The Canadian housing market puts us all at risk

Banks and real estate analysts were busy last week. There were reports of bank book losses, due to the decline in oil prices, and an international organization as well as two Canadian banks called on Ottawa to tighten up the risks associated with soaring home prices. Rebuttals were made. Bank economists defended their choices and the week ended.

But in light of concerns raised and counter-arguments offered, I wanted to point out that there is validity in the concerns being raised. We are at risk. Canadian homeowners are at risk. Canadian investors are at risk. And Canadian taxpayers are at risk. Here’s why.

Canadian Homeowner Risks

It’s no secret: Canadian households have gone on a borrowing binge in the last few years. Late last year, Statistics Canada released data showing that the average household had nearly $1.64 in debt for every dollar of disposable income. That was a record high.

Part of the equation are the persistently low interest rates; rates that became even cheaper in 2015, after the Bank of Canada twice dropped its benchmark rate to help cushion the blow of the global oil and resource price slump.

But how does that impact homeowners? It’s the risk of what quickly climbing interest rates could do to our household balance sheets, said CIBC Deputy Chief Economist, Benjamin Tal, earlier this year. While, Tal doesn’t expect interest rates to climb anytime soon, it’s hard to discredit the debt numbers particularly when our nation’s own bank, the Bank of Canada, describes our ever-increasing mountain of household debt level as “the most-important vulnerability in the financial system.”

These concerns were most vocally addressed this past December, when Bank of Canada Governor Stephen Poloz stated that most of the debt exposure is concentrated among 720,000 households, or 8% of mortgage-holders, who currently hold more than 350% of debt when compared to their annual gross income. These are the households that would struggle to make debt payments either in the face of a significant economic downturn or when interest rates rise. It should be noted that while the number of households that seem to walk the insolvency line is under 10%, it’s still twice as many when compared to 2008, at the start of the global economic crisis.

Poloz did state the households that were closest to being in jeopardy tended to be younger Canadians (under 45 years old) who usually earn less money.

Up until now, there’s been little evidence of significant increases in mortgage defaults and delinquency rates. But the Royal Bank of Canada and the Equifax consumer credit monitoring firm have pointed to early signs of trouble—through a slight increase in auto loan defaults and credit-card delinquencies—in oil-producing regions like Alberta, where unemployment has climbed following the oil-price slide. The real test, however, will come when the concentration of debt, which is in household mortgages, is tested. As of January 2016, only 13,216, or 0.28% of Canadian mortgages, were in arrears (compared to almost 4.7-million mortgages on lenders’ books). The last time the percentage of defaulted mortgages rose above 1% was in 1996.

Yet recent statistics on Calgary, Alta. home sales appear dismal and, some say, this could be the real test. According to Canadian Real Estate Association (CREA) numbers, homes sales in Calgary, Alta. were down 12%, while the number of properties being listed spiked to 14% at the end of May 2016.

And rates haven’t even started to rise. And they will rise. That’s when households will feel the pressure. According to a recent Manulife Bank Canada survey, 37% of homeowners were “caught short” at least once in the past year—meaning they didn’t have enough money to cover their expenses. Add to this budget pressure a rate shock and we could begin to see more and more foreclosures. “As interest rates increase, mortgage holders will need to pay more to meet their debt obligations and this may seriously impact what they can afford,” says Dan Werner, Canadian bank analyst with Morningstar.

What can you do? You can Crush your mortgage debt
Understand the difference between good debt and bad debt
You can Pay down your mortgage faster

Canadian Investor Risks

All this has serious implications for Canadian investors. As Werner explains, any uptick in mortgage foreclosures or any decrease in the number of Canadians who qualify for a mortgage, will affect banks. “As rates go up, payments go up. This puts a strain on homeowners, which impacts a bank’s bottom line.”

Given the current economic climate, this should set off some alarm bells. And, as if on cue, U.S.-rating agency, Fitch just released a report showing that Canada’s six big banks have a combined mortgage exposure of $730-billion and an additional $182-billion in home equity loan exposure. Fitch analysts argued that “high unemployment or interest rate shock could aversely affect the ability of leveraged homeowners to meet their mortgage obligations,” and this would have dramatic consequences on the banks and bank shareholders.

“Keep in mind,” says Werner, “there’s a big difference between U.S. and Canadian banks.” For instance, Canadian banks aren’t as vulnerable to subprime mortgages and they tend to hold their mortgages, not sell them off (mainly because of fundamental differences in the markets and the way the industry is regulated).

Werner is also convinced Canada’s big banks are well-diversified. “Unless there’s a significant event that really puts the overall economy into a downturn, I don’t see any bank cutting their dividends,” says Werner.

This theory was put to the test last week when National Bank of Canada delivered their quarterly results. To outside observers the results looked downright ugly. The smallest of the Big Six Canadian Banks reported profit was down 48% since last year, due to bad loans to the energy sector. While this loss didn’t come as a surprise—National Bank had already set aside $250-million a month earlier to cover the $317-million loss—it also came with another announcement: It announced a dividend increase, raising the quarterly payout to $0.55 per share, up $0.01 cent, even though the dip in quarterly profits pushed its payout ratio to 61% from 44% last year.

