Saturday, September 25, 2010

An Alternative View

I read an interesting post from "Whispers from the Edge of the Rainforest" where the author constructs a straw man case for real estate in Canada and responds in an opposite but similarly exaggerated way. This post will address some of the inaccuracies in the bear case and doing so will present a more serious and nuanced view.

Here is the straw man:

'Real Estate never goes down, you can't ever go wrong buying and our solid Canadian banking system won't facilitate any sort of collapse here.'

This is an example of how the average Canadian views real estate. I don't think anyone believes real estate never goes down or that it is a can't lose investment. Maybe it's different in Vancouver but in Alberta it's been three years since peak prices. The author counters with events that happened or risks present that apparently most Canadians don't have a clue about.
Nor do many realize that Canadian Banks were bailed out by receiving $65 billion in liquidity injections from the Insured Mortgage Purchase Program (IMPP) in 2008 - Canada's version of TARP - whereby the CMHC purchased insured mortgages from Canadian banks to provide additional liquidity on the asset side of their balance sheets.

The Insured Mortgage Purchase Program was part of Canada's Action Plan after the financial crisis. The program ended in March of 2010 as a result of improved credit conditions. It is important to point out that this was a transaction and not a direct cash subsidy. These mortgages were already insured by CMHC so the move was a liquidity measure as opposed to a gift.

No one seems to be aware that the Bank of Canada then gave our Canadian Banks an additional $45 billion in temporary liquidity facilities or that the Canada Pension Plan, through the purchase of $4 billion in mortgages prior to the IMPP program, raised the total government bailout to $114 billion.

As part of their mandate the Bank of Canada successfully acted as a lender of last resort during the financial crisis. Now that the crisis is over their balance sheet is back to normal with zero financial loss (see green in the chart below).

As for the Canadian Pension Plan, why wouldn't they purchase insured fixed income assets? This also highlights that CPP is accumulating assets in preparation for retiring baby boomers. That's comforting.

And what about the CMHC being ordered by the Federal Government to approve as many high risk borrowers as possible to prop up the housing market (with entry level buyers) and keep credit flowing?
  • In 2008 some 42% of all high risk applications were approved, a 33% increase over 2007.
  • Between the beginning of 2007 and 2009 Canadian Banks increased their total mortgage credit outstanding listed on their books by only 0.01% - possibly the smallest amount of change in post WWII history - which was the only way we managed to keep credit flowing in our country while it dried up in the USA.
Canadians are oblivious.

I have noticed that information regarding the CMHC starts with no source and gets recycled through blogs to Wikipedia and back to blogs. For instance the claim that CMHC was ordered to approve as many high risk loans as possible is unsubstantiated.

The reason that loans on Canadian books increased so little is the Insured Mortgage Purchase Plant discussed earlier and securitization.

They can't see how this all impacted the debt orgy. Aren't aware of how CMHC's obligation has grown from $100 Billion in 2006 to $776 Billion in 2010.

The amount of CMHC insured loans has grown from $291 billion in 2006 to a forecast $519 billion in 2010. A 78% increase is substantial and unsustainable but it is an entirely different magnitude of the almost 700% increase claimed here.

Last year the Conservative Government, after our nation spent 10 years digging ourselves out of a $45 Billion deficit with onerous taxes like the GST and years of cutbacks in government services, replunged us back into hock with a record breaking $50 Billion deficit.

Before the recession hit the GST and corporate taxes were lowered and a child tax credit was introduced. They have been no spending cuts in recent history. The high deficit was partially cyclical due to lower tax revenues during the recession, higher unemployment benefits and a temporary stimulus. Some of these temporary effects are fading and the federal deficit in July was $500 million, down from $5.8 billion the year before. I'm not saying the Conservatives are awesome financial stewards but that doesn't mean we have to be demagogues.

If CMHC is forced to pay out on a mere 10% of that guaranteed $776 Billion, that amount would more that double that historic $50 Billion debt.

Note the math error and the incorrect figure for outstanding insured mortgages. In addition to this assuming a 10% payout is far too pessimistic as I explained in this post. Remember, CMHC provides insurance in case of default and has the house as collateral in such an event. So in a crisis the total payout would equal the formula below.

  • (Amount insured) * (Per cent default) * (Average Per cent Loss After Liquidation)

In one scenerio I estimated: about a $6.25 billion dollar loss.
They are wilfully blinded to the ads all around them whereby someone with no money can go out and, courtesy of bank initiatives like this one that offers them 7% back, can get their 5% downpayment covered and actually get PAID 2% of the mortgage value to make that purchase.

Nothing down and get PAID to buy a house!!!

True, the cash back loan is pretty reckless and indefensible. One point to consider is the incremental risk here compared to a 5% down mortgage falls on the bank and is not CMHC insured. So the bank makes a free market decision based on the credit worthiness of the borrower to take on the additional 7% risk in order to increase market share.

When I spoke to two tourists from Minnesota in August, they asked what the interest rate was on a 30 year mortgage here. When they found out virtually no Canadians have long term mortgages... that the vast majority have 5 year terms or less that reset at whatever the going interest rate is... they recoiled in shock. They instantly recognizing that all Canadian mortgages are set up exactly like American subprime mortgages: 2-5 year low teaser rates that reset higher once the teaser term is over.

