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 D Word

There's a theory that overinflated market prices fall because there are always those who need to sell and nobody, ultimately, who needs to buy (even if they convince themselves they need to). In a further effort to think thoroughly about risk analysis and property I thought I'd share some interesting data mined by France-Pascale Ménard of McGill University in some analysis of marriage dissolution in Canada.

The focus is on dissolution of first unions, and Ménard displays the data as a survival graph, showing what fraction of unions have not dissolved after a certain number of years. Below is the graph of interest, which is for Canada ex-Quebec (see here for breakdown of cohorts)

The three lines indicate the fraction of unions still together after a certain number of years of their start, assigned into three cohorts. These are first marriages only, not included are those of non-first unions. Look at the first five year time horizon -- even for the best-performing cohort ("marriage without prior cohabitation") the survival rate is 95%, or 5% of those marriages dissolve. After 30 years 25% of that cohort dissolves.

How does this relate to housing? Marriage dissolution is an event that is difficult to budget at the household level but causes significant impairment to the reduced ability to service mortgages that are dependent upon multiple sources of income. These data highlight a small part of the inherent risks of property ownership, especially through bouts of reduced liquidity and/or depressed prices, not necessarily related to credit rating. While those entering into housing investments are doing so with the intention of never needing to sell, the data paint a different picture of what the reality will be for some.

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.

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.

Canadian Mortgage Market Primer and Some History

TD published a mortgage market primer (PDF) back in 2010 written by Eric Lasalle. Lasalle outlines some succinct information about financing methods and regulations surrounding Canadian mortgages, including differences to the American model, outlines some numbers in terms of the mortgage market size and composition, and comments on his take on the stability of CMHC and banks given this backdrop, all dated 2010.

Also an interesting read is the history of mortgage financing since World War 2 in chapter 6, written by James Poapst, from the CMHC-published book House, Home, and Community: Progress in Housing Canadians, 1945-1986.

This all is nerdy, but readable, stuff, for those who take it upon themselves to pronounce over what ails the current Canadian housing and mortgage markets. You know what they say about history...

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.

From the Canadian Press

Canada will likely avoid a crash or serious correction in its “somewhat pricey” housing market, with the possible exception of Vancouver, says a new paper from the Bank of Montreal.
The analysis by BMO economists suggests alarms about Canada’s housing market by international observers, from the International Monetary Fund to The Economist magazine, are exaggerated or simplistic.
“The main takeaway is that the national housing market appears somewhat pricey, but is far removed from a bubble,” said economists Sherry Cooper and Sal Guatieri in the report released Monday.
“In our view, the (market) is more like a balloon than a bubble. While bubbles always burst, a balloon often deflates slowly in the absence of a ‘pin’.”
Even Toronto’s hot condo market–one of the subjects of many of the warnings–is more likely to cool rather than collapse, BMO said, noting that a sharp decline in construction for rental units is stimulating demand for condos.
The report estimates that half of new condos in the Toronto area are purchased by investors, and about 22% are rented.
The one exception to the sanguine view appears to be Vancouver and parts of British Columbia, where home prices and demand from an influx of non-resident Chinese investment is elevating prices and construction. Home prices in Vancouver have climbed by 159% over the past 10 years, more than 50% higher than the national average.
“Bottom line is, we expect the Canadian housing market to cool down rather than bust over the next couple of years, with the possible exception of Vancouver and parts of B.C. which will likely experience further correction,” said Guatieri in an interview.
By cooling, he predicted that prices, sales and start-ups will essentially be flat this year and likely next.
Housing has become an area of concern for policy-makers over the last few years as Canadians continued to dip into the mortgage market to take advantage of historically-low interest rates. As a consequence, household debt to disposable income has shot to over 153%, the highest in ever and close to the levels reached in the U.S. before the subprime crash.
Earlier in the month, Finance Minister Jim Flaherty said he was prepared to intervene for the fourth time in six years if there is no let-up in borrowing.
The BMO economists say the government, and the Bank of Montreal, are correct to worry about a continuation of the trend, but that is not likely. In fact, except for a few hot spots, that cooling trend has already begun with prices rising only by 0.9% last year. Home starts have also dipped well south of the over 200,000 level.
Nor is it likely that Canada will fall into another recession, or that interest rates would rise so quickly that a significant number of households would be unable to meet mortgage payments.
Canadian households are not as vulnerable as their American counterparts, the economists say.
Canadian home ownership equity is 67% in Canada, compared to 39% in the U.S., and even debt-to-income ratios are far better in Canada when the cost of health care U.S. households must pay is factored in.
The report argues that many of the measures used by alarmists to suggest housing is due for a severe correction are exaggerated or simplistic.
On the important measures which gauge affordability, households are on firm ground. House prices to family incomes are elevated from 10 years ago, but not excessively so, at a ratio of 4.9 versus 3.2 a decade ago.
The exception again is Vancouver at 10, nearly double what it was a decade ago. Also elevated is Toronto at 6.7 versus 4.3.
“Let’s assume the worst case scenario and house prices fall by 10%, would that affect anything?” asked Guatieri. “There has been such an increase in house values, that I don’t think it would pose a serious problem for Canadians or the economy.”
Guatieri said the situation would become a problem if home prices and household debt continued to outstrip income growth, but trends on both fronts are moderating.
Originally published on Advisor.ca

