vancouver."

The government, through OSFI and CMHC have enacted a series of changes to mortgage underwriting guidelines and mortgage insurance qualifications so as to attempt to make credit more dear. I believe the most recent efforts have been made more urgent because real rates on the 5 year bond have been negative for several months.

An interesting exercise is to compare how much loan a borrower can get for a conventional 5 year term mortgage amortized over the maximum allowable, assuming debt service ratios and incomes are flat. To show this effect I have calculated the maximum loan amount a borrower can take assuming a fixed payment and fixed income. I have normalized the results. This shows the effect of amortization and interest rates on how much loan can be taken:

In 2000 interest rates were higher than today and then fell through most of the early 2000s. In late 2006 the government changed maximum amortization lengths to 40 years. This was subsequently pared back to 35 years in 2008, then to 30 years in 2011. In addition there was a change where insured mortgages must qualify under the posted, not actual, rate. Finally, in July 2012 the government reduced maximum amortization length to 25 years on insured mortgages only. (Uninsured mortgages can still obtain 30 year amortizations.)

Despite the recent round of amortization pullbacks the maximum affordability is still well above levels seen in the early 2000s. Compared to January 2000, a borrower can obtain 32% more insured loan and 61% more uninsured loan.

The gap between uninsured and insured mortgages is stark. If prices are coming off their highs and continue to show weakness, uninsured loans will start to become insured as loan-to-value (LTV) ratios start increasing. Given the discrepancy between uninsured and insured loans, that will hit the market hard, so hard I expect a reversal of recent moves to tighten lending, in some form, if prices continue to trend weaker.

While the government may want to protect the interests of taxpayers from future liability, if it's like any other asset bubble in history, that goal is likely not realistic. In my view the question has always been how the government is going to have Canadians consume (read: eat) poorly-performing mortgage debts.

Mortgage Spreads

This is a quick look at Canadian 5-year mortgage spreads. I am not a financial analyst or anything, but here are the data using some basic calculations. Here are the mortgage rates: the posted rate, the "average" rate that includes discounts from posted, and the rate listed on RateHub that tracks the maximum discounted rate.

Mortgage rates are dependent upon the real rate of interest, inflation expectations, and an additional spread that includes the spread between risk-free and mortgage securities as well as servicer markups. I have graphed the three components (real rate, inflation, and additional spread) of the 5-year average mortgage rate below:

The inflation expectation is calculated by taking the difference between the long Government of Canada real return bond and the Government of Canada long bond. The real 5 year rate is calculated according to the Fisher equation, however I used the long breakeven rate (BER) and not the 5-year BER when calculating inflation expectations.

The "spread" has been increasing since the beginning of 2011. Recent reduced mortgage rates seem to be attributable to lower real rates and lowered inflation expectations. By these calculations, the real spread from risk-free has been higher than before the 2008 recession.

A Rare Post Worth Reading

Asset manager, blogger and twitterer (?) Morally Bankrupt wrote some thoughts on the factors affecting US house prices over the next few years.

"With mortgage rates near record lows, due both to low inflation and negative real rates, the leveraged purchasing power of real wages is near historic maximums. Additionally, for the most part, it looks like the bottom is in for housing price declines. Does this make it a good time to buy leveraged real-estate to capture future price appreciation while financing it at low rates? I do not think it's as clear as many people think it is."

I encourage "housing analysts", both professional and amateur, (me being the latter) to read the post to understand why. One of the big takeaways is on how mortgage payments that vary linearly with debt amounts relate to changing rates that affect affordability geometrically:

"For home prices to sustainably exceed inflation, wage gains have to outpace inflation by more than the increase in rates over that same time period... [P]urchasing power increases at an increasing rate as rates decline... [A]t a fixed interest rate, purchasing power increases at a stable rate with payment. This means that for home prices to sustainably increase, growth in wages not only has to outpace inflation, but it has to outpace it by a margin wide enough to compensate for losses in purchasing power from any changes in the mortgage rate during that same period."

This has implications for the Canadian housing situation as well. The conclusion:

"Depressed real estate prices and low financing rates are leading many to see the current climate as a golden opportunity to buy leveraged real-estate, but price increases are not guaranteed, and the pay-out on a leveraged bet on housing is dependent many different factors. While affordability remains high and payments as % of income are near historic lows due to the Fed's extremely accommodating policy, an economic recovery can put an end to Fed accommodation and suspension of the Fed's MBS reinvestment program would be reflected on both, the risk-free interest rate and the spread at which MBS trade, turning a tailwind into a headwind for price appreciation. Leveraged buyers also run the risk of near-term price declines or inflation rates below the rate priced in by nominal rates. Leveraged real estate requires price appreciation and/or profits from rents to outpace the rate of inflation built-in to interest rates, which as we already saw, is not near lows. 

