Canadian Debt Levels Hit Record

In a speech this week that was as straightforward as possible, Bank of Canada governor Mark Carney told the crowd at the Economic Club in Toronto that "low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce; the greater the complacency, the more brutal the reckoning."

Mr. Carney was, of course, referring to Statistic's Canada's announcement that household debt ratios have hit a record high, and that people could get stung badly if rates increase. Statistics Canada's announcement was surely a frustrating development for Mr. Carney, who has been warning Canadians about their debts for over a year.

The debt-to-income ratio for Canadians is now higher than that of Americans - a fact which many Canadians likely refuse to believe, since their self-image is that of financial prudence compared with their Southern neighbors.

Dangerously, these record debt levels coincide with unusually high home prices and unusually low interest rates: a situation that could easily lead to the double-whammy of rising payments on falling equity values - a sure formula for financial disaster.

Meanwhile, deaf ears continue to buy new condos and pull out the plastic for Christmas shopping. It is likely that most indebted Canadians will never read this article, or, for that matter, give it a second thought even if they do.

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"It’s a matter of concern but it’s not a matter with respect to which we’re going to act immediately."

Jim Flaherty, Canadian Finance Minister, December 2010, when asked if Canadian personal debt levels are a concern.

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See also:

Canadian Debt Levels now Higher than Americans

Loose Wallets Sink Ships

How bad is it? Bad.

In many previous articles, I explained the obvious: that the Canadian housing market is grossly overpriced - driven by low interest rates and personal debt - and ripe for a crash.

Many disagreed. Those who disagreed most strongly were, unsurprisingly, those who had bought rental properties or first homes within the last 3 years (for the reason why, see Cognitive Dissonance). Yet, what was obvious to some is slowly becoming obvious to all: the Canadian housing market is sinking.

A recent press release by the Bank of Canada was brutally straightforward: “The slowing since the spring in resale, renovation, and new home construction activity has been driven by a number of factors, including the passing of pent-up and pulled-forward demand; the expiration of the federal Home Renovation Tax Credit in January; the tightening of standards for government-backed insured mortgages that came into effect in April; the introduction of the HST in Ontario and British Columbia in July; declining affordability; and subdued income growth.” This painful laundry list is the reality of the Canadian housing market today.

The demise of the housing market has received surprisingly little coverage in Canadian news. In fact, a recent headline in the Financial Post (Ottawa ponders further tightening of mortgage rules) suggests that the housing market is still hot and may require cooling.

Canadian personal debt levels, which have risen along with the housing market, have been a cause of great concern for the Bank of Canada for some time. Again, the Bank of Canada has been blunt, noting that “Canadian households have now collectively run a net financial deficit for 37 consecutive quarters. That is, their investment in housing has outstripped their total savings for over nine straight years.” The Bank of Canada concludes in a single line, “This cannot continue.”

Debt levels have reached the point where any further increase in interest rates – which may be necessary to combat inflation – will strain Canadian families. If inflation rises, the BOC may be forced to raise interest rates and push those citizens who are now “just hanging on” into bankruptcy.

The Canadian housing market’s decline is just beginning. How long this process will take is anyone’s guess, but it will likely be measured in years, not months. A decline in value of an asset class this large ensures no quick recovery.

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To review the progression...

The Canadian Housing Market
Canadian Debt II
Spin City
The Canadian Housing Bubble - CREA to the Rescue
The Canadian Real Estate Market: Trouble in the Pipeline
Canadian Real Estate: Stick a Fork in It

The Bank of Canada - Employment in a Modest Recovery
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"Results - Fall 2010

The Canadian Real Estate Association says first-time home buying activity is slowing. What’s happening in your region?

I’m seeing more first-time homebuyers this year - 24%
I’m seeing fewer first-time homebuyers this year - 66%
I haven’t noticed a change - 10%

Genworth Financial Canada - The Homeownership CompanyPrime Source"

A recent poll by Genworth Financial Corp, given to mortgage brokers and bankers across Canada
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Canada’s Banking Albatross

And How to Benefit from it.