.

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.

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.

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!

Mortgage Renewal Gap

Blogger VHB used to post the so-called "renewal gap", the difference between current mortgage rates and rates "N" years ago, where "N" is the mortgage term. So here it is, updated to May 31, 2011:

Note the 3 and 5 year rates are still at negative gap, meaning that homeowners renewing their mortgages today can receive lower monthly payments, and this has been the case for just over two years now.

Why is the renewal gap important? The gap indicates how much financial relief current homeowners can receive when they renew. As we can see, until the end of 2008, the renewal gap was positive. Since then the gap has been negative for the past few years this means that cohorts of mortgage holders have been receiving relief in the form of lower monthly payments for close to 3 years now and counting.

With some consensus that rates may start edging up as the economy improves and employment reaches towards full capacity, it is worth looking at what could happen to the renewal gap in years ahead. To help with picturing this, I have extrapolated mortgage rates at a high and low end: at the low end assuming "flat" rates for the next 3 years, at the high end assuming a linear extrapolation to the "max" mortgage rate seen in the past 10 years in mid-2014, as shown below:

So the scenarios play out as follows. First the "flat":

• 1 year renewal gap stays around zero, as we would expect
• 3 year renewal gap approaches and stays at zero by early 2012
• 5 year renewal gap stays negative until early 2014

And "max":

• 1 year renewal gap moves up to and remains at 1% starting the second half of 2011
• 3 year renewal gap shoots positive by early 2012 and trends even higher until 2014
• 5 year renewal gap stays slightly negative but "shoots" up positive in early 2014

There are other scenarios, of course, but if one believes the Bank of Canada's statement, that the recovery will be "sluggish" in the coming years, I have chosen a "sluggish" return to full capacity. Of course if the elusive bond vigilantes rear their heads, all bets are off.

Who to listen to

I don't know. But I do know that Paul Krugman was recently rated as the "top prognosticator" by a recent Hamilton University analytical survey (PDF).

The Hamilton students sampled the predictions of 26 individuals who wrote columns in major print media and who appeared on the three major Sunday news shows – Face the Nation, Meet the Press, and This Week – and evaluated the accuracy of 472 predictions made during the 16-month period. They used a scale of 1 to 5 (1 being “will not happen, 5 being “will absolutely happen”) to rate the accuracy of each, and then divided them into three categories: The Good, The Bad, and The Ugly...

The top prognosticators – led by New York Times columnist Paul Krugman – scored above five points and were labeled “Good,” while those scoring between zero and five were “Bad.” Anyone scoring less than zero (which was possible because prognosticators lost points for inaccurate predictions) were put into “The Ugly” category. Syndicated columnist Cal Thomas came up short and scored the lowest of the 26.

