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.

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.

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!

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 Rules Changing and Timing

News abounds of the impending changes to maximum amortization lengths for government-underwritten mortgage insurance. This announcement follows the general form of previous announcements affecting CMHC, "strengthening" the housing market, and comments by Minister of Finance Jim Flaherty on concerns particularly about overbuilding in Toronto.

What's different this time is the implementation period is, in business terms, immediate: only 13 days to complete a transaction and fill out an application for mortgage insurance under the old guidelines. This was in an effort to avoid the surge in activity witnessed last year when the rules were changed with 60 day notice. To recap the changes to all mortgages that are eligible for government-underwritten mortgage insurance are as follows:

• Maximum amortization falls from 30 years to 25 years
• Lower the maximum amount Canadians can borrow when refinancing to 80 per cent from 85 per cent of the value of their homes
• Fix the maximum gross debt service ratio at 39 per cent and the maximum total debt service ratio at 44 per cent
• Limit the availability of government-backed insured mortgages to homes with a purchase price of less than $1 million.

Certainly none of these moves can be considered stimulative for housing, and in total impact it's around 10% less total debt that can be withdrawn based on the 30-25 year move, even more for top-prime borrowers, and completely snuffed for loans above $1MM, though it's unclear how many loans are insured above this level. There has been some good commentary on the moves and the implications in the short term.

What I wanted to concentrate on are two things, first the implications at the high end of the market in the event of a significant bout of weakness, (houses in higher-end areas of Vancouver are seeing months of inventory well above 10, which all but guarantees subsequent price drops) second the timing of the announcement.

1) If prices do become weak, many borrowers will find their equity has been compromised and banks, due to upcoming guideline changes to how it must account for mortgages, will be loath to carry these loans and require mortgage insurance as a hedge. If the property is valued above $1MM that leaves fewer options for the borrower and rates will increase, in some cases significantly. It's hard to tell by how much, but if current weakness extends through the remainder of the year -- which is no sure thing -- the high end of the market will suffer from another solid blow to the midsection.

2) The timing of this announcement caught me off-guard. It was issued subsequent to the G20 meeting in Mexico and at a time where rumours of a renewed bout of stimuli and recapitalizations occurring in the Eurozone, the United States, and China. My guess is that discussions regarding coordinated and large stimulus efforts were discussed at this meeting, ahead of the EU summit occurring this weekend. If a renewed bout of stimulus is put forward, this can flow, and in the past has flowed, into speculative assets, further deteriorating earnings ratios. The changes to CMHC's rules, designed to dam against further increasing household debt, by themselves could destroy a housing market in the face of slowing jobs and wage growth in the normally slower second half of the year for housing transactions. But if paired with a significant global stimulus, the effects may be muted.

(It may also be that this was the last opportunity for the Department of Finance to shoot off a policy directive before the vacation season kicks off, so the timing may be one of practicality more than any global machinations.)

The changes directed at the high-end and high-quality borrowers are interesting in the context of a potential renewed bout of global stimulus coupled with what looks like an unsustainable investment boom in other parts of the world, particularly China. Given the Bank of Canada has hinted in the past about the relatively high level of foreign investment in Canada's property markets, I wouldn't be surprised if they are attempting to both divert capital inflows and ensure another foray of borrowing by Canadian residents is impossible.

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.

This

I've been calling for changes in OSFI guidelines for close to a year now. This is no surprise, and it should not be a surprise if this is the type of tightening of credit the Bank of Canada has been lobbying.

http://www.osfi-bsif.gc.ca/osfi/index_e.aspx?ArticleID=4831

OSFI is issuing for comment Draft Guideline B-20 - Residential Mortgage Underwriting Practices and Procedures. Guideline B-20 sets out OSFI’s expectations for prudent residential mortgage underwriting, and is applicable to all federally-regulated financial institutions that are engaged in residential mortgage underwriting, the purchase of residential mortgage loan assets and, where appropriate, the issuance of mortgage insurance – in Canada and internationally. Interested parties may submit comments to OSFI regarding draft Guideline B-20 by May 1, 2012 through their industry associations or directly to OSFI. Comments concerning the draft Guideline should be sent by e mail to B20@osfi-bsif.gc.ca.


