An In-depth Look at the Canadian Housing Market

by Tom Bradley, Steadyhand Investment Funds
In the last couple of weeks, there has been two excellent reports published on the Canadian housing market – one by the Canada Mortgage and Housing Corporation (CMHC) and the other by RBC Global Asset Management. Both are good reads for people who want to dig into the detail and get a better understanding of the many factors that drive housing prices and activity.
Both reports draw conclusions that are consistent with what the real estate industry and banks are saying – there are some signs of strain in the market, but the risks are more benign than what the doomsayers like me are suggesting.
CMHC’s fourth quarter assessment provides an overview of where we are today (price trends, sales to listings ratios, unabsorbed inventory levels and vacancy rates on rental units). Overall, the report concludes that the Canadian market is not overbuilt and overheated, and only moderately overpriced.
Despite the conclusion, I find the CMHC report less useful in addressing what lies ahead. It uses some sophisticated modeling to measure current valuation, but the interest rate cycle is not discussed. Given that house prices are highly geared to changes in interest rates, some sensitivity analysis would have been useful.
The RBC report is very thorough and attempts to address all of the doomsayers’ concerns. There are many interesting charts, including the scorecard below:

I find the author’s conclusion (Chief Economist Eric Lascelles) to be surprising in light of this scorecard. He says, “Broadly, the near-term outlook appears benign, tilting only slightly in a negative direction.” Yes, the near-term is holding up OK, but there’s nothing benign about his 1-5 year outlook.
I learned a lot from both reports, but they didn’t change my view. There are a number of factors that weren’t discussed or need more emphasis:

• House prices hinge on mortgage rates that are, by any measure, well below normal levels. Basing the price of an asset on another asset that is overpriced (bonds) is a scary proposition.
• Pricing and market psychology will not be determined by the 72% of homeowners who have more than 25% equity in their house. Rather, it will be driven by the 5% who have less than 10% equity. The mistake forecasters made in the U.S. a decade ago was taking comfort from the majority instead of being wary of the weak minority.
• What is bothersome is the number of factors that are in negative territory. It’s possible to explain away one or two ratios that are off trend (which Eric does well), but when there’s a wall of them, it gets to be a stretch.
• Even the most positive of analysts have trouble pointing to any factors that are highly positive. The best either report can do is ‘neutral’. In my mind, it’s hard to make a case for investment when there are no positive indicators to offset the risks.
• There’s little recognition in either report of how good the environment has been. These are not normal times. Housing prices have had a howling tailwind at their back – subsidized mortgage rates, abundant credit, a growth spurt in the buying cohort (25-34 year olds), rising home ownership and foreign buying. In a few years, we’ll look back and marvel at how good everything was.
• And the one I feel most confident about – extreme cycles don’t end with ‘benign’ corrections. It just doesn’t happen.

Copyright © Steadyhand Investment Funds

Update on mortgage rates

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

The 5 year Government of Canada bond yield:

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

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

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

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

Increasing Interest Rates

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

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

Macroprudential Mortgage Rates

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

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

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

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

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

Changing Uninsured Amortizations to 25 Years

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

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

The Effect of Overt Macroprudential Policy and Interest Rates on Borrowing

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

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

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

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

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

Upper Body Work on the Five Year

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

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

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

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

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

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

You Can Still Get A Lot Of Loan

Canadian Finance Minister Jim Flaherty was quoted recently:

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

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

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

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

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

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

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

Mortgage Spreads

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

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

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

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

A Rare Post Worth Reading

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

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

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

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

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

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

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

The Mortgage Renewal Gap

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

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

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

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

And the spreads between the data series:

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

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

Analysis:

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

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

Financing Advantages

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

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

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

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

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

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

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

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

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

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

Mortgage 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.

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...

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.

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!

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.

2011 TD Canada Trust Repeat Home Buyers Report

http://cnwtelbec.com/en/releases/archive/August2011/23/c5497.html

- 2011 TD Canada Trust Repeat Home Buyers Report finds three-quarters of repeat home buyers move earlier than they originally intended -

(VANCOUVER, Aug. 23, 2011) - Nearly six-in-ten B.C. repeat buyers are moving on to larger or more luxurious homes - and they're moving sooner than expected. In fact, the TD Canada Trust Repeat Home Buyers Report, which surveyed Canadians who recently bought or intend to buy a home that is not their first, found that three-in-four British Columbians are moving earlier than planned. More than half (51%) had no intention of moving but now find themselves on the house-hunt again and 22% thought they would move again but not this soon. Not ones to settle, B.C. residents are experienced movers; they are the most likely in the country to have owned more than four homes in their lifetime (39% versus 29% nationally).

"Our research indicates that British Columbians aren't staying in one home too long," says Barry Rathburn, Manager, Residential Mortgages, TD Canada Trust. "There are costs associated with a move, so I'd recommend that people explore all of their options before making the decision to change homes. It might be more affordable to renovate and make your current home work for you."