But the average Canadian is oblivious.

Are variable rate and fixed term mortgages a risk in Canada if they reset at higher rates? Yes. However there are some important differences between these loans and the teaser rates offered in the states during the housing bubble. The Canadian 5-year fixed is based on the bond market and will vary depending on expectations on inflation and growth. These loans are amortized so principal is paid back during the initial term, even if it is at a lower rate. In the U.S. loans were made below prevailing market conditions and reset to levels higher than standard fixed rates. Some of these loans had a artificially low payment options where the mortgage balance increased each month. This created a time bomb effect independent of the bond market or falling home prices.

The conclusion is not entirely clear. It is undeniable that house prices are currently falling in Canada, but it does not appear this will cause a national emergency. In some ways it truly is different here (snark).


Unknown said...


so what you are actually saying and let me get this straight that our housing prices her in Calgary are normal?

The only reason that we are not in a so called panic mode yet is because our bubble has not popped yet. The scary part is from personal experience I have witnessed 2 apprentices with less than 2 years experience get mortgage's in the 300k and 400k range this year.

My company is in the housing market and we have been told outright that this winter will be much quieter and to prepare.

I have actually saved your post over to word and when our sub-prime 0/40's come up for reset with negative equity you will finally see the elephant in the room.

BearClaw said...


Where did I say house prices in Calgary were normal? My last call was an additional 15% nominal drop from early 2010 levels. The post before this one I determined the price to income ratio was 4.26 for Calgary compared to 3.5 or less in the states..

I have been expecting a weaker new housing market because of competition from resale and slow demand.

Bringing up 0/40 reset is a good illustration of the difference between here and the states. Its actually quite possible that those who took out 5 year fixed mortgages in 2006 and 2007 will be reset with lower rates in 2011 and 2012. That's the difference between teaser rates and convention 5-year fixed terms. One was bound to reset higher from artificially low levels and the other is set in the bond market.

Carioca Canuck said...

From the real world files.......

A house a few doors down on the same street as my father's place just had a for sale sign put up yesterday.

They are asking $349K........and from the cities municipal tax records, I can see that they paid $337K in 09/08........the same place was listed at $409K back in 2007 and slid down from there......

I have talked to the guy who lives there a couple of times in passing on the street, while visiting my dad.......

He put $5% $17K + CMHC fees equals about $20K +/- out of pocket......and it is mortgaged over 35 at a 2.5% variable rate that is $1143 a $159 a month of taxes, pus $250 a month of utilities.......comes to $1,552 a month......and he's been there exactly 24 he's paid $37,248 in carrying costs.....add in the down payment and CMHC fees/closing costs and it is about $57K so far that he is out of pocket.......not counting the lost opportunity cost on the money, another $2-3K over 2 it really cost him $60K.

Based on roughly on what places are selling for today....that is......5% off the listed price +/-.......he "might" net a final offer of $331K....less RE fees of 7/3% ($14K) means he'll get $317K less legal fees and closing costs fees, so he'll probably end up with $315K....and based on the mortgage amortization table owes $308K after 2 years.....assuming a constant rate that is.

So at the end of the day, he clears $7K at resale, but only if he gives a 5% discount, if he gives more, and he may very well have to, he loses big time.

As he has paid $60K to buy the house and carry it for 2 years........what is the net difference in real dollar terms for shelter.....??

$53K.......($60K - $7K)

$2,208 a month......he could have rented with his girlfriend for $1,000 a month and saved the difference........and he'd be ahead $29K + accumulated interest instead.......

RE......what a great investment eh ?

Well, for the "REIC" it sure was.....the realtor who sold it to him generated about $14K in commissions, and if it sells today another $14K +/- will be roughly $28K in RE commissions in 24 $1000 of home inspections......$1,000 of appraisals....$2,000 of legal fees......advertising......etc....etc...etc......

No wonder they all lie cheat and steal........

BearClaw said...


The main point of this post is to cast doubt on some of the doomers who argue for systematic failure and a U.S. style foreclosure crisis.

Is real estate a good investment buying and selling in the span of 24 months in a flat or decreasing market? No. Will this case result in a foreclosure or any loss to the CMHC? Probably not.

Also, you compare the owning expenses to renting $1000 all inclusive which I am assuming is for an apartment. I would guess the rent for a similar house would be $1400 + 250 utilities.

Carioca Canuck said...

He was a single person with his girlfriend.......he didn't need a 4 bedroom house on a 100' x 50' lott with a double garage.....but her hormones did......and his realtor convinced him he should buy today using all the lies we already know about.

There were about 25-30,000 people like that in each of the last 3 years who bought real estate here in Calgary.

Now multiply that buy the entire country.....

Look at the wealth destruction effect that has taken place......if he gets out with his hide intact and does not have to write a cheque to close he'll be lucky, but still down tens of thousands of dollars regardless. But what are his chances of that......there are 10,500 homes and condos for sale right now on MLS in Calgary, and about 5,0000 in the shadow inventory, not counting new builds which are another 10K or so........sales are off 30-40% for 4 months in a row........and we're entering the slow season now, unempoyments is way over 10% in "real" terms, not the government's fabricated number they hand out.......

Tell me again why we are different ? We are worse off than the US.......and always a few years behind them......