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.

Greater Vancouver Market Snapshot November 2011

Below are updated sales, inventory and months of inventory graphs for Greater Vancouver to November 2011.

And the detached benchmark price:

Commentary: November 2011, continuing from previous months, has produced more tepid sales numbers than years past. Months of inventory (MOI, the number of months it would take to clear month-end inventory at current monthly sales levels), a key indicator of market liquidity and impending price strength, is at about 6, a level concomitant with flat prices.

Total inventory has likely peaked in October (it peaked mid-month, but not shown due to monthly sample rate); if the market were under significant distress we would have expect increased inventory buildup through November, which did not happen. New listings have been consistently about 20% higher in 2011 than 2010 with sales roughly flat. That indicates a greater percentage of listed properties will be unable to elicit a sale.

Below is the predictor of price gains, based on half-over-half price change to months of inventory correlation:

What this shows is the change in prices in a month from 6 months ago based on actual data and “predicting” the price based on months of inventory from that month based on linear regression of half-over-half price change to months of inventory (with 3 month moving average).

In summary November 2011 has mirrored November 2010 closely, with slightly more weakness due to higher inventory levels and lower sales. December and January are slow months for listings and sales, so while the reports may be of some interest there won't be much to draw any meaningful conclusions. It is likely that severe market distress, should it occur as in 2008, would only be evident going into the summer, validated by robust inventory growth and increasingly slower sales. While I am not calling for such an event in 2012, there are real and tangible risks of it occurring based on slower population growth, increased dwelling starts, slower GDP growth in Asia, and potentially further mortgage lending restrictions in overheated markets like Vancouver's.

Elections and the Unspoken Fear

I have been following local Vancouver City election campaigning of late. I have been particularly interested in looking at the various platforms aimed at combating housing "affordability" and "speculation" in Vancouver. Various parties and candidates offer potential solutions to solving "affordability" and "speculation", ranging from "cutting red tape", adding low-to-medium-income rental housing, changing the housing mix, embedding neighbourhoods in the planning process, to outright curbs on foreign ownership.

I think, though, there is a lack of debate surrounding high prices in general. Most candidates seem to understand that prices are high but few seem convinced, at least publicly, that prices are destined to drop. All debate seems to surround the possibility that high prices are here to stay as Vancouver "graduates" into the ranks of a world city with commensurate high prices. This may simply be that telling homeowners prices -- and their homeowner equity -- are destined to fall is unpopular it wouldn't garner popular support, but after listening to the candidates speak, Tweet, and comment, I come away with the impression that crashing prices experienced by our urban Cascadian neighbours to the south are almost entirely foreign.

Nonetheless the assumption of high prices leaves me feeling raw, first that prices are obviously in a speculative bubble as measured by price-income and price-rent ratios. The evidence supporting prices remaining high is suspect, it relies on a continuous flow of foreign capital and continuously low interest rates. Most purchases of property in the Greater Vancouver area (though perhaps not certain sub-areas) are by locals with locally-derived incomes. By that measure it's a relatively simple exercise to calculate how much foreign investment would be required to keep prices from dropping, and it amounts to something approaching British Columbia's annual GDP.

Given that house prices are on an earnings basis a poor return on investment, we should be asking first whether these poor earnings are in the long-term best interests of Vancouver's economic growth. Second, if we determine that expensive house (actually, land) prices are a net harm to economic output, we should be asking a big question: is it possible and desirable to suppress land prices to enable more stable and diverse economic growth?

Keeping land prices low is not an unheard of concept. Through various schemes surrounding limiting leverage, land use plans, landlord and tenant protection legislation, and taxation various jurisdictions have been more (though arguably not wholly) successful at reducing land speculation. Parts of Texas and Germany have done this.

No easy answers -- and no doubt simplistic suggestions the blogosphere seems to be prone to peddling are riddled with flaws -- nonetheless I dismiss chronic boom-bust cycles that have plagued Vancouver are not controllable using thoughtful and long-term feedback mechanisms.

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.

Greater Vancouver Market Snapshot October 2011

Below are updated sales, inventory and months of inventory graphs for Greater Vancouver to October 2011.

Oh yeah, and the detached benchmark price. Remember: prices lag, sales and inventory lead, so the price chart is put here for posterity, to remind us how significantly prices have changed over the past decade:

Commentary: October 2011, continuing from previous summer months, has produced more tepid sales numbers than years past. A continued trend of higher months of inventory (MOI, the number of months it would take to clear month-end inventory at current monthly sales levels), a key indicator of market liquidity and impending price strength, is typical in the second half. Lest we forget that prices are still high by most validated measures and it will take a prolonged period of MOI well above 6 to bring them down to more historic levels. We are currently at about 6.

Total inventory has likely peaked in October (it peaked mid-month, but not shown due to monthly sample rate); if the market were under significant distress we would expect increased inventory buildup through November, mostly due to lower sales. It looks unlikely to be the case this year, though new listings have been consistently about 20% higher in 2011 than 2010 with sales roughly flat. That indicates a greater percentage of listed properties will be unable to elicit a sale. If past years are a guide many owners will simply choose to rent instead of lower prices due in part to historically low carrying costs -- they don't "need" to sell (and instead take their chances in the "Mines of Landlord").

Below is the predictor of price gains, based on half-over-half price change to months of inventory correlation:

What this shows is the change in prices in a month from 6 months ago based on actual data and “predicting” the price based on months of inventory from that month based on linear regression of half-over-half price change to months of inventory (with 3 month moving average).

In summary October 2011 has mirrored October 2010 closely, with slightly more weakness due to higher inventory levels. I expect November to be a similar trend, with listings elevated and sales roughly flat compared to 2010.