The top features British Columbians felt they compromised on when they purchased their previous home that they are not willing to budge on this time is the number of bedrooms (34%). Other compromises that they won't make again include price (30%), features of the home (30%), layout of the home (28%) and number of bathrooms (26%).

"If you are dissatisfied with something like the layout or features of your home, a renovation can be a convenient option to save the hassle and expense of moving. A Home Equity Line of Credit will allow you to use the equity you've built in your home to finance the renovation. Further, if you do ultimately decide to sell, the renovation could increase your resale value," says Rathburn.

British Columbians are among the least likely to have considered a Home Equity Line of Credit (HELOC) (37% versus 50% nationally). Of those who would consider this financing option, nearly half (47%) say they would use it for the purposes of a renovation, but nearly as many (44%) would like to have it simply as a cushion. Thirty-nine percent would use the line of credit to invest.

Timing is everything: Canadians think it's a good time to buy - and to sell

B.C. buyers are the most likely in the country to say investment opportunities (26% versus 21% nationally) and market conditions (28% versus 21% nationally) played a factor in their decision to buy another home. This is a significant increase over 2010 when 21% said investment opportunities affected their decision to buy and 15% said market conditions. The large majority (81%) plan to sell their current home and four-in-five expect to sell at or above asking price (70% versus 62% in 2010).

Among those who have purchased a second home and do not plan to sell their previous home, more B.C. buyers this year said they will keep the first home as a rental property (54% versus 48% in 2010). They are also more likely this year to say the new home they're buying will be a vacation home (15% versus 10%) or that that a family member will be moving into their previous home (15% versus 3%). Three in ten buyers say they will stay in their current home and the new home they buy will be a rental property.

"Buyers should keep in mind that if they are expecting to sell above asking price, it's likely they will need to also buy at above asking price," says Rathburn. "A home is, obviously, a very big purchase - especially if you will not be selling your previous home to put towards the cost. A mortgage expert at your bank can walk you through your financing options and show you strategies and products that may save you money and provide flexibility over the course of your mortgage."

Decisions, decisions! B.C. sellers know they have options but they haven't thought about them

The TD Canada Trust Repeat Home Buyers Report showed that 61% of B.C.'s repeat buyers have a mortgage on the home they are moving from and 60% will take out a mortgage on their new home.

In 2010, nearly one-in-five (18%) British Columbians who planned to sell their home didn't know they had options when it came to their mortgage. This year, that number decreased to 14%. Still, although they are aware of their options, nearly half (46%) haven't considered what they will do with their mortgage. Thirty-eight percent of sellers say they will bring their mortgage with them. Only 2% say they will use it as a selling feature.

"It's just as important to consider your mortgage options as a seller as when you are buying. You may be overlooking your mortgage as an important selling feature of your home or you may be able to save money by keeping your low rate and bringing your mortgage terms with you. Talk to an expert to find out what option might work for you," says Rathburn.

About the 2011 TD Canada Trust Repeat Home Buyers Report

Results for this study were collected through a custom online survey conducted by Environics Research Group. A total of 1,025 completed surveys, including 131 in B.C., were collected between June 16-28, 2011 of people who have either purchased a home that was not their first home within the past 24 months, or intend to purchase a home that is not their first home within the next 24 months.

About TD Canada Trust

TD Canada Trust offers personal and business banking to more than 11.5 million customers. We provide a wide range of products and services from chequing and savings accounts, to credit cards, mortgages and business banking, to credit protection and travel medical insurance, as well as advice on managing everyday finances. TD Canada Trust makes banking comfortable with award-winning service and convenience through 24/7 mobile, internet, telephone and ATM banking, as well as in over 1,100 branches - most open 8 'til late and many now open Sunday. For more information, please visit: www.tdcanadatrust.com. TD Canada Trust is the Canadian retail bank of TD Bank Group, the sixth largest bank in North America.

Highlights for me:
- Fewer BCers have HELOCs than national average.
- 70% expect list or overlist sales price. (The actual overlist is probably less than 20%.)
- About 60% repeat buyers are buying larger or more luxurious homes.
- 80% of buyers sell their existing property.
- 39% have owned at least 4 homes in their lifetimes, well above the national average.
- 73% are moving before they thought they would, meaning transaction costs are occurring more frequently than anticipated and highlighting that our lives rarely work to plan.

Interesting stuff.

Lower Mortgage Rates a-Brewing

In case you don't know, the 5-year government bond rate is positively correlated to the 5 year fixed mortgage rate. It is entirely possible people will be able to get a 5 year fixed closed mortgage for close to 3% in the not-so-distant future. That isn't free money, but it's getting pretty darn close, for 5 years, anyways.