In recent years, there have been many market commentators and analyst asked whether Canada is in a housing bubble. Since that is a question that I often get from many home buyers, real estate investors, and real estate agents. Here is my view –
Impact of regulatory changes
A December 2018 report from the Bank of Canada reviewed the impact of the government’s policy changes on the mortgage market. The Bank of Canada found that overall market activity had slowed – something most everyone expected would happen eventually since that was the goal of the policy changes.
Put differently, if the housing market and debt levels did not slow, additional policies would have likely been introduced to slow the market since that is what the policy makers were trying to achieve in the first place.
The Bank of Canada’s data shows a slowdown in “riskier” mortgages which they defined as having more than have a high (above 4.5 times) mortgage to income ratio as a result of these changes. The Bank of Canada patted itself on the back for the good work they had done to protect the financial system.
The reality is that many of these borrowers have turned to the unregulated mortgage market as these (high debt to income) mortgages are no longer allowed within the regulated banking world.
History of Mortgage Lending Changes
In 2016, the Office of the Superintendent of Financial Institutions (OSFI) announced a stress test for insured mortgages (mortgages with less than 20% down and requiring mortgage default insurance), stipulating that those buyers must qualify at the Benchmark rate (currently 5.34%) using the same 39/44 Gross Debt Service/Total Debt Service ratios.
In October 2017, a similar rule was unveiled for uninsured mortgages (mortgages with more than 20% down payment) stipulating that those buyers must qualify at either 2% more than the contracted mortgage rate or the Benchmark rate, whichever is higher.
These two rule changes known as the “stress test”, along with several others, including increasing minimum down payments, mortgage default insurance premium hikes, and decreasing amortization limits, have made it harder for Canadians to qualify for mortgages.
The rationale for these policy changes was to encourage people to take on less overall debt, including less mortgage debt, which would (in theory at least) keep the housing markets safe by protecting borrowers in the event interest rates increased and by protecting lenders from borrowers being unable to service debts and from falling house prices.
Clients who qualified for an “A” mortgage immediately qualified for only about 80% of what would have previously been approved as a result of the “stress test”. By October 2017, this impacted all regulated mortgages in Canada.
It is important to understand that with very few exceptions in Canada’s regulated mortgage market, the size of the mortgage that can be approved is determined by the applicant’s income (not the value of the property). In Canada, a mortgage is a loan against your income, not a loan against the value of your house.
Many high-quality borrowers shifted down the ladder to lenders with a higher risk tolerance and more flexible lending policies. These mortgages of course come with higher interest rates. Borrowers who don’t fit into the mainstream box are not limited to those with past credit issues, and may include self-employed, those who are new to Canada, and previously “A” clients with excellent credit but lower incomes.
Alternative mortgage lenders also known as “B” lenders, are more willing to look at each situation on a case-by-case basis and consider a borrower’s “story”. For example, if a borrower had a bankruptcy or previous credit issues, they want to know the story behind it in order to assess whether it is likely to occur again.
In addition, B lenders typically have more flexible income definitions than A lenders. For example, with self-employed borrowers or borrowers that rely on tips, B lenders will consider bank statements to demonstrate income rather than exclusively focus on tax returns as is typically the case in the “A” space.
The Unregulated Market
The unregulated market is primarily comprised of private mortgage lenders – companies, individuals, and mortgage investment corporations (MICs) — who fall outside the purview of Canada’s banking regulators. Private lenders offer mortgage rates much higher than traditional mortgage lenders and for shorter terms.
Borrowers who could not qualify for traditional lending turned to these alternative and private lenders. Private lenders are less concerned with an applicant’s credit or income and much more focussed on the value of the property. The lender wants a cushion between what they are owed and what the property can be sold for, in the event the borrower stops paying the mortgage.
As a result of the rule changes, alternative lenders saw an uptick in business as credit worthy mortgages clients are now often required to explore borrowing options in the unregulated space.