Deathly afraid to enter the stock market, Canadian retail investors are keeping their money in low-yielding GICs and bond funds - if they are investing at all. Mortgage and refinance business has collapsed. The self-employed have entrenched. Business is slow.

With mortgages newly dead and rigor mortis setting in on investing, there is nothing to sustain the currently high stock prices of Canadian banks. As an investor, what can you do to protect yourself, and perhaps make some money in the process? The Frost Report states the case in black and white.

First off, sell your Canadian bank stocks, as well as your Canadian dividend mutual funds (which usually contain 50% bank stocks). In order for stocks to drop, banks don’t need to have a disastrous quarter; they just need to have a quarter that is less spectacular than the last one.

Secondly, sell your Canadian REITs (Real Estate Investment/Income Trusts). There is no point holding on to REITs to generate income when you know that income from real estate will soon drop, and the price of REITs along with it.

Thirdly, buy distant at-the-money put options on Canadian banks, so that you can make a profit on the coming stock price decline. If you don’t know what an at-the-money put option is or how it works, completely ignore this piece of advice, for now is not the time to be learning.

Alternatively, you can buy Inverse financial ETFs, such as the Horizons BetaPro S&P/TSX Capped Financials Bear Plus ETF 2X, (symbol HFD). Again, if you just read this description and have no idea what any of it means, don’t even consider buying HFD. For those who understand, read the full prospectus.

Lastly, Canadians should start paying down debts and building cash reserves. While everyone else is experiencing a crisis, you can be comfortable. Cash gives you a sense of control & security, and, when things start to pick up again (which they always do), you can take advantage of the bargains that will be everywhere.

The Bank of Canada shot the albatross with its low interest rates months ago, and for a while the results looked good. Now, however, the storm is approaching. As with any other impending disaster, preparation is crucial.
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Bank of Montreal reports Tuesday Aug 24th. Analysts expect third-quarter share profit of $1.21, up from $1.05.

Canadian Imperial Bank of Commerce reports Wednesday Aug 25th. Analysts expect third-quarter share profit of $1.53, up from $1.36.

Royal Bank of Canada reports Thursday Aug 26th. Analysts expect third-quarter share profit of $1.02, down from $1.21.
National Bank of Canada also reports Thursday Aug 26th. A third-quarter share profit of $1.52 is expected, down from $1.79.

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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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“Instead of the cross, the albatross / About my neck was hung”

The Rime of the Ancyent Marinere, Samuel Taylor Coleridge.
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Canadian Real Estate: Stick a Fork in It

IT'S DONE.



The Canadian housing boom is officially over.

In addition to the myriad of anecdotal stories from real estate agents and mortgage specialists who tell me that the market “has shifted in favor of buyers,” banks are finally experiencing the inevitable decline.

Back in July, I mentioned that the mortgage pipeline was drying up, and that the results should soon hit the banks. Well, they have. According to my contacts at three of Canada’s major banks, new mortgage and refinance business has fallen off a cliff. Pre-approved mortgage applications – an indication of sales beyond 30 days - are virtually non-existent. Any of this may be confirmed by a casual visit to a local bank or credit union, which reveals empty reception areas and bored lenders.

In an effort to kick some life back into the markets, major Canadian banks reduced their mortgage rates twice in the past two weeks, but it had no impact whatsoever. In light of these circumstances, I suspect the Bank of Canada will rethink its intention to slowly raise interest rates.

At the same time as the Canadian media was announcing that home prices have dropped, sales have slipped, and housing starts fallen, the Canadian Real Estate Association was busy announcing that home prices will continue to rise. I love the CREA. When sales and demand increase, they announce that real estate prices will rise. When sales and demand drop, they announce that real estate prices will rise. You can say a lot about the CREA, but you can’t fault them for inconsistency.

