CAAMP assumptions

CAAMP put out a report dismissing the risk of low interest borrowers defaulting when rates increase. The goal was to downplay the talk which has modeled recent borrowers as 35-year variable rate risk takers speculating on increasing prices. While this model is inaccurate, there are some fairly extreme assumptions in this report to look at.

First things first - it is way too soon after Bernanke said subprime is contained to title the report `Revisiting the Canadian Mortgage market - Risk is small and contained`. The title is a bearish signal by itself.

After running numbers for current buyers with higher interest rates they conclude:

No harm can be done by reminding Canadians to be prudent in borrowing money. But…

Virtually every Canadian who is in a position to buy a home and qualify for a mortgage is well-educated and capable of assessing what is in their best interests, of looking forward, and of anticipating threats to their financial well-being. The Canadian mortgage lending industry is amply incentivized to avoid making bad loans and to optimize risk exposures. This research on the characteristics of recent mortgage transactions suggests very strongly that current rules and practices are resulting in an acceptable level of mortgage related risks in Canada.

However some of their assumptions to lead to this conclusion are questionable.

Mortgage interest rates are assumed to increase to 5.25% for both fixed rate and adjustable/variable rate mortgages. For mortgages with current rates above 5.25%, the rates are assumed to be unchanged in future.

Fixed rates at 5.25% is a low number to run a stress test against when current rates are around 4%. Of course if interest rates only rise 1.25% the impact on payments in 5 years will be limited. This is not the type of rates commentators are warning about so its not exactly fair to use them to dismiss these risks. From the bank of Canada statistics fixed rate mortgages were 2.05% higher as recently as December 2007 than they were in 2009. These historically low rates are higher than their future rate scenario not to mention 8, 9 or 10% interest rates which also have somewhat recent historical precedent.

Incomes rise by 2.5% per year. This is a conservative assumption, as most of these recent borrowers are early in their careers and can expect raises due to promotions, in addition to cost of living adjustments. Other costs for housing and debt service that are included in the calculation of GDS and TDS increase by 2.5% per year.

Historically incomes have been rising, but I question extrapolating that gain going forward given the current unemployment rate. Even if incomes do rise by that amount it will not happen uniformly across all highly leveraged buyers.

A further factor mitigating risk for these households is that they have varying degrees of equity in their properties. Among the households with adjustable/variable rate mortgages, who may face TDS ratios of 40% or more, about 40% have 10% or more equity in their homes. In the event of future financial difficulty the home equity gives them options to solve their problem, as a last resort by selling their home. That leaves about 6,000 Canadian households with adjustable/variable rate mortgages who have less than 10% equity. Some of these households may face very difficult challenges in the event of significant rises in mortgages rates, but relative to 13.25 million Canadian households, the overall risk is very small.

There are a couple of problems in taking comfort in those with 10% equity. One is the equity is assuming current market prices which have had a significant run up. Even the most mild national "correction" would erase 10% which seems quite optimistic given the situation south of the border has been severe enough to wipe out much more. While I don't think the Canadian situation will be as bad in terms of peak to trough national decline I believe 10% is probable if not optimistic given the gains made in 2009. Next the transaction costs take up a fairly significant portion of those with 10% equity - commission alone could easily take half.

Now I do appreciate them stating the assumption in this report, and there were a couple of points that I believe are important. It re-iterated the fact that most new purchases are taking fixed rate mortgages with less than 35 year amortization. It also accounts for some of the recent increase in disposable income to debt ratio to an increase in home ownership. I think that is an important point, but I believe they are too dismissive of the amounts people are able to borrow from low interest rates and lax CMHC lending.