Take the survey for what it's worth, but Krugman recently highlighted the dangers of over-leverage, namely it being a harbinger of subsequent financial problems:

When I wrote the first edition of The Return of Depression Economics, I was reacting in large part to the Asian financial crisis, which I thought could presage similarly difficult crises here in America. Sadly, I was right.

But what made Asia so vulnerable then but not so vulnerable now? Even then, the best available stories ... focused on issues of balance sheets and leverage. And it’s now standard to focus on household leverage as a key part of what went wrong in 2008:

[end quote]

Now if we put this measure beside the equivalent Canadian measure it looks all the more interesting (courtesy theeconomyanalyst.com):

Looking at disposable income isn't quite an apples-apples comparison due to Canada's greater contribution to social services like education and health care. Also the normalization of the scales can add in some debate over the relative peaks. Insofar as the debt-to-disposable-income ratio was brought forward before the GFC by Krugman, a pundit with a proven track record, and comparing the order of magnitude of debts Canadian households are currently carrying, irrespective of some tax policy differences, it should give policymakers some food for thought in the coming year.

Debt Crunch

Recommend visiting this site: http://www.debtcrunch.ca/

RBC, Scotiabank lift benchmark mortgage rate to 6.1%

BY JOHN GREENWOOD AND ERIC LAM, CALGARY HERALD, APRIL 14, 2010, 8:04 AM

Many homeowners face increased costs as interest rates have begun what is expected to be a series of hikes.Photograph by: Archive, Calgary HeraldRoyal Bank of Canada and Bank of Nova Scotia have hiked residential mortgage rates for the second time in as many months, likely sparking another round of increases from other banks at the onset of what is expected to be one of the busiest homebuying seasons in recent years.

As of today, RBC and Scotiabank's five-year closed fixed-rate home loans will carry an interest rate of 6.1 per cent, the highest since November. Those same mortgage products carried a rate of 5.25 per cent a little more than two weeks ago.The 25-basis-point hike, announced by RBC and Scotiabank on Tuesday, comes fast on the heels of a 65-basis-point hike by the big banks late last month. It also comes as expectations rise the Bank of Canada will raise its key interest rate earlier than previously thought.Eric Lascelles, chief economics and rates strategist at Toronto-Dominion Bank's TD Securities unit, said investors are now factoring in a 50 per cent probability that central bank governor Mark Carney will raise interest rates on June 1. Carney has pledged to keep the central bank's benchmark rate unchanged through June, "conditional" on the outlook for inflation.The first round of mortgage rate hikes kicked off on March 29, as RBC, TD and Laurentian Bank announced the cost of their mortgage offerings would rise between 40 and 60 basis points.

RBC was the first to announce on that day as well.A day later, Scotiabank, Canadian Imperial Bank of Commerce and National Bank of Canada did the same.The banks say they are raising their rates because their own cost of funding is going up as investors demand higher yields.Canada's real estate market has been booming since the economy emerged from recession last year as consumers take advantage of some of the most favourable mortgage rates in decades.

Homebuyers are facing hurdles on other fronts as well, with more stringent mortgage lending rules set to take effect on April 19 and the looming introduction of the harmonized sales tax in Ontario and British Columbia.Many homebuyers are expected to try to rush to make their purchases ahead of the changes to keep their costs down.

"Mortgages are tied to the bank's funding costs, which change from day to day," said Gillian McArdle, a spokeswoman for RBC."Our long-term funding costs have gone up considerably since mid-December and it is now necessary for us to increase . . . fixed-rate mortgages."

© Copyright (c) The Calgary Herald

Rational Thought Not a Factor in Home Purchases

By The Canadian Press

Referencing RBC Study.

TORONTO - Recent first-time homebuyers say they felt pressure to enter the market as they contended with jitters about rising home prices and higher mortgage rates.

The Bank of Montreal says as many as one-third of respondents in a homebuyers survey believe their expectation that housing prices would increase, and interest rates would soar, left an impression on their decision to make a purchase in the short term.

