Predicting Minsky moment for Canadian housing

Indicators aren’t hinting toward a bubble burst, if any

In my pitches, I always mention Lehman’s collapse in September 2008 was the Minsky moment for US real estate. But it was a proverbial “slow moving train wreck”. I distinctly remember assisting in making a presentation for the senior management in early 2007 on subprime mortgages in US and how it will affect the financial sector. Obviously I didn’t foresee it to be this huge otherwise I would have been profiled in Michael Lewis’s “Big Short”.

My friend worked one of the two Bear Stearns funds that got liquidated in mid 2007. The severity of crisis still hadn’t hit home as I remember getting calls from him that he and his colleagues have established a new hedge fund based in Mayfair, London, UK in late 2007. Though Lehman Collapse in September 2008 was the moment when all hell broke lose but real estate prices were already falling long long way before that.

For many of us who have dealt with or followed international real estate, it feels like that similar real estate bubble is building up in Canada. But that is not necessarily the case.

Relative to US

Maclean’s published a very insightful report yesterday Canada’s housing bubble makes America’s look tiny which had beautiful and insightful charts including the one below.

What usually is overlooked that US real estate prices didn’t collapse. The rate of increase and decrease before and after the peak was almost the same. There was no proverbial prices “falling off the cliff” which we keep expecting in the Canadian real estate i.e. bubble bursting. But then the Canadian line is scary especially going vertical in the end.

Mortgage Arrears

In case of US, the rate of delinquencies in subprime loans had started increasing becoming delinquent at increasing rate but no such problems are evident in Canada. Below is a chart and a table from CMHC I posted in my earlier note CMHC to issue “RED” warning on Canadian Housing Market but data doesn’t agree

Mortgage arrears are showing a downward trend which is positive sign.

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.

No signs of worry here.

New Mortgage Rules

I excerpted the key points and charts of the research reports of PWC, TD Economics, DBRS and even CMHC’s Red Alert housing assessment in my post Canada Housing — False Alarm and summarized their conclusion as

every thing is ok and manageable at the moment.

However, in contrast to all other financial institutions, mortgage provider Genworth tried to assess the impact of new mortgage rules in hard numbers and issued a press release stating

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.

Now this is significant. If we want to compare with US, we can draw some parallels with Freddie Mac’s decision in 2007 to no longer accept most risky subprime mortgages.

Depending on what is share of Genworth in overall mortgage origination, this can lead to slowdown in mortgage originations and may reduce velocity of sales. The impact should be visible in CREA sales data which for September 2016 showed an increasing trend

National home sales edged up 0.8% from August to September.

Actual (not seasonally adjusted) activity in September rose 4.2% year-over-year (y-o-y).

The number of newly listed homes ticked up 0.5% from August to September.

It will have to be seen whether on seasonally adjusted basis home sales have started going down November onward. If the decrease is significant (we can argue on definition of ‘significant’) we can start to worry.

Homeowner Speculation

Urbanation recently published a report to debunk the myth that foreign buyers are huge factor in condo market which I covered in What was Urbanation thinking? with the conclusion being

I do not know about you but I will make the following guesses

1. It is based on a voluntary survey so my guess is that the brokers and developers would have under reported the numbers

2. Urbanation wouldn’t have taken a simple average but would have tried to adjust the numbers. 5% seems like a very nice round percentage [I’d have preferred a 4% or 6% but that is just me].

Anyway, considering that 5% are foreign investors and 52% are domestic investors, 57% of supply is being picked up by investors. No wonder that prices are increasing and those who want to buy to live are finding it harder to locate new inventory. If this 57% was available to owner occupiers, there wouldn’t be a shortage of high rise inventory in the market and prices won’t be this high.

Things get more interesting in the second paragraph in the above excerpt. In some projects domestic investors are buying up to 90% of the inventory and foreign investors can go up to 25% of the available units.

The above report just considers the number of units and not the price of units. If the speculator (oops I meant Investors) are buying pricier units and owner occupiers are picking up cheaper units then the percentage of inventory purchased by investors will be bigger than the 57%.

In addition, I had a discussion with Urbanation economist in 140 character limits where I was told that I derive the wrong lesson from the research report.

Her point being that if there weren’t investor’s, there would have been even less condo inventory to go about as these investors are what is making developers build.

Urbanation study just talked about condo sector. For the overall, housing sector, CBC asked What’s really driving Toronto’s red-hot real estate market

Toronto-area real estate agents say domestic investors have grown to make up 25 per cent of their client base, according to a recent survey by Ben Myers, who researches trends in residential real estate for Fortress Real Developments.

He estimates that foreign buyers make up no more than five to 10 per cent of home purchasers in the Toronto area, and are primarily focused on the pre-construction high-rise condo market.

Myers said the growth in domestic investors makes sense, given the state of the market. “When you have a situation where prices are going up rapidly, you’re going to see more investors,” he said.

So on overall basis, 35% of the housing market is comprised of investors. But the real kicker is the fact that ordinary home owners are stretching themselves to play the real estate game and like the subprime investors in US believe that prices will only go up as shown below:

The investors are often ordinary homeowners — not high-rolling business people — who use the equity in their primary residence to buy another house in an attempt to capitalize on the hot market, said Pasalis. “When they see prices going up 10 to 15 and now 20 per cent a year, it looks like a no-brainer.”

Now if I want to compare this with US subprime crisis, CNN reported Big drop in speculation in April 2007

During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchased were not intended as primary residences.

During peak 2005, 40% of market was comprised of investor which dropped down to 36% in 2006 thus signalling a slowdown. So far, there hasn’t been a slowdown in investors so we are ok. I would be really worried about condo segment though where investors can go up to 90% of the project.

The risk I see in investors having large share of the housing segment is that housing isn’t being built to the specifications and needs of occupiers. Investors will buy anything as long as they believe that price will keep on going up not caring whether it is suitable accommodation in terms of transit connections, shopping, educational institutions etc.

TD increases the mortgage rate

Toronto Dominion Bank has become the first major lender to hike its mortgage rates after Ottawa’s move last month to change some of the rules that govern insured mortgages.

The bank’s mortgage prime rate is rising 0.15 points to 2.85 per cent, effective immediately, after it had remained steady for 15 months.

The increase in only 15bps and on a 500,000 mortgage requires an additional payment of $750 per annum. I think that is manageable. But then again I was directed on twitter that a 25bps increase can lead to hardship for 718,000 people

More than 700,000 Canadian borrowers could be facing payment shock on their debt obligations if interest rates rise by a quarter point, and that rises to as many as one million people should rates go up by 1 per cent, says a study by credit monitoring firm TransUnion.

So when will Real Estate bubble burst?

Taking each event alone may not have a major impact but taken together they can have a snowball effect. People have been calling for the bubble to burst for last 8+ years and frankly speaking it has become like the proverbial story of boy crying wolf.

Following data points will provide good (leading?) indicators if we are looking for the Minsky moment

  1. Decrease in monthly housing sales (seasonally adjusted) on account of mortgage insurance no longer available.
  2. Increase in investor’s share of housing sales as owner occupiers cannot afford the price or the mortgage payments.
  3. Increase in mortgage arrears as reported by CMHC.

1 and 3 are reported monthly so I believe we can have a pretty good view of the housing sector if it takes a turn for the worst.

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