Dividend investors may be taking notice already, but just about every investor with a balanced fund should also be paying attention.

“For the last 35 years it’s been a bear market for interest rates,” says Tom Bradley, CEO of Steadyhand. “That’s given stocks a wonderful tailwind, but when companies see profits drop, stock prices go down, and so do your dividends.”

When rates start to rise, businesses, including banks, will start to feel the pressure, particularly in sectors that have the heaviest debt loads: utilities, telecommunications and real estate. All sectors heavily favoured by banks. To put this in perspective, in 2008/2009, bank stocks dropped by almost 40%.

To be clear, the banks aren’t facing collapse. But instead of an earnings per share growth of 10% year after year, bank earnings will grow more like 5% for the foreseeable future, explains Werner. For investors trying to grow their portfolio, or retirees looking to live on their investment earnings, this doesn’t look good.

What can you do? Stop focusing on yield, which often leads investors to bank stocks. Instead focus on a total return portfolio; a portfolio comprised of holdings that pay dividends, interest income as well as capital gains. For more, see:

The income illusion
A better way to generate retirement income
Why you should learn to love a sell-off
The risk of too much cash

Canadian Taxpayer Risks

Up until now, the fallout of taking on increasing debt-loads or investing in bank stock has been the sole responsibility of each individual. We reap what we sow. The problem is that these individual decisions have a collective consequence. A dilemma the Organization for Economic Co-operation and Development (OECD) alerted Ottawa to, once again.

In a recent report, the OECD once again called on Ottawa to introduce measures to reduce some of the risk associated with soaring home prices and household debt levels in Toronto and Vancouver. It’s not the first time the OECD has asked the feds for measures to cool sky-high house prices in Toronto and Vancouver, which together comprise a third of the country’s real estate market. Since the OECD first aired its concerns last December, the feds increased the minimum down payment for homes over $500,000, a measure aimed specifically at the red-hot Toronto and Vancouver markets. A year later and the OECD report still points to the distinct possibility of a housing market correction, particularly in the two hottest markets, that could threaten the country’s financial stability.

Part of the problem is that federal changes to down payments and to maximum amortization terms has done little to tame the country’s hottest markets. Part of the problem was that most of the changes were made to the insured mortgage segment of the market.

The insured segment are all mortgages that are for homes priced at less than $1-million, where the home buyer puts less than 20% equity into the purchase as a down payment. The banks are required, by law, to take out mortgage loan insurance at a cost they pass on to the homebuyer.

However, banks will often take out this mortgage loan insurance—which protects them against a loss should the home buyer default on the mortgage—even when a buyer puts down more than 20% and even when the home is priced above $1-million.

The problem is what if there was a huge uptick in mortgage defaults. The premiums collected to cover this mortgage loan insurance should cover the losses. At present, the Canada Mortgage and Housing Corporation holds $520-billion in mortgage exposure (by law, they can’t hold more than $600-billion) and there is about $1.072-trillion in outstanding mortgage debt currently held in Canada. But CMHC is only one mortgage loan insurer. Genworth also holds mortgage loan insurance and its U.S.-parent company is battling its own financial struggles right now.

So, what if there is a run on the default insurance offered by CMHC and Genworth to the banks? If enough money is made on the sale of the home to payback the bank, then there’s no shortfall and no claims paid out. But what if you can’t sell the home for its full value (think Calgary) and the foreclosure sale cost doesn’t cover the debt owed. Banks turn to their insurers for payments to make up the losses. There’s a run on the premiums collected by CMHC (and Genworth) to pay these losses. It depletes the coffers. That’s when lending restrictions could tighten, quickly. This could halt mortgage lending, particularly in the new first-time buyer segment, and this could prompt a bit of panic in homeowners who opt not to enter into the housing market, which could seize up one of the few prospering economic drivers of our nation’s current economy. At the same time, our government would have to cover the shortfall for any mortgage loan insurance claim that can’t be covered by the premiums collected. The money the government uses to cover this shortfall is collected through taxes. Your taxpayer dollar, in other words, is the lender of last resort.

Sound a bit dystopian? Yes. But it’s not entirely implausible. Perhaps that’s why the Bank of Nova Scotia and the National Bank of Canada also weighed in last week to ask the federal government to take more steps to intervene in the nation’s housing market.

Scotiabank CEO and president Brian Porter said the government should consider raising down payments, again, and increasing the qualifying rate for five-year fixed mortgages or imposing a temporary luxury tax on foreign buyers.

What can you, as a taxpayer, do? The most obvious is to become a more responsible consumer; the more we track our own money habits, the less the government has to curtail these habits for us. But if that’s not enough, you may want to petition your local, provincial and federal government representative. Get them talking about the issues that impact us all. For more, read:

8 solutions for Vancouver real estate madness
Interest rates stay the same (it’s time to tax capital gains)
And for those contemplating it, here’s whether or not you should buy a house