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).