Things just got interesting.

Bank of Canada - Working Paper on Housing Prices, Turnover and Bubbles

Thought this was an interesting read:  http://www.bankofcanada.ca/wp-content/uploads/2012/02/wp2012-03.pdf

This paper develops and estimates a model to explain the behaviour of house prices in the United States. The main finding is that over 70% of the increase in house prices relative to trend during the increase of house prices in the United States from 1995 to 2006 can be explained by a pricing mechanism where market participants are ‘Fooled by Search.’ 
Trading frictions, also known as search frictions, have been argued to affect asset prices, so that asset markets are constrained efficient, with shocks to liquidity causing prices to temporarily deviate from long run fundamentals. In this paper a model is proposed and estimated that combines search frictions  with a behavioural assumption where market participants incorrectly believe that the efficient market theory holds. In other words, households are ‘Fooled by Search.’ Such a model is potentially fruitful because it can replicate the observation that real price growth and turnover are highly correlated at an annual frequency in the United States housing market. A linearized version of the model is estimated using standard OLS and annual data. In addition to explaining over 70% of the housing bubble in the United States, the model also predicts and estimation confirms that in regions with a low elasticity of supply, price growth should be more sensitive to turnover. Using the lens of turnover, a supply shock is identified and estimated that has been responsible for over 80% of the fall in real house prices from the peak in 2006 to 2010.

CMHC Tightening

I have been calling for further loan tightening being ordained by the federal government. CBC seems to be able to easily quote Mr. Flaherty while he's on tour:

Finance Minister Jim Flaherty said he shares the concern of Canada's top banking regulator that lenders are loosening their mortgage standards too much, but said any problems in the system are being corrected...
"OSFI's concern arises out of some work that OSFI has done as part of the ordinary course of its business to look at some of the loans being made by financial institutions," he said. "I was informed of what their assessment showed with respect to a few financial institutions, which is a matter of concern."
"That is being corrected," Flaherty said.

As I have mentioned in the past, further tightening amounting to reduced access to loans or faster amortizations seemed to be a shoo-in, now we are getting hints that the government is very concerned about debt levels and systematic financial risks, and will ensure they do not become worse than they already are.

This is akin to the previous explicit announcements on CMHC mortgage insurance qualifications announced in previous years. This year, it appears, guidance from OSFI and implementation of Basel 3 accounting practices -- not to mention higher prices -- are going to act as a brake on housing activity in 2012.

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!

Y U No Spend?

Bank of Canada governor Mark Carney is speaking again -- again -- this time to businesses, on how to pull Canada through what looks to be a period of uphill growth (emphasis mine):

Canadian households increased their borrowing significantly. Canadians have now collectively run a net financial deficit for more than a decade, in effect, demanding funds from the rest of the economy, rather than providing them, as had been the case since the Leafs last won the Cup. 

Developments since 2008 have reduced our margin of manoeuvre. In an environment of low interest rates and a well functioning financial system, household debt has risen by another 13 percentage points, relative to income. Canadians are now more indebted than the Americans or the British. Our current account has also returned to deficit, meaning that foreign debt has begun to creep back up...

In other words, households are chasing diminishing returns and the point at which this debt will be impossible to properly service is a looming risk.

Our strong position gives us a window of opportunity to make the adjustments needed to continue to prosper in a deleveraging world. But opportunities are only valuable if seized.
First and foremost, that means reducing our economy’s reliance on debt-fuelled household expenditures. To this end, since 2008, the federal government has taken a series of prudent and timely measures to tighten mortgage insurance requirements in order to support the long-term stability of the Canadian housing market. Banks are also raising capital to comply with new regulations. Canadian authorities are co-operating closely and will continue to monitor the financial situation of the household sector. 

To eliminate the household sector’s net financial deficit would leave a noticeable gap in the economy. Canadian households would need to reduce their net financing needs by about $37 billion per year, in aggregate. To compensate for such a reduction over two years could require an additional 3 percentage points of export growth, 4 percentage points of government spending growth or 7 percentage points of business investment growth. 

Any of these, in isolation, would be a tall order. Export markets will remain challenging. Government cannot be expected to fill the gap on a sustained basis. 