"I don't have an opinion on whether residential real-estate is a good or bad investment, it's not my line of work, but I think many investors are failing to see that a leveraged bet on real-estate price appreciation is, indirectly, a bet on inflation exceeding current inflation expectations and future wages increasing at a rate faster than inflation. Under an inflationary environment, increases in the real price level of real estate would require a mix of an increase in the % of income spent on housing and real wages in order to allow growth in outlays to outpace the loss in purchasing power created by any increase in real-rates, inflation expectations, or mortgage spreads."

The Mortgage Renewal Gap

Something that used to be tracked on local blogs (by Van Housing Blogger) is the so-called "renewal gap" that asks the question, what interest rate differential (IRD) would someone see if they renewed their mortgage today? This is calculated by looking at the mortgage rate N years ago, where N is the length of the term, and subtracting it from the current mortgage rate.

There are both posted and "discounted" mortgage rates and Ben Rabidoux pointed out to me that this spread has been increasing recently due to some "mortgage wars" reported between vendors chasing yield (or whatever). To help weed through this, with Ben's help, I have found three data series of mortgage rates:

• The "posted" mortgage rate tracked by the Bank of Canada on its website (V122521)
• The "average" mortgage rate surveyed by CMHC from its lending partners (CANSIM Table 176-0043)
• The mortgage rate tracked by Ratehub, which tracks discounted rates.

The first graph looks at the 5 year rates from these three data sources:

And the spreads between the data series:

The renewal gap of the average and posted rates, with the spread between the two, is as follows. I have assumed future rates maintain July 2012 values indefinitely into the future. (This could be slightly improved by using bond futures to provide best-estimate of rates going forward.) (The Ratehub and average have almost exactly the same renewal gap calculation)

Here is the posted renewal gaps for 1, 3, and 5 year terms:

Analysis:

• The 1 and 3 year posted renewal gaps are now roughly zero. That means borrowers on these term lengths will not see much debt relief upon renewal going forward. This is a big change from 2011 when the 3 year posted had average IRDs under -2%.
• The 5 year renewal gap is markedly negative, to the tune of close to -2.6%. Absent any significant interest rate moves or changes to discounting this will continue for another 16 months or so after which the renewal gap shrinks close to zero again. This means that the fraction of households whose mortgages are up for renewal in the next while are able to significantly reduce their financing costs, all else equal.
• The "mortgage wars" where significant discounts are being offered compared to posted rates have been increasing over the past year.
• It should be no surprise the Bank of Canada and the Government of Canada have acted by clawing back amortization lengths, twisting rates, limiting refinancings, and taking OSFI's machete to bank lending practices (to name a few), given the large and persistent negative IRD on 5 year term renewals.

The renewal gap on mortgages is still accommodative but 2012 has seen some tightening due to the 3 year gap hovering around zero again. The 5 year gap is still markedly negative and this will tend to be a tailwind for the economy as borrowers continue to refinance in favourable conditions. That, taken by itself, is a bullish indicator for housing over the next year or so. Whether households are increasing their debtloads upon renewal or keeping their original amortization schedules is another discussion.

Financing Advantages

Something that goes somewhat unstated in the real estate discussions I read online and in print is how, in Canada, residential financing receives preferential rates over similar investments not only for owner-occupiers (aka "homeowners") but also investors ranging from the family renting out a basement suite to those who actively manage multiple properties and derive the lion's share of their income from these operations. The article that piqued my interest is one written by Martin Wolf last year:

According to a FT article last week, Lloyds’ bank has a target return on equity of 14.5 per cent. Banks like to argue that this is the level of return on equity they need to earn, in order to gain funding from the markets. Naturally, remuneration is linked to achieving such objectives. The question, however, is whether such objectives make any sense. The brief answer is: no. 

Forget banks, for the moment. What would you say if someone offered you an investment with a promised real return of close to 15 per cent? You might say: “How much can I buy?” Alternatively, you might say: “What is the catch?” Sensible people must take the latter view. If you thought that you were being offered a reliable real return at such an exalted level, you would buy as much as you could. This must be particularly true now when real returns on the bonds of relatively safe governments are close to zero. 