The Bank of Canada acknowledges that this segment of mortgage lending is growing. The bank indicated that the market share for private lenders in the GTA has grown by 50% from 2017 to 2018, and now makes up nearly one out of every 10 borrowers.
There are now questions about risk in the unregulated market.
Is there cause for concern?
There can be many reasons to access short term funding in the private lending space. But let’s be clear, in the world of private lending a first mortgage would approach 10% when interest rates and fees are included, and second mortgages generally start at 12%.
Sometimes clients will need to consolidate debts in order to lower monthly payments or improve their credit score in order to qualify for a better mortgage in the future. Sometimes borrowers will face a huge IRD penalty and higher interest rates to refinance a bank mortgage and will borrow privately until the existing mortgage is due.
Whatever the reason for accessing an alternative lender, private lending is not a long-term solution. With private lending t is critical to have an “exit strategy”. If you have a private mortgage, and you don’t know exactly when and how you are moving back into a better mortgage than you need a much better mortgage broker.
If 10% of borrowers are using private lending, alarm bells should be ringing at the Bank of Canada and financial regulators in Canada. As borrowers rely on the private funds for longer periods, this will have a destructive impact on the borrower’s financial health.
In real life
Joanne had contacted me last year to enlist my help to reduce the interest she is paying on her private mortgage and her story is representative of the pitfalls of accessing private lending and why I believe it is a certainty that many of the overheated markets in Canada are headed for a meaningful correction.
In 2018, Joanne had a good job, making in excess of $100,000 annually, was single and had a habit of spending more than she made (not a recipe for long term financial success). There were unexpected expenses along the way that compounded some of her financial issues.
Joanne had purchased a condo for $390,000 in 2014 that had risen in value substantially since she purchased it. In 2016 she had refinanced successfully with an A lender to consolidate some debt she had on credit cards. In 2017, she had taken out a $50,000 private mortgage behind her bank mortgage based on a $600,000 appraisal of her condo. She had borrowed $480,000 on a condo that she purchased for $390,000 only 4 year earlier.
Joanne had just leased a BMW and had another $20,000 that she would like to consolidate into her mortgages.
The first problem was that with car payments, condo fees, and mortgage, even with her income the TDS ratio was tight. In addition, with the $20,000 which was close to the maximum of her 4 credit cards her credit score had taken a beating.
The second problem was that there was now little to no equity in her condo, since values in her area had started to fall. Her appraisal came in at $550,000 and there are no worthwhile mortgage lending options to go above 80% of the value of her property, which meant that she couldn’t even payout her mortgages, never mind the consumer debt.
Short of winning the lottery, Joanne’s best financial option is to sell her property. It is also her only realistic option. But Simone like thousands of homeowners in the GTA/GVA is planning to wait out the market. Simone and many others currently believe that if they hold on long enough, the market will resume it’s inevitable upward trajectory and she will be able to refinance and payout all her debts at a lower rate.
There is a private lender that has been charging 15% for her $50,000 second mortgage and collecting $625/month in interest every month, meanwhile the principal on her loan has not been reduced by a penny. When the mortgage comes due in the summer, renewing the private mortgage will be an issue.
The lender is no doubt aware of a lengthy, expensive, and complicated legal process to force a sale of the property, and during that time values could continue to fall. In addition to falling market values, I wouldn’t expect the property to be ready for showings by the time the proud current owner vacates. There will also be commission paid to a real estate agent to facilitate the sale.
There are many people who have paid living expenses through the 25-year bull market in real estate by accessing the equity in their homes. This is only possible when property values increase, when values decrease the system starts to fall apart quickly.
Regulatory capture is a form of policy failure which occurs when a regulatory body, created to act in the public interest, advances the commercial interests of the industry it is charged with regulating.
In Canada, regulators have repeatedly prevented meaningful competition, from foreign companies to technology start ups, from entering the financial service space in Canada. It is also my view that regulators have taken steps to advance Canada’s big bank interests ahead of the public interest in financial service regulation. Look no further than the mortgage rules that have been introduced recently.