But Canadian companies, with their balance sheets in historically rude health, have the means to act—and the incentives. Canadian firms should recognize four realities: they are not as productive as they could be; they are under-exposed to fast-growing emerging markets; those in the commodity sector can expect relatively elevated prices for some time; and they can all benefit from one of the most resilient financial systems in the world. In a world where deleveraging holds back demand in our traditional foreign markets, the imperative is for Canadian companies to invest in improving their productivity and to access fast-growing emerging markets.

This would be good for Canadian companies and good for Canada. Indeed, it is the only sustainable option available. A virtuous circle of increased investment and increased productivity would increase the debt-carrying capacity of all, through higher wages, greater profits and higher government revenues. This should be our common focus.

Carney is pleading with businesses to invest to make up for what household spending has done in the past 3 years (and longer), in part by expanding enterprises away from Europe and the United States where growth prospects look anaemic. It appears that increases in -- or even the maintenance of -- the average household debt-to-income ratio will be a trigger for further tightening of credit availability.

Carney has also provided confirmation that banks are increasing their capital reserves for household loans, which means less credit will be available going forward and banks will need to be more selective in the loans they make. It is unclear what criteria banks will use to ration their loans but may involve regional considerations, as was done by HCG earlier this year.

The Bank of Canada is trying, with the limited tools it has available, everything it can to get businesses to spend. If businesses do not spend the burden will be borne by households and governments and this, in Carney's view, is the outcome most likely to lead to subpar (or negative) economic growth. The federal government has been attempting to facilitate private investment through tax breaks and other investment programs, but now Carney, at least, is appealing to patriotism. That is a wonderful stance in principle.

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.

Canada and Fiscal Stimulus Round 2 Fight!

Mark Carney is in Washington this week trying to convince 17 Europeans to agree. He was generous to take 20 minutes of his time to talk to The House's Evan Solomon on Europe's sovereign and banking debt crisis. Europe's woes are interesting -- Carney understands that to keep Greece and other countries a part of the common currency there will need to be large fiscal transfers to enable smooth transitions of these economies to lower their wages until they are competitive again. The more interesting part for Canada's housing market is Carney's comments (or lack of comments) on what Canada's government and central bank will do in case of a European-centred credit crunch giving the rest of the world a cold.

I'll summarise Carney's comments on how Canada will react to a potential impending global downturn (feel free to listen; unfortunately I don't have time to transcribe the most interesting bits):

• Canada's banking system will remain solvent one way or another.
• The US and Europe look to be undergoing slow growth for some years to come.
• Canada's businesses have been investing in capital equipment and need to continue to invest, making up for a chronic productivity gap with other countries.
• Canada needs to start selling and investing in ventures in the developing world.
• Elements of the massive fiscal stimulus unleashed in 2008 and 2009 can be retooled for 2011-2012, however many of the measures were less "effective" than desired [By less effective not sure if he means with undesirable side effects].

What Carney didn't say:

• Household debt issues were not discussed or alluded to.

Even with a massive fiscal stimulus emanating from Europe, which is looking unlikely, we should fully expect another round of fiscal stimulus to aid the Canadian economy. Given Carney's comments over the past year on: high household debt levels , robust house prices and sales despite tightened credit conditions, plum corporate balance sheets, and his relative silence on government fiscal spending, I will formulate some guesses on what fiscal and monetary stimulus will be concentrated on:

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

When a stimulus of the magnitudes required to stave longer lasting effects of a second recession, my feeling is the government is aware that increasing household leverage risks tipping households into an unsustainable debt spiral similar to what Ireland experienced a few years ago. This does not mean Canada is the next Ireland or Spain but the effects of overleveraged households should be obvious to anyone who has read the literature on these countries' housing busts. It may even be the case that if a stimulus is unleashed that commensurate crimps on residential investment will be required to ensure investment money flows are properly targeted away from the overbought housing market, and instead concentrating more on consumption with broader wage growth.

In summary, I expect the chances of a second fiscal stimulus package from the federal government are high, and we should expect that household borrowing will be carefully watched -- even regimented -- to ensure their debt-to-income ratios are not increased further. This will likely mean higher federal deficits in the next one to two years, and a probability the government misses its "balanced budget in 2014" pledge.