"There's definitely a sense of urgency among home buyers," said Lynne Kilpatrick, senior vice-president of personal banking at BMO.

"While we encourage Canadians to pursue their home ownership dreams we recognize it's easy to get caught up in the emotions of the purchase and this can lead to stretching one's budget too thin."

The results come as Royal Bank released its own homeownership survey on Wednesday which showed that a majority of Canadians expect to see higher mortgage rates over the next year.
RBC's annual homeownership survey said 64 per cent of Canadians expect high rates, with about the same number of mortgage holders concerned about higher rates.

Economists expect the Bank of Canada to raise interest rates by between half a percentage point and a full point over several months beginning this summer to fight inflationary pressures in the economy.

With many Canadians taking on larger and larger mortgage debt in expensive markets across the country, higher rates could create financial problems for some homeowners.

In the Royal Bank survey, three-quarters, or 73 per cent of homeowners, feel strongly that homebuyers need to think ahead to ensure they will still be able to make their mortgage payment if rates rise.

The bank says six-in-10 mortgage holders say they have taken advantage of current low interest rates to pay more principal on their loans.

Eighteen per cent of homeowners say they've made a lump sum payment on their mortgage and 16 per cent have doubled their payment to reduce their principal.

While 84 per cent of mortgage holders believe they are doing an excellent or good job of paying down their mortgage, 49 per cent say their mortgage is larger than they thought it would be at this stage in their life.

Marcia Moffat, RBC's head of home equity financing, says the best advice for homeowners is to review their mortgage holdings with a financial adviser to position themselves for any changes.
BMO's senior economist Sal Guatieri added that a cooler housing market is "just around the corner."

Recommended Reading

I recommend you read this and heed the implicit warning.

http://americacanada.blogspot.com/2010/03/country-of-fiscal-prudence.html

The idea that Canadians are fiscally prudent is a farce to anyone in-the-know. Most Canadians live paycheque to paycheque, have no savings, overuse their credit cards and HELOCs and are overleveraged on their real estate assets. The collective 'we are better than the US' mentality is a joke since the average Canadian's personal balance sheet looks just like their American cousin's balance sheet from 3 years ago.

The only thing fiscally prudent about Canada is that our banking system was never 'transformed' to the US / European model back in the 90s, with no small protest from the banks. Because of the high reserve ratios that the banks are required to maintain and with no small help of taxpayer backed mortgage loan guarantees via CMHC, it is not surprising that Canadian banks are phenomenally profitable. Mind you, in a credit contraction, bank earnings will be far from stellar.

In a related note - Canadians need to save more - according to David Dodge

Canadians need to save between 10 per cent and 21 per cent of their pretax incomes each year – if they save consistently for 35 years – to have comfortable retirement incomes, according to a new report by former Bank of Canada governor David Dodge.

The report says many Canadians are unaware of the high savings levels they need for their retirement years, and may believe they are saving adequately when they are not.

The report, co-authored by Alexandre Laurin and Colin Busby and published by the C.D. Howe Institute, calculates various savings scenarios based on assumptions that Canadians aim to have annual retirement incomes between 50 per cent and 70 per cent of their preretirement incomes.

“Our findings provide Canadians with a ‘reality check' about the saving rates required to meet their retirement goals,” Mr. Dodge said in a release Thursday.

A Meaty Read

The Bank of Canada produces some great analysis that I read from time to time. This paper was quite interesting.

A quote:

From an aggregate perspective there are a number of reasons to think that house prices

could ináuence consumption decisions in Canada. First, residential structures and land

account for a large share of Canadian household sector wealth. Sixty eight per cent of

Canadian households own a home and for many it represents their largest asset. Second,

house price growth is associated with higher household borrowing. The positive correlation

between consumption and house prices may be related to housingís role as collateral. Between

2000 and 2007 the real price of existing homes increased by 52 per cent. At the same time,

the ratio of household debt to GDP rose dramatically from 58 per cent in 2000 to 76 percent

in 2007. By 2007 roughly 80 per cent of Canadian household debt was secured by real estate.