So what is the catch? The obvious answer has to be that the real return in question is extremely risky, because it is volatile and offers a significant chance of total wipe-out.

So yes on the surface when someone claims a double-digit return on equity on an asset that ostensibly grows at the same rate as the overall economy one must think a bit, but Wolf makes a few observations about how this can be sustainable over long periods (emphasis mine):

In truth, there are two other reasons why banks might earn 15 per cent returns on equity, apart from the fact that these highly leveraged balance sheets are risky. One is that they can earn monopoly profits. The other is that they are subsidised, principally because taxpayers provide insurance against catastrophic risk, particularly for bank creditors. The two – monopoly and subsidy – are, of course, related. Without barriers to entry, subsidies would be arbitraged away. 

In short, when banks tell us that 15 per cent (or something in that neighbourhood) is their target returns on equity, they are saying that their businesses are very risky and/or protected against competition and/or well subsidised and probably a bit of all three.

In the case of housing in Canada, both investors and owner-occupiers have access to government-underwritten financing that pushes spreads down to levels that, without a government backstop, would be higher. In terms of the added spread, I've heard estimates of the added spreads of around 100bps for prime low-ratio loans. In cases where land is leased, liability is limited, LTV ratios are high, or cash flows are risky, this spread increases.

Canada has, for a prolonged period, subsidized residential investment and home ownership through preferential lending rates. If this produces net beneficial externalities the lower spread is somewhat justified but on the other side, as Wolf highlights in his post, government subsidy is not necessarily a free lunch; rather risks can build and must eventually be borne on government balance sheets, taxing future growth.

Canada has been riding increasing real land prices for over a generation and we should be cognizant of the risk that preferential financing is incurring a large and looming liability on the government's books. With the recent run up in prices nation-wide, with prices becoming detached from their utility and consumer debt loads increasing, it is worth pondering whether that reduced spread from free market has to be given back, in whole or in part. Given recent moves by the Bank of Canada and the federal government, it appears this line of thinking is under active consideration.

Mortgage Renewal Gap June 2012

Below are some updated charts highlighting the so-called "renewal gap", the difference in mortgage rates a borrower will see upon renewal at certain terms. For example a borrower refinancing today who was in a 5 year term will see about a 2% reduction in interest rates. First the mortgage rates, second the "gap":

The renewal gap is projected assuming rates remain flat at current levels for the next 18 months. As can be seen, the majority of renewals with a negative gap from the past few years have taken place, with the exception of the 5 year which, barring any increase in rates, would see a negative renewal gap for the remainder of 2013. The tightening of the 3 year renewal gap can go some way to explain slower real estate activity in 2012. This graph should also be a reminder that lower rates for a prolonged period acts as a multi-year stimulus as households continue to reduce their carrying costs, all else equal.

Mortgage Rate Update January 13 2012

A key element to watch are mortgage rates to determine affordability, these days with inflation low it looks like mortgage rates are heading down again, perhaps with a slightly larger spread to risk-free than in the past. Here are the 1, 3, and 5 year conventional mortgage rates as reported by the Bank of Canada:

The 5 year rate, as reported by BMO today, is now below 3% for the first time. The issue facing the Bank of Canada and the Canadian economy is what happens if credit growth increases further. Canada's household debt-income ratio has been moderating of late but there are significant risks if credit begins to increase again with historically low mortgage rates.

As mentioned by the Bank of Canada in its most recent financial system review:

Despite the rebound in the growth rate of mortgage credit in October, the Bank expects a gradual moderation in the underlying trend in household debt accumulation over the medium term as activity in the housing market slows and as lower commodity prices and heightened volatility in financial markets weigh on the wealth and confidence of Canadian households. Since the growth of personal disposable income is also projected to be moderate, the gap between credit and income growth is expected to narrow but remain positive, implying that further increases in the aggregate household debt-to-income ratio are likely.

Ultimately a decision needs to be made: is it in any way acceptable that debt-income ratios continue to increase, or is it necessary for the government to step in and ensure this ratio does not grow, and even starts to reverse? These are difficult decisions, it could mean that Canada's growth rate would need to be reduced to deleverage debt to more sustainable levels in the interim and could temporarily tip the economy into recession. 