How Money is Created

I've been fascinated and somewhat confused of late by the concept of how money is created. Given certain developments recently involving the Swiss unilaterally instituting an exchange rate ceiling, summarized by Kash over at The Street Light, Canada's horror and dismay what we would do when "currencies go to war", and the general idea about how Canada "creates" money, I thought I'd link to some thoughts on the subject. This does not necessarily clarify much on the matter, but does indicate the Bank of Canada is somewhat of a black box and there is no ultimate online authority I was able to dig up.

Worthwhile: Currency, Interest, and Redeemability

Money as Debt (video)

Wiki: Fractional Reserve Banking

Gilligan's Corner: Canada’s Private Banks have no Reserve Requirements (read the comments too)

Steve Keen: The Roving Cavaliers of Credit

First year macro textbook chapters on money in Canada ch10 and ch11 (PDF)

MacroMania: Fractional Reserve Banking

When trying to get information on the basic functions of the banking system and currencies, I am reminded that the web has a few disagreements, and can make things seem rather complicated.

The private investment gambit

Finance Minister Jim Flaherty and Bank of Canada Governor Mark Carney gave public testimony to the House of Commons Finance committee on Canada's fiscal health. I am following these statements as it provides some indication on the methods the government will use to attempt to elicit economic growth in a low interest rate environment.

Scott Brison had some pointed questions for Carney, summarized by the CBC reporter through her live feed:

Carney noted austerity measures contributing to problems in Europe, Brison says, so will that happen here and what should we do? Carney says reducing spending is entirely appropriate. the private sector will need to sustain investment. we need to grow productivity. investment is strategic for governments to decide, carney says, sidestepping the question of where the government should invest.

This is the interesting situation Canada is in, in a nutshell. There is chronic high unemployment and a dearth of spending, in part due to reduced government spending -- austerity -- and reduced house price appreciation and tightened credit conditions due to high debt loads of households. Households are overextended and only servicing their debts by way of low interest rates. Meanwhile the private sector is "sitting" on cash and not investing for whatever reasons.

Public sector austerity coupled with a dearth of private consumption and investment is deflationary, as European countries are discovering. Carney is arguing Canada is different because the private sector can absorb decreases in public and household sector spending if given the right incentives to spend; if that fails to materialize the best alternative is would be increased government spending.

What does this say about future interest rates? I think the key statistic to watch is the unemployment rate dropping towards "full capacity", and we should be under no illusions that this may be several years away.

Bank of Canada Keeps Interest Rates Steady

The Bank of Canada has kept its overnight lending rate band at 0.75% to 1.25% but has signaled rising rates are within a tangible horizon. The CAD/USD exchange rate is up over $0.01 on the news. What I always find amusing about national housing and interest rate related stories is how they seem to make it onto the BC regional webpage of CBC's website. The only other city to promote this story to its regional page was Ottawa. I guess one needs to promote stories that concern local readers, though personally I would normally go to their business page for such finance and economics stories.

Carney on Housing (and some obscure bill)

There are two parts to this post, the first on Mark Carney's speech on the Canadian housing market, the second on new legislation surrounding CMHC.

As promised, I will cite what I consider a few key passages from Mark Carney's speech (PDF) to the Vancouver Board of Trade today. Emphasis is mine.

The single biggest investment most Canadian households will ever make is in their home. Housing represents almost 40 per cent of the average family’s total assets, roughly equivalent to their investments in the stock market, insurance and pension plans combined. In recent years, housing has proved a very good investment indeed. The value of residential real estate holdings in Canada has climbed more than 250 per cent in the past 20 years, vastly outpacing increases in consumer prices and disposable income over that period.

However, Canada is arguably no better off because of it. That’s because while homeowners may feel wealthier because of this rise in prices, housing is not net national wealth. Some Canadians are long housing; others are short. Housing developments can have important implications for equality both across and between generations. Though some people in this room may have been enriched, their children and neighbours may have been relatively impoverished…

With this renewed vigour building on the decade-long boom that preceded the crisis, the average level of house prices nationally now stands at nearly four-and-a-half times average household disposable income. This compares with an average ratio of three-anda-half over the past quarter-century. Simple house price-to-rent comparisons also suggest elevated valuations. While neither of these metrics reflect the impact of low interest rates, even after adjusting for these effects, valuations look very firm. For example, the ratio between the all-in monthly costs of owning a home and renting a home, as measured in the CPI, is close to its highest level since these series were first kept in 1949.

