APRIL 01, 2012
I’ve often said that the next decade for real estate in Canada will be fundamentally different than the last. I’ve suggested that a demographic imbalance, dislocation between prices and underlying fundamentals, and rising instead of falling interest rates are all reasons for this. However, the greatest difference will be in the availability of credit going forward, and those who try to explain real estate prices in Canada without acknowledging the role of easy, accessible credit over the past decade have completely missed the boat.
We’ve seen a decade of loosening underwriting standards in Canada. The signs are many that this is now changing: The incremental tightening of mortgage credit that we’ve recently seen, with lenders scaling back on business for self (stated income) and equity lending was the first sign that things were changing.
The tightening in mortgage credit will not remain incremental for long. News has come from OSFI and CMHC that major changes are on the way, and it’s hard to understate how significant these changes may prove to be. In a nutshell, the unprecedented gap between house prices and income growth in nearly every Canadian city (see here for charts), coupled with savings rates hovering near al-time lows means that by necessity the gap between house prices and incomes is being bridged by an expansion in credit by new buyers. So restricting access to the abundant credit needed by first time buyers to enter the market represents a strong headwind against future demand.
Here’s how it looks:
1) CMHC: A hard stop in insurance
There is $1.1 trillion in residential mortgage credit outstanding in Canada, 50% of which is insured by CMHC. The growth in CMHC insurance has been shocking, a topic I explored in an earlier post. The charts are quite telling:
The issue is that CMHC has a parliamentary-approved mortgage insurance cap of $600B and is rapidly approaching that cap. The political climate in Canada is not conducive to CMHC requesting a raise in the mortgage ceiling given the mounting scrutiny of taxpayer risk to an overheated housing market, and particularly considering that the limit in 2007 was $350B....meaning taxpayer exposure to the housing market has risen by 70% in just four years. People are (finally) beginning to ask some tough questions.
And by the way, lest people think that the “private” mortgage insurer, Genworth Canada might pick up the slack, I would remind readers that they too are subject to a parliamentary cap of $250B since in the event of Genworth insolvency, the government steps in to insure the mortgages for 90% of their value. So there is a very large contingent liability baked into Genworth’s insurance as well. It’s unlikely that Canadian regulators, growing nervous about taxpayer exposure via CMHC , would somehow let contingent liabilities continue to stack up with Genworth also. Executives at Genworth have indicated that the chances of Genworth’s cap being raised to $300B is less than 50%. I agree.
Below is their projected growth in insurance in force out through 2016:
Bottom line is that CMHC plans to work within their cap until 2016. This represents an expansion of less than $10 billion annually between 2012 and 2016. Compare this to an average annual increase closer to $50B annually between 2007 and 2011.
So at 50% of the mortgage market, it’s fair to say that a rationing of CMHC credit is a big friggin deal. This is a hard stop if ever I've seen one. To appreciate how significant this is, note how the projected growth in mortgage insurance compares to prior years:
2) OSFI targets HELOCs, conventional mortgages
The Office of the Superintendent of Financial Institutions (OSFI), Canada’s chief financial regulator, has released draft recommendations on mortgage and HELOC lending which can be read here. In particular, the proposed changes to HELOC lending are very significant and would be a major headwind to consumer spending. The major proposed changes are outlined below:
Proposed HELOC Standard Changes:
-Proposed cap at 65% LTV with new and more conservative means of estimating value of residence
-HELOC payments would be changed from interest only to fixed terms
These two changes would be massive. Capping HELOCs at 65% LTV and amortizing the loans would pressure consumer spending, which has grown to become over 63% of the Canadian economy and is correlated to increases in consumer credit.
In addition, it would weigh on personal disposable income as HELOC balances would have to be paid off. Home equity extraction (HELOCs + Refis) in Canada is running at 8% of personal disposable income, roughly where the US was at peak. These new guidelines would not only cause a hard stop in HELOC growth, sapping aggregate demand, but the elimination of interest-only payment options means that principal repayment would be set to eat into disposable income.
Proposed mortgage lending guidelines:
-The end of the cash-back mortgage as a down payment. Banks will have to ensure that the down payment has been saved from the borrowers own means. Currently, the verification typically consists of three months of bank statements, meaning it is currently possible to borrow a down payment, leave it in a bank account for three months, then claim it as saved capital. This is ridiculous!