First, when regulators determined that mortgage refinances (meaning increasing mortgage balance or extending the amortization), rental properties, 30-year amortization, and properties over $1M could not be insured they eliminated an important source of capital and competition for these types of mortgages.
Monoline mortgage lenders had relied on the mortgage default insurance, and subsequent securitization and sale of the insured mortgage pools, to compete effectively with banks for these types of mortgages. Banks have much larger balance sheets and typically lend from their own capital and can now do so with reduced competition as monolines mortgage lenders can no longer compete.
Instead, today all monoline mortgage lenders are aggressively focussed on growing their alternative lending businesses.
Second, the introduction of the “stress test” immediately reduced each borrowers capacity to borrow by ~20%, while interest rate increases have reduced each borrower’s capacity by an additional ~10%. The result is that many borrowers do not have enough income to qualify for the mortgage that they already have.
On renewal, these borrowers have limited options and are usually required to accept whatever rate is on the renewal offer is from there existing lender. Since banks have steadily seen falling market share in mortgage origination as borrowers increasingly enlist the service of mortgage brokers, the bank regulators have implemented the stress test in a way to allow the banks access to maintain exclusive high margin business.
Effectively, your bank can charge you whatever they want on your mortgage renewal when they know you can’t leave.
Credit and Debt
Credit is buying power, which is generally good in that it facilitates economic transactions. The buying power is given in exchange for a promise to pay it back which is called debt. Most of what Canadians consider money is really credit.
When a bank advances a mortgage (or any loan) money is created. With a mortgage, the house seller receives the money and the buyer has a debt to repay.
The question on whether credit and debt growth is good or bad depends on what the credit produces and how the debt is repaid. Generally, because credit creates both spending power and debt, whether more credit is good depends on whether the borrowed money is used productively enough to generate enough income to service the debt.
Canada’s Housing Bubble
Bubbles generally start with fundamentally driven bull markets. In Canada, housing market fundamentals including low and stable interest rates and ongoing immigration. Strong and stable economic conditions have supported increasing home prices for close to 25 years.
As home prices increased net worth and income levels increased, and confidence supported additional borrowing and spending. The housing boom encouraged new buyers into the market who didn’t want to miss out on the action (FOMO), often pulling purchase decisions forward.
As new speculators and additional lenders entered the market, confidence increases and credit standards fall, allowing for more market participants, more people to enter the market further supporting demand and confirming the boom.
Rising house prices lead to more spending and more buying, which raises house prices further. Everyone wants to own a house and eventually everyone who wants to own a house already owns a house, and many have borrowed as much as they can to buy a house, often to buy as many houses as they can.
The following is something I posted on LinkedIn the day the first stress test was introduced for insured mortgages.
Effective today (October 17th, 2016) all insured mortgages with a down payment of less than 20% will need to qualify at the greater of either the Bank of Canada benchmark rate (4.64%) or the contract rate offered on their mortgage commitment. For reference, a five year fixed rate mortgages are currently available at 2.19% (less than half the “stress test” benchmark rate).
What this does policy means to the average Canadian family and the average Canadian house price? In short, it means that unless an average family has $100,000 for a down payment (and closing costs) they can no longer afford an ‘average’ house.
The average Canadian family earns $82,056/year and the average price of a house in Canada is $474,590.
If we assumed the average family had a great credit history, no car payments, no credit card debt, or no other borrowing (and assuming property taxes of 1% of the purchase price of the house) that family could have qualified to purchase a property for $570,000, until October 17th.
After October 17th, by requiring this family to qualify at the benchmark rate of 4.64% they can now afford to purchase a property only worth $457,500.
What happens when an ‘average’ Canadian family can no longer afford an ‘average’ house?
Availability of credit certainly plays a role in residential real estate prices and it is likely we are entering a period in Canada (with this policy and more to come) where credit growth will be lower than income growth. The value of residential real estate plays an important role in how households perceive their wealth, and that perception impacts decisions regarding household consumptions, savings and investments.