In order to facilitate deleveraging in a low interest rate environment there are several things the government can do, including reducing loan amortizations to 25 years from the current 30, and even as far as issuing quotas on available loans. No matter what methods that are announced to maintain or reduce household credit, if any, and there are signs that debt is increasing faster than incomes, I am speculating the government will employ mechanisms that ensure debt levels are contained. 

In the past when the government has announced tightening of credit conditions through its mortgage insurance arm (CMHC), it has done so within the first 5-6 weeks of the calendar year. Further curbs through mortgage insurance guidelines are not a guarantee that households will curtail their lending; more deterministic methods of capping loans may be required. We shall see!

Bank of Canada Blows the Alarm on Housing Again

As the Eurozone crisis continues its slow impact with the current account iceberg, Canadian financiers, politicians, and technocrats (yes Canada has technocrats too) are planning for fallout (PDF). One key area of concern is the health of Canadian household finances. Below are excerpts from the risk analysis of Canada's housing market (emphasis mine):

The rising indebtedness of Canadian households in recent years has increased the possibility that a significant proportion of households would be unable to make debt payments in the event of an adverse economic shock. This growing vulnerability has heightened the risk that a deterioration in the credit quality of household loans would amplify the impact of the shock on the financial system. The resulting increase in loan-loss provisions for financial institutions and the reduced quality of the remaining loans would lead to tighter credit conditions and, in turn, to mutually reinforcing declines in real activity and in the overall health of the financial sector. 

The vulnerability to this risk remains elevated and is broadly unchanged since June. There are tentative signs that the sustained rise in the proportion of vulnerable households in recent years has moderated and credit growth has slowed noticeably over the past six months. Nonetheless, our simulation results suggest that household balance sheets remain vulnerable to adverse economic shocks... 

While the growth of household credit has slowed since early 2011, it has continued to increase more rapidly than income. As a result, the debt-to-income ratio of the Canadian household sector increased to a historical high of 149 per cent in the second quarter (Chart 23) and has been higher than the ratio in the United States since the start of 2011.

If recent trends persist, the ratio of household debt to income will continue to rise

Despite the rebound in the growth rate of mortgage credit in October, the Bank expects a gradual moderation in the underlying trend in household debt accumulation over the medium term as activity in the housing market slows and as lower commodity prices and heightened volatility in financial markets weigh on the wealth and confidence of Canadian households. Since the growth of personal disposable income is also projected to be moderate, the gap between credit and income growth is expected to narrow but remain positive, implying that further increases in the aggregate household debt-to-income ratio are likely. 

The overall financial situation of households remains strained  

Data for both individual households and the sector as a whole indicate that the financial situation of the household sector remains vulnerable. In particular, both the share of indebted households that have a debt-service ratio exceeding 40 per cent and the proportion of debt owed by these households remain above the 2000–2010 average.
The aggregate credit-to-GDP gap for Canada has fallen from its cyclical peak but remains high by historical standards, owing to the growth in household credit. International evidence has shown that this indicator is a useful guide for identifying a potential buildup of imbalances in the banking sector. 

Financial stress in the household sector has eased since the beginning of 2011, although it remains above pre-crisis levels: mortgage and consumer loans in arrears have moderated somewhat during 2011 but are nonetheless elevated. As well, the ratio of household debt to assets remains above its pre-crisis level, and household net worth declined modestly in the second quarter. Given negative returns across a broad range of assets since mid-year, net worth is expected to have declined further in the third quarter. 

Households are vulnerable to adverse shocks to the labour and housing markets 

Given the vulnerable state of their balance sheets, households would be less able to cope with the impact of significant adverse shocks. Two interrelated events to which Canadian household balance sheets are vulnerable are a significant decline in house prices and a sharp deterioration in labour  market conditions. 

Since high-ratio mortgages in Canada are insured, it is likely that a moderate fall in house prices would affect systemic risk primarily through the negative feedback loop with the real economy. In such a scenario, declines in house prices would lead to lower household net worth, reduced access to secured credit and lower employment in the housing-related sector. These factors would reduce consumer spending and increase strains on household balance sheets. 

Some measures of housing affordability suggest continued imbalances, owing to the robust performance of this market. In particular, house prices remain very high relative to income. Since the adverse impact of elevated residential property prices on affordability has been largely offset by low interest rates, affordability would be considerably curtailed if interest rates were closer to historical norms.

Certain areas of the national housing market may be more vulnerable to price declines, particularly the multiple-unit segment of the market, which is showing signs of disequilibrium: the supply of completed but unoccupied condominiums is elevated, which suggests a heightened risk of a correction in this market. 