-LTV for low ratio mortgages must be recalculated at renewal based on updated appraised value rather than simply being renewed, as is common practice. This raises the question of what borrowers must do if their property falls in value and they are now in a high ratio mortgage. Mortgage insurance at renewal would likely be required, but it remains to be seen how banks will handle negative equity situations for uninsured mortgages at renewal.
-New standards for business for self (stated income) mortgages that will force banks to assess proven capacity to repay. This will be the death knell of stated income mortgages originated by Canadian banks. If these guidelines are passed, expect non-conforming and subprime lenders like HCG to pick up market share.
-Limits on underwriting exceptions. Banks will have to adhere to hard-and-fast rules for mortgage lending. Exceptions are made primarily to low ratio mortgage underwriting.
-More conservative debt-to-income ratio calculations, including calculating insurance in the Total Debt Service (TDS) ratio.
-More conservative property appraisals. The bottom line is that the appraisal system in Canada massively lags behind US standards, contrary to popular belief. In the US, when buying a house a Residential Housing Valuation Report must be completed for the lending institution. It is about 20 pages, measures the house, rates the quality and location and most importantly looks at comparable sales within a 1 mile radius that have sold within the past one year or less. So bottom line, for valuation they use the comparable sales as a base value. Then they adjust that up or down based on the other metrics...sq footage, location, quality etc. Then the bank lends a certain loan to value on the appraised value or purchase price, whichever is less. The current appraisal process in Canada is nowhere near as rigorous.
OSFI also echoed a concern that I’ve expressed before regarding the fact that growing HELOC volumes can mask financial stress in the borrower:
“[…] it can be easier for borrowers to concealpotential financial distress by drawing on their lines of credit to make timely mortgage payments and, consequently, present a challenge for lenders to adequately assess credit risk exposure.”
Note that these are guidelines and are open to public discussion until May. Expect opposition to these proposed changes to be fierce, particularly among mortgage brokers.
I recently gave an interview for This Week In Money in which I discussed these proposed rule changes. Readers interested in this topic may also want to catch that interview. Start at the 16:00 minute mark:
3) “Increased oversight of CMHC” coming
The federal budget contained no new measures targeting amortization lengths or down payment requirements, which was largely expected after OSFI and CMHC took care of much of the dirty work. Instead the government has indicated that they will propose increased oversight of CMHC. Recently the IMF suggested that CMHC should fall under the jurisdiction of OSFI. I suspect this may well be exactly what the government will propose. CMHC currently falls under the jurisdiction of the minister responsible for Human Resources and Skills Development Canada (WHY EXACTLY?).
If so, I would comment that putting CMHC into OSFI hands may well represent a greater tightening of credit that Flaherty could have done by shortening amortization lengths or increasing down payments. Julie Dickson of OSFI is perhaps the most astute and respected regulator in the country and has gone public on several occasions to express concerns about underwriting standards in Canada. The incremental tightening we’ve seen at banks lately has been precisely because OSFI has been in the background applying pressure.
To put it simply, I suspect OSFI will tear CMHC "a new one" approximately 0.2 nanoseconds after CMHC falls under their jurisdiction. Expect significant changes to happen, though likely “behind the scenes”.
As an aside, if this shakes out as I expect, it will represent a pretty cowardly move on the part of Flaherty and the Harper conservatives who very clearly recognize the risks baked into the housing market, want it to cool, but want the blame to fall on someone else if the “soft landing” proves impossible to orchestrate.
This strikes me as political cowardice at its finest. I’ve written a letter to my MP, CC’d to Mister Flaherty expressing these sentiments. If you agree, you may want to consider doing the same.
ADDED: Dave Larock pointed out that much of the increase in CMHC's insurance in force has been due to bulk portfolio insurance, a fact detailed in CMHCs recent annual report. The implications remain: More credit tightening and higher funding costs for the banks. However, they certainly have the capacity to support their primary madate of supporting first time home buyers....for a time. But with only $33B in cap room remaining to use until 2016 and the average increase in low ratio insurance still being over $20B annually over the past four years, the story remains the same. IF CMHC is to operate within their $600B cap as indicated in their 2012-2016 Corporate Plan (and as clearly expected by Ottawa given Flaherty's remarks) credit will still tighten by necessity.
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