We are starting to see some issues with the market including asset-liability mismatches (private lending), as people like Joanne take short term loans to buy long term and often illiquid real estate and others invest in riskier debt (private lending) and assets (including MIC’s) with borrowed money.
Debt to income ratios have increased rapidly in Canada.
As debts have risen, the cost to service those debts has risen even faster. In Canada that is the double whammy of higher interest rates and tighter mortgage regulations.
Now we are starting to see tighter lending policies from all mortgage lenders who are increasingly concerned with credit scores, a borrower’s other assets, and additional limitations on the types of properties they will consider reducing lending further.
Monetary policy helped inflate the bubble by keeping interest rates at record low levels. It is important to recognize that the Bank of Canada has a single mandate in Canada which is to keep inflation within a 1 to 3% target band. The Bank of Canada does not target debt levels or house prices.
Canada’s housing bubble has popped despite what your real estate board may indicate. Now falling asset prices decrease the owner’s equity and collateral values and which cause lenders to pull back further. This forces speculators to sell, driving down prices even more.
Ray Dalio from Bridgewater Associates has developed a list of defining characteristics of bubbles from prices being high relative to traditional measures, prices are expecting further appreciation from these levels, bullish sentiment, purchases being financed by high leverage, buyers who have made forward purchase, new buyers entering the market, and stimilative monetary policy.
It would be easy to make a case that all of these elements were present in Canada as real estate prices peaked in early 2017 with house prices high relative to historic rents and income measures, borrowers purchasing negative cash flow investments and banking on further appreciation, housing becoming a regular topic of water cooler conversation, the sharp increase in use of private mortgages, buyers purchasing preconstruction investment properties, people entering the market who have seen friends and family’s houses increase in value (FOMO), and stimilative monetary policy from record low interest rates.
From data since the introduction of the foreign buyers, tax we can see that foreign buyers were also very active in many urban markets, Toronto and Vancouver specifically.
Mortgage fraud has also been a driver of additional borrowing. In my daily business, I have had many mortgage prospects indicate that banks fabricated income documentation in order to get mortgages and these clients would not qualify for the mortgages otherwise. The fee to arrange one of the mortgages was 1 or 2% of the mortgage advance which was paid directly to the bank’s mortgage specialist of these ‘regulated’ financial institutions.
Canada’s housing market in 2017 was a classic bubble, specifically focussed in the Toronto and Vancouver areas.
In addition to historically low interest rates, through mortgage default insurance provided by Canada Mortgage and Housing Corporation, where the government guarantees lenders will be made whole in the event of a borrower default, fiscal policy has also supported the housing bubble.
The top of the Canadian housing market was triggered by a combination of regulatory changes and interest rates increases that have caused a debt servicing squeeze and this has impacted house prices. As lenders begin to worry about repayment, borrowers face higher interest rates or less available credit. Spending in the economy slows and the bull market now begins to play in reverse.
Looking at average numbers of debt to income (or debt service costs to income) for the economy fails to capture if risk is concentrated in certain sectors and here is where Canada is especially vulnerable.
Canada’s construction and real estate employment sector now makes up a greater portion of the economy than at any time in Canadian history, residential investment as % of GDP is within spitting distance of historic highs. These developments are a notable issue for 2 reasons.
First, for the construction sector to continue to grow in line with the economy, bigger projects will need to be built in the future. Consider a builder who constructs 200 homes one year will need to build 204 homes to grow 2%, roughly in line with the economy.
If fewer homes are in demand, meaning investors and end users don’t need more homes, the workers and suppliers are quickly impacted.
In the United States, fewer homes have been built each year since the financial crisis of any year prior to 2008. The only exception was 1983 a time when interest rates approached 25%.
As housing construction projects approach completion housing, including of course condos, supply is expected to increase significantly over the coming years. This will lead to additional selling especially as speculative investors find it much harder to get mortgages and can only do so at much higher interest rates.
Borrowers who extended themselves, often with the help of banks creating mortgage income documentation may find themselves unable to