A sharp and persistent increase in the unemployment rate would reduce aggregate income growth and make it more difficult for some households to make their debt payments. It would also have adverse knock-on effects on consumer confidence, the housing market and Canadian household net worth. 

The elevated debt loads of the household sector require continued vigilance

The Government of Canada has taken important measures in recent years to strengthen underwriting practices for government-backed insured mortgages. The most recent set of measures was implemented in March and April 2011, when the maximum amortization period was reduced from 35 to 30 years, the maximum loan-to-value ratio when refinancing a mortgage was lowered from 90 per cent to 85 per cent, and government-backed insurance on lines of credit secured by houses was withdrawn. These measures represented the continuation of a series of actions taken by the Government of Canada since 2008 to foster stability in the domestic mortgage market, and should help to moderate the future growth in household debt. Nonetheless, continued vigilance is warranted, since adverse debt dynamics remain in place. The Bank is co-operating closely with other federal authorities to continuously assess the risks arising from the financial situation of the household sector. 

Given the robust pace of mortgage credit growth in recent years, the Office of the Superintendent of Financial Institutions has conducted focused research on retail lending products over the past 18 months. An advisory was recently released noting that additional analysis is planned in the coming months. Where appropriate, this analysis will build on international mortgage underwriting principles being developed by the Financial Stability Board. OSFI has reiterated that mortgage lenders are expected to have an established policy for mortgage underwriting that is supported through appropriate risk-management practices and internal controls.

Key points and comments:

• Household balance sheets are likely to deteriorate further in coming months, and potentially years, with current controls in place.
• The Bank of Canada sees high house prices relative to incomes as unsustainable in the long run.
• OSFI is concerned about a disconnect between bank lending practices and long-term economic stability.
• Curbs on lending in terms of implementing risk management measures and countercyclical buffers on mortage loans are likely in the works.
• Usually announcements of further tightening of mortgage credit are announced in the first two months of the year to allow for proper implementation before the brunt of the peak of Canada's spring selling season.

If the Bank of Canada feels the need to lower interest rates in early 2012, this paper suggests that they are seriously considering additional curbs on mortgage lending to offset any additional monetary stimulus. This may mean, in particular overheated regional markets (like Vancouver's), that OSFI will start enforcing measures more closely tied to regional price-income metrics. This means Vancouver homeowners may find credit availability tougher than other regions of the country.

This is an important report. I have been surmising that further curbs in mortgage lending are coming, but am still unsure what form they will take. It is still possible that curbs going forward will start delving into the low-ratio mortgage market -- if prices do start falling banks who are lending on terms incompatible with government-backed mortgage insurance will create a significant liability for Her Majesty's Government.

Canada and Fiscal Stimulus Update November 2011

Back in a post in September I remarked it was relatively obvious that Europe was going to head into recession and that the Government of Canada was less likely to meet its "balanced budget in 2014" pledge; now Mark Carney is calling for a near certainty of a Eurozone recession and it looks like Canada will suffer lower GDP growth as a result. Recall my predictions of potential areas of stimulus should Canadian GDP growth falter:

Highly probable

• Accelerating capital cost allowance for businesses

• Slowing of public sector layoffs

• Lower corporate taxes

• Employment insurance hiring incentives

• R&D tax credits

• Extending employment insurance benefits

• Targeted but piecemeal government spending programs, geared towards non-residential infrastructure.

Somewhat probable

• A second "Canadian Action Plan"

• Energy efficiency upgrades

• Reducing Bank of Canada's overnight lending rate

Unlikely

• Reducing CMHC requirements for loans

Now today a fiscal update from the Department of Finance indicates more stimulus will be needed:

Flaherty also announced Tuesday the government is extending a work-sharing program that lets some employers hang onto skilled workers while they deal with money problems. Under the program, workers can drop to part-time hours and the government will top them up with Employment Insurance... 

Flaherty also cut in half the increase in EI premiums employees and employers are expected to pay starting Jan. 1, 2012. 

EI premiums were set to increase in the new year by up to 10 cents per $100 for employees and 14 cents per $100 for employers. Those increases will now be capped at five cents and seven cents respectively...

Border and trade talks with the U.S. will mean more spending on border infrastructure, Flaherty said after the speech.

So we have: corporate tax reductions (in the form of slowing EI premium increases), extending EI benefits, and non-residential infrastructure spending.