Financial vulnerabilities have increased as a result. Canadians are now as indebted (relative to their income) as the Americans and the British. The Bank estimates that the proportion of Canadian households that would be highly vulnerable to an adverse economic shock has risen to its highest level in nine years, despite improving economic conditions and the ongoing low level of interest rates. This partly reflects the fact that the increase in aggregate household debt over the past decade has been driven by households with the highest debt levels.

Some excesses may exist in certain areas and market segments. In particular, the elevated level of “multiples” inventories, the ample pipeline of developments under way, and heavy investor demand (much of it foreign) reinforces the possibility of an overshoot in the condo market in some major cities…

In the Bank’s view, Canadian housing market developments in recent years have largely reflected the evolution of supply and demand. While supply of new homes should remain relatively flexible, many of the supportive demand forces are now increasingly played out.

For example, while measures of housing affordability remain favourable, this is largely because interest rates are unusually low. Rates will not remain at their current levels forever. The impact of eventual increases is likely to be greater than in previous cycles, given the higher stock of debt owed by Canadian households. At a 4 per cent real mortgage interest rate—equivalent to the average rate since 1995—affordability falls to its worst level in 16 years…

The Bank has been expecting moderation in the housing sector as part of a broader rebalancing of demand in Canada as the expansion progresses. Overall economic growth is expected to rely less on household and government spending, and more on business investment and net exports. Household expenditures are expected to converge toward their historic share of overall demand in Canada, with expenditures growing more in line with household income. In this context, the Bank anticipates a slowing in both the rate of household credit growth and the upward trajectory of household debt-to-income ratios.

There are conflicting signals regarding the extent to which this moderation is proceeding. While growth in consumer spending slowed markedly in the first quarter, housing investment re-accelerated, as did household borrowing, with mortgage credit growing at a double-digit annual rate. It is likely that some of this resurgence in borrowing is transitory, reflecting the lagged effects of the surge in existing home sales in the fourth quarter of last year, as well as recent changes in mortgage insurance regulations that may have resulted in some activity being pulled forward into the first quarter. Mortgage credit growth slowed in April, reinforcing the view that the particularly strong increase in borrowing in the first quarter was temporary. Nonetheless, at a 5 per cent annual rate, growth in mortgage credit in April was slower but not slow, particularly given the sustained above-trend increases of recent years.

Overall there is not much earth-shattering in the speech for those who have followed this blog for a while. Chart 19 is used by Carney to highlight a divergence between new home prices and existing home prices as adding uncertainty in tracking the housing market. One thing to remember here is that the NHPI is more heavily weighted to certain regions of the country where large-scale developments are more common. Vancouver is relatively sparse in terms of these types of developments so the deviation between the Teranet HPI and the NHPI can at least be partially explained by Vancouver's increasing share of influence over the Teranet index.

Carney points out that the share of indebtedness has been borne by more recent homebuyers who have had to take on larger debt loads to "keep up" with rising prices. In other words, the ones setting the marginal prices have been taking on the largest levels of debt.

Carney additionally highlights that multiple unit inventory has been growing faster than single family units and certainly inventory levels in Vancouver of condo units seem to be more elevated than that of detached dwellings. If the experience in the US is any gauge, weakness in condo prices will precede weakness in detached prices, though one should remember that in Vancouver a "detached" dwelling is not necessarily synonymous with a "single family" dwelling.

This speech is an interesting insight into how the Bank of Canada is tracking the housing market and household indebtedness. By these measures it is clear the bank is not unaware of the basic long-term sustainable levels of house price-income, house price-rent, and debt-income ratios. My concern is that they underestimate the implications of the magnitude of these measures at current levels and their potential to fall below -- not necessarily return to -- their long-term averages.