I suspect that several months will pass before the severity of the downturn becomes fully apparent. By then, it should be so obvious that not even the CREA will be able to ignore it.
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Further reading:

The CREA's Use of Spin (The Frost Report)
The Canadian Real Estate Market - Trouble in the Pipeline (The Frost Report)
Housing Starts Slip in July
Shaky Days in the Housing Market
Homeowners Sell, Start Renting Instead
CREA's Resale Housing Forecast

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How to Speak Fed

The Federal Reserve: seen by some as an economic savior, and by others as an evil force.

Through its direct manipulation of interest rates and other mechanisms, the Federal Reserve determines the overall pace of U.S. economic growth (or decline).



Since investors trend toward euphoria when times are good & panic when times are bad, the Fed’s mandate is to control the economy; for example, to stimulate a weak economy by lowering interest rates, or to slow down an overheated one by raising interest rates. Yes, that's right – the Fed sometimes purposely initiates recessions. This is not conspiracy, but rather a method of controlling human stupidity (or at least cleaning up after it).

In good times wages tend to increase, which in turn increases spending, which increases prices of goods, which increases stock and real estate prices, which induces inflation, which causes wages to increase and so on. When times are good and voters are happy, the government wants it all to continue. If an independent Fed did not exist, human greed and optimism would allow bubbles to grow to stratospheric levels, then come crashing horribly down. The recent crash and burn of the U.S. housing bubble is an example of the Fed's failure to do its job – it let the bubble grow for too long.

Importantly, while the Fed always hints at what it wants to accomplish in the future, it does so in a cryptic manner. So, while the Fed’s intentions may be crystal clear to professionals, they pass by virtually unnoticed to non-professionals – exactly as intended.

Buying reasonably priced stocks of good companies is always a good idea, but it’s an even better idea to buy them when the tide of the economy is moving with you. The purpose of this article is therefore to teach the rules of “Fed speak,” the cryptic voice that shapes the nation’s economy.


Rule #1 - The Fed Understates Everything

The Fed is aware of its huge influence in the market, and takes care not to overstep its boundaries. If the Fed simply said, for example, “we intend to raise interest rates because we think there is a bubble in technology stocks,” the market would likely dive and the Fed would be blamed. For this reason, the Fed avoids stating anything of importance directly. Thus, “this market has a bit of froth,” really means, “this is a bubble of massive proportions.” Asking, “Is there a reason to think that homes are overvalued?” means that homes are terribly overvalued. Whenever the Fed states or suggests an opinion, you can safely magnify it tenfold.


Rule #2 –Recognize Moral Suasion

Moral suasion, also known as “jawboning,” is the name for scolding market participants in order to change behavior. By sending a warning to the market, the Fed hopes that it can delay or even avoid taking a negative course of action.

For example, in 2009 the Bank of Canada (Canada’s equivalent to the Fed) stated, “the recent sharp increase in the value of the Canadian dollar, if it proves persistent, could fully offset recent positive developments in financial conditions, commodity prices, and confidence.” This stern warning (see Rule #1) told market participants that if they keep buying the Canadian dollar, the Bank will take measures to devalue it (to improve exports).

In the long run moral suasion rarely works, but in the short run it can have the desired consequences. Moral suasion also indicates the course of action the Fed will take if moral suasion fails.


Rule #3 – Read the Speeches Verbatim

The introductions and conclusions of Fed speeches are made for public consumption (the media) and generally reflect useless broad opinions (such as, "the economy is improving.")

The subtle nuances with true predictive value are in the carefully chosen text. For this reason, any online news article about a Fed speech will include a link to the Fed’s word-for-word text. This verbatim text is meant for market professionals.