Though it would be unlikely to be announced, I expect there will be a slowing of public sector layoffs going forward. I'll have to wait until the new year to find out for sure about the R&D tax credit and grant prediction but I expect it won't be cut. I'm not sure about the CCA acceleration.

So far no major surprises. I am also anticipating that there may be further mortgage credit tightening announced in January, though I'm not certain if mortgage insurance will be the mode by which the government acts. Speculation has spread to the low-ratio loan market and, ultimately, the Government of Canada will be on the hook for many of these loans should prices retrench -- banks may not be aligning borrowers' ability to pay with longer-term rates in mind. Further curbs to mortgage lending may show up behind-the-scenes through OSFI decrees.

Central 1 B.C. Housing Forecast 2011-2013

Report available here (PDF). Excerpts (emphasis mine):

On the bifurcation of BC's real estate market:

A key characteristic of the post-recession housing market has been the divergent housing strength between the Lower Mainland and most other areas of the province. While the Lower Mainland-Southwest and, to a lesser extent, the Capital region had shown relatively stronger post-recession sales activity, most other regions remained at recessionary levels. The impact of low interest rates was more benefi cial for real estate markets in larger, diversifi ed economies with a higher proportion of local area buyers. In addition, employment growth was generally weaker outside of the Metro Vancouver region.

On overvaluation in the Lower Mainland:

It has become fashionable to suggest that price levels in Lower Mainland-Southwest region of the province, and particularly Greater Vancouver, are set to correct substantially due to the significant price gains in recent years and a de-linking of home prices relative to income and rental rates. Central 1 does not subscribe to this view, but does expect price gains to slow considerably over the forecast horizon. While price levels may turn lower in the near term, the annual Lower Mainland-Southwest median resale price level in 2012 is forecast to surpass 2011 by 1.4% to reach $497,000. A further gain of 3.6% is forecast in 2013 Central 1 deems a significant price correction in the Lower Mainland-Southwest to be unlikely for various reasons. First, much of the price growth in the region has been attributed to disproportionately strong demand for higher priced single-detached product in localized regions such as the west side of the City of Vancouver and Richmond. In contrast, price gains have been less substantial in other markets and product types, meaning this has not been a region-wide price surge. Moving forward, demand will likely remain stable as economic growth, albeit slow, persists and mortgage rates remain low.

In addition, speculative demand in the region remains low. The proportion of units re-sold within six months of purchase can be used a proxy for speculative activity. In theory, speculators look to gain through capital appreciation over a shorter time-frame relative to home-owner occupiers. In a period of higher speculation, which is generated by strong market activity and price gains, this proxy generally rises. However, this metric has exhibited a declining trend since early 2008, currently hovers near 2% and operates near normal levels. In contrast, this proxy surpassed 10% in the late 1980s, and was closer to 6% in 2006 when markets were overheated. The lack of excessive speculation suggests that we are unlikely to see a speculation-induced bust in pricing.

Meanwhile, price levels will be further supported by supply-side adjustments. Sales activity and the flow of new listings are positively correlated – when demand increases, new listings tend to follow in the months that follow. The opposite is also true. This reflects the tendency of sellers to capitalize on strong markets and rising prices, and sit tight when market conditions weaken. In the absence of any major shock in the economy such as a large and unexpected increase in interest rates or another recession, Central 1 expects the recent slowdown in demand to be met by declining listings activity, which will mitigate growth in standing inventory of resale product.

On population growth:

Weak population growth through 2013 will be a limiting factor for housing over the forecast horizon. The provincial population is forecast to expand at a lackluster rate of 1.1% this year, and fare only slightly better in 2012 and 2013 with 1.2% growth. The slow pace of growth will reflect a drop in the number of landed immigrants to B.C. from international markets this year and increased net outflow of residents to other provinces, primarily Alberta, in 2012 and 2013. This interprovincial net outflow reflects the stronger rebound in Alberta’s economy and improved labour market conditions.

On interest rates:

Mortgage rates will remain low and edge up beginning in the latter half of 2012 and through the remainder of the forecast horizon. This reflects a compression of bond yields, which have recently declined sharply in the U.S., Canada, and Germany during the latest round of market concerns and volatility. The U.S. central bank has stated that it expects no rate increase until mid-2013 and only then if conditions warrant.

I do not necessarily endorse this view in full; nonetheless the data presented are worthy of review. Personally I would give greater weight to price-rent ratios but to each his own. House purchases come with obligations lasting longer than to 2013. Place your bets.