A Big Bill

On a related note, and perhaps more important than the musings of an influential central banker, the federal government tabled a bill (the "Supporting Vulnerable Seniors and Strengthening Canada’s Economy Act"), within it the "Enactment of Protection of Residential Mortgage or Hypothecary Insurance Act":

"An Act to authorize, in certain circumstances, the making of payments or the purchase of replacement insurance by Her Majesty in respect of certain types of mortgage or hypothecary insurance provided by an insurance company in respect of which a winding-up order is made and to terminate certain agreements relating to mortgage or hypothecary insurance"

This bill is designed, as far as I can ascertain, to allow more specific and targeted oversight of nation-wide mortgage lending. Though I'm not a legislator by training, this Act appears to do the following, amongst other provisions (to paraphrase):

• The Ministry of Finance can impose additional capital reserve ratios on CMHC
• The Ministry of Finance can effectively revoke the ability of certain lenders from applying for government-backed mortgage insurance.
• CMHC must pay fees in accordance with elevated risk levels it incurs
• CMHC must open its books to the Ministry of Finance (it wasn't before?!?)
• CMHC's books will be available through FOI if not publicly displayed
• There is a 10% deductible to any funds that are paid by the government to backstop private mortgage insurers. CMHC is 0%

I have stated in the past I thought countercyclical capital reserves would become more pervasive as time elapses. Regimenting contercyclical capital reserves in primary mortgage insurance is a welcome change and one in-line with Carney's efforts on the international stage. Though not explicitly stated in the Act, given the breadth and authority explicitly given to the Ministry of Finance to influence CMHC's actions, there is provision to ensure that lenders who use, or plan on using, CMHC insurance, are making sustainable low-ratio loans.

I'm not sure current legislative framework but the 10% deductible on government-funded backstops is another welcome change to mortgage insurance, effectively requiring lenders to undertake, or at least consider, some of the burden associated with defaulted insured loans and consider counterparty default in their risk analyses.

We'll have to leave it to the policy, financial, and legal experts to sift through this legislation, but from the surface I would say that the government is partially removing the "moral hazard" from CMHC and getting more in the face of the inappropriate lending habits of certain banks that should really know better.

When Atlas Shrugs

It is rare that I listen more closely to people more than I do to central bankers and their entourage of economists, one because their words are clouded in nuance, two because their words are few and strategically meted. It so happens that Mark Carney will be giving a speech to the Vancouver Board of Trade tomorrow (Wednesday June 15 2011), apparently on Canada's housing market. Coincidence Carney is speaking in Vancouver about the housing market? You decide!

Carney's speeches are important because they have provided substantive hints at future directions of government policy, not only overnight lending rates on which his bank has direct influence but also on auxiliary government policies that affect economic growth in the medium term. One such area of concern recently highlighted by Carney has been the over-valuation of assets and elevated debt levels propagated by low interest rates, speculative bubbles, and international capital flows in Canada's housing market.

I will be eagerly awaiting the speech as I see it as providing key clues surrounding policy options for the federal, provincial, and municipal governments to quench speculative excesses in the housing market, at a time when interest rates are unusually accommodative. The speech is concurrent with ongoing OSFI investigations into banks' exposure to potential asset price bubbles (of which I touched on here). While this is a housing analysis blog and undoubtedly biased towards all things "housing", it should be made eminently clear that, in my view, an unstable housing bubble is the key risk in Canada's economic growth in the medium term and in the interests of all Canadians to ensure such a bubble is mitigated as efficiently and quickly as possible.

I will provide my thoughts on Carney's speech after it is distributed.

edit: it is rare that the Bank of Canada and Department of Finance diverge from bringing a common message. Here is the latest press release from the Department of Finance:

Among the important measures included in the Act are those to: ...

Reinforce the stability of Canada’s housing finance system

• Strengthening the Government’s oversight of the mortgage insurance industry.

If it were me I would regiment that all low ratio loans be qualified at the 5 year posted rate, and that mortgage insurance be capped in markets where prices have deviated from incomes. My concern is that, like certain Asian economies, over-indebtedness is not necessarily limited to high-ratio loans, and current low-ratio loans may end up being tomorrow's high-ratio loans. Strengthening oversight may have to be extended beyond CMHC. We shall see!