“The (stock) market has predicted nine of the last five recessions” — Paul Samuelson [Nobel Laureate]
People have been calling out the Canadian real estate bubble for last many years. However, the prices continue to go up and up.
There have been occasional concerns. Most recently IMF / OECD raised alarm bells that Canadian real estate is running into “over heated” territory.
The trouble with such ratios is that there isn’t any optimal or correct ratio. One can look at them on a relative scale either as a time series i.e., how it has changed over time or cross sectional i.e., where do we stand with respect to other countries.
The ratio has increased. But is it higher than normal? This begs the que stion what is normal? Considering that economists and central banks are wrestling with the issues about how to define a normal inflation rate, a normal growth rate etc, one can also add a house price index / ratio into the mix i.e, they should also let us know what is normal house price to income ratio in current circumstances.
With returns from stock markets as welli as bonds at record lows, housing (read real estate) is the only sector that continues to provide decent returns to home owners, investors, mortgage brokers, sales agents, banks, insurers etc. Though Canadians have been complaining about housing becoming expensive, however, financial institutions providing mortgage or insurance against these houses haven’t expressed any apprehensions.
All it took was a new stress testing requirement introduced by the Federal government. It is a two step process.
Applying a Mortgage Rate Stress Test to All Insured Mortgages
Effective October 17, 2016, all insured homebuyers must qualify for mortgage insurance at an interest rate that is the greater of their contract mortgage rate or the Bank of Canada’s conventional five-year fixed posted rate, which is currently 4.64%. This requirement is already in place for high-ratio insured mortgages with variable interest rates or fixed interest rates with terms less than five years. To qualify for mortgage insurance, debt-servicing ratios cannot exceed the maximum allowable levels of 39% and 44%, for Gross Debt Service ratio and Total Debt Service ratio, respectively.
Changes to Low-Ratio Mortgage Insurance Eligibility Requirements
Effective November 30, 2016, mortgage loans that lenders insure using portfolio insurance and other discretionary low loan-to-value mortgage insurance must meet the eligibility criteria that previously only applied to high-ratio insured mortgages. New criteria for low-ratio mortgages to be insured will include the following requirements:
A loan whose purpose includes the purchase of a property or subsequent renewal of such a loan;
A maximum amortization length of 25 years;
A maximum property purchase price below $1,000,000 at the time the loan is approved;
For variable-rate loans that allow fluctuations in the amortization period, loan payments that are recalculated at least once every five years to conform to the original amortization schedule;
A minimum credit score of 600 at the time the loan is approved;
A maximum Gross Debt Service ratio of 39 per cent and a maximum Total Debt Service ratio of 44 per cent at the time the loan is approved, calculated by applying the greater of the mortgage contract rate or the Bank of Canada conventional five-year fixed posted rate; and,
A property that will be owner-occupied.
Back of the envelope calculations show that before the new rules, a family with an annual income of $80,000 would likely have qualified to buy a $400,000 house, now they would likely qualify for a house priced at $320,000, he said.
So far three institutions have giving an inkling of times to come.
Least worrisome is from First National Financial, which is Canada’s largest non-bank mortgage lender which was summarized as follows:
Following an initial review of the policy changes and their expected influence on Canada’s single family housing market, the Company stated the following:
1. Due to the economics of new single family originations, they provide little if any earnings in the year they are underwritten. Profits are delivered to shareholders as the Company receives servicing income and the net interest margin from securitized mortgages. As a result, we believe that any reduction in origination as a result of these rules will have little to no impact on our 2016 or 2017 earnings.
2. First National originates approximately $22 billion of mortgages annually consisting of $13 billion of new single family residential, $5 billion of single family renewals and $4 billion of commercial mortgages. Of the new single family originations, approximately 41% or$5.3 billion are insured mortgages subject to the new qualifying rate. We anticipate a decline in these originations of approximately 8–10%, or approximately 2–3% of overall originations. We do not anticipate any material impact on our other originations and renewals as a result of the new rules.
Slightly higher on the risk scale, Genworth Canada summarized the impact of new regulations as follows:
Based on year-to-date 2016 data, we estimate that a little over one third of transactionally insured mortgages, predominantly for first time homebuyers, would have difficulty meeting the required debt service ratios and homebuyers would need to consider buying a lower priced property or increase the size of their down payment.
Furthermore, approximately 50% to 55% of our total portfolio new insurance written would no longer be eligible for mortgage insurance under the new Low Ratio mortgage insurance requirements.
Last but not the least, it was the Crown Corporation. They will be issuing a 1st “red” warning on the Canadian Housing market. As quoted by various news websites
“High levels of indebtedness coupled with elevated house prices are often followed by economic contractions,” Siddall said Monday in his article. “The conditions we now observe in Canada concern us.”
CMHC raised its assessment of the Vancouver market from moderate to strong for strong signs of problems, joining Toronto, Calgary, Saskatoon and Regina.
“These factors will be reflected in our forthcoming Housing Market Assessment on Oct. 26. They will cause us to issue our first “red” warning for the Canadian housing market as a whole.”
We will have to wait till October 26 to find out how severe is the situation. The data available at CMHC website doesn’t show any significant deterioration when compared over the last few quarters.
Below is the chart based on CMHC data of mortgage arrears. Canadian mortgage arrears are stable at 0.28% for quite some time. Being an aggregate percentage, mortgage arrears would be hiding higher arrears in Saskatchewan and Alberta that would have been offset be lower arrears in other areas. But it is clear that overall there hasn’t been an adverse movement in arrears rate.
In terms of number of insured mortgages outstanding, though the number of units insured in Q2 2016 almost doubled to 117,463 unit from 63,699 units in Q1 2016, however, the overall CMHC insurance in-force outstanding has been steadily declining since 2013.
Even looking at the credit profile of the borrowers, there hasn’t been a significant change quarter over quarter in the portfolio composition of CMHC portfolio.
This begs the question that what is causing CMHC to raise the red alarm considering that none of the indicators have changed for the worse. My guess is that CMHC ran stress tests based on following scenarios and the results thrown out by the test weren’t pretty:
Test 1: What if the mortgage market slows down due to the new federal regulations?
Test 2: What if the price of the real estate declines?
We will have to wait till October 26 to find out.