Examples of Fed Speak in Action:

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"
Alan Greenspan, Chairman of the Federal Reserve Board, 1996 Speech

Translation: Stocks appear to be grossly overvalued (the Internet bubble).
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"It's pretty clear that it's an unsustainable underlying pattern. People are reaching to be able to pay the prices to be able to move into a home."
Alan Greenspan, Chairman of the Federal Reserve Board, 2005 Speech

Translation: There is a housing bubble in the U.S., and it will crash.
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“With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus.”
Bank of Canada, Press Release, Apr 2010

Translation: We will be raising interest rates soon.
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The importance of understanding the Federal Reserve cannot be underestimated. To a large extent, the Fed determines the near-term growth or contraction of business, and therefore the direction of the stock market. In addition, the Fed is a reliable asset bubble "early warning system." Learning to speak Fed can save you a lot of anguish.

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“Augmenting concerns about the Federal Reserve is the perception that we are a secretive organization, operating behind closed doors, not always in the interests of the nation as a whole. This is regrettable, and we continuously strive to alter this misperception.”

Alan Greenspan, Federal Reserve Board Chairman, 1996

The Canadian Housing Bubble: CREA to the Rescue

In response to a series of headlines suggesting that real estate is overpriced, visibly annoyed members of the Canadian Real Estate Association issued a statement today denying any possibility of a housing bubble, with scores of statistics and beautiful charts to support their claim.

In this article, The Frost Report reviews the CREA's rebuttal (and why they should be ashamed of themselves).

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CREA: “Canada’s solid mortgage market trends, conservative lending practices, and prudent borrowing by home buyers means that Canada will avoid a U.S.-style housing price correction.”

The Frost Report: Canada's conservative lending practices are a myth. In the heat of 2006 Canadian banks were, just like their American counterparts, doing loans without even confirming the borrower’s income. As long as the client’s credit bureau reported the name of the company they claimed to work for, this was considered enough evidence. In addition, although the Canadian Mortgage and Housing Corporation has strict guidelines regarding credit scores and income levels required for approval, a CMHC representative recently told me that they had been making exceptions to the rules "left right and center."
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CREA: The “vast majority” of Canadians have mortgages they can afford.

The Frost Report: Canadians can afford them today because of record low interest rates, which is exactly what caused the bubble to re-expand. For several months now the Bank of Canada has been warning consumers that interest rates will be increasing, and expressing concern about their personal debt levels. From June until Nov 2009, many if not most new mortgages were variable rate; this worried the Bank of Canada as well as the Big 5 banks. As a result, laws were passed stating that all buyers must qualify for a fixed rate even if they intend to take a lower (for the moment) variable rate mortgage.
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CREA: “Over the past 12 months, most new mortgages (64 per cent) have amortization periods of 25 years or less. This is an increase compared to 54 per cent one year ago.”

The Frost Report: The insinuation here is that since people are choosing 25-year mortgages (with higher payments) instead of longer-amortization mortgages, they must have money to spare. In fact, the opposite is true. In the past year home prices have become so high that the majority of home purchases have been from existing homeowners - either selling and repurchasing, or doing equity take-outs to purchase second properties. First time homebuyers are seldom able to afford 25-year amortizations. The decline in longer mortgages means that first time homebuyers are abandoning the market.
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CREA: Twenty five per cent of mortgage holders recently increased their home equity via lump sum payments against the principal and/or by increasing their mortgage payments above their scheduled payment.

The Frost Report: It is not these homeowners, but the 75% of homeowners that do not or cannot make extra payments that is concerning. The CREA's comment ignores that fact that if even a small percentage of homeowners fall behind on their payments it will bring down the entire market. In the United States in Q3 2007, subprime adjustable rate mortgages made up only 6.8% of the market, yet accounted for 43% of foreclosures.
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CREA: Most mortgage holders (77 per cent) have a home equity position of at least 25 per cent.

The Frost Report: This is because until 2006, 25% was the minimum requirement to purchase a home in Canada. At that point, the minimum down payment was changed to 0% in order to boost the housing market. Presumably because of the risks, CHMC pulled the plug on zero down payment mortgages in 2008. The minimum is now 5%.
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CREA: Housing prices will not drop. Instead, personal incomes will rise to match home prices.

The Frost Report: I feel vomit in my mouth right now.
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It's hard to imagine a more biased source of information about real estate than an organization whose purpose is to represent “more than 96,000 real estate Brokers/agents and salespeople working through more than 100 real estate Boards and Associations.” Still, the CREA could do the morally upright thing and at least present the potential downside risks. Due to the CREA's press release, hundreds of dreamy-eyed homebuyers will once again enter the market, oblivious of the dangers.

For more examples of CREA spin-doctoring, see Spin City.

For the full text of the CREA statement from which this article was based, see: Relax: It's Just Another Housing Market Cycle.

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“There is no evidence of a housing ‘bubble’ in the United States and housing demand should stay strong for years to come.”

James F. Smith, Society of Industrial and Office Realtors, 2005
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The Canadian Housing Bubble – The Denial Continues...

I could talk about the Big 5 Banks’ meeting with the Bank of Canada, where they expressed concerns about a potential collapse in real estate prices. I could talk about rising mortgage debt as a percentage of income. I could talk about condo developments in areas with an abundance of rental suites available. I could talk about the increasing incidence of fraud. But, I think the bare facts speak loudest.

This home in Vancouver –for sale at $1.18 million.


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“Right now, there is no compelling evidence of a housing bubble in Canada." Jim Flaherty, Canadian Finance Minister, Feb. 2010
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The Canadian Housing Market

The bubble is back.

Not content with a single housing bubble, Canadians have apparently decided to ignore reality and give it a second go, especially in Vancouver. Just a few days ago, my mortgage broker confirmed that, just like in the bubble years, multiple bids on properties are back with a vengeance. A typical, two-bedroom bungalow/rancher in the West Side is now priced at 1.3 million dollars, right back to where it was at the peak in 2008.

A few different factors are responsible for this brutal overpricing. First is the typical Vancouverite’s belief that theirs is the greatest city in the world. Granted, Vancouver is a nice place. But, everyone seems to believe the city is so spectacular that Olympic visitors will return to London, Paris, Tokyo etc. and immediately put their homes up for sale so they can move to Vancouver.

Second and more important is the Asian factor. In Vancouver a substantial number of immigrants, mostly from China, are buying residences primarily or completely in cash. Cash purchases are a big factor in propping up high prices; however, they are an even bigger factor in the decision making process for local buyers. Vancouverites are convinced that because of immigration, prices cannot drop; therefore, any price is justifiable, as one will always find a buyer at that new higher price (in economics, this is known as “greater fool theory.”)

Finally, the average Canadian is making a mistake typical for those who know little about finance: they are concentrating on monthly payment amount instead of amount of debt owed. To the financially naive, owing $500,000 at a 2.25% variable interest rate with a monthly payment of $1718 is better than owing $400,000 at a fixed rate of 4% with monthly payments of $1763. More importantly, people are not aware that today's 2.25% variable interest rate, and the resulting barely-affordable monthly payment, will soon be going up.

The governor of the Bank of Canada, Mark Carney, is trying his best to send out the warning ("It is the responsibility of households now to ensure that in the future, when the recovery takes hold and extraordinary measures are unwound, they can service their debts”), but it’s largely falling on deaf ears. While Americans have spent the last two years paying down their credit card and mortgage debt, Canadians have been busy racking it up. The Bank of Canada estimates that by the 4rth quarter of 2011, Canadian personal debt payments will reach record-breaking levels (shattering the previous record set in 2000).

Of course, after the housing bubble bursts for the second time, we’ll probably hear a chorus of, “It’s the fault of the banks. They shouldn’t be approving these loans in the first place!” As a banker, I can say without hesitation that trying to tell a customer they can’t afford to buy their dream home is like telling a child they can’t have ice cream: they throw a tantrum, threaten to run away (take their business elsewhere), and frequently do exactly that. If the next bank doesn’t approve them, they will keep trying until someone does, eventually lying about their assets or income if necessary. People don’t seem to realize that when your banker (who wants to give out loans) tells you that you can’t afford it, maybe you should listen.

And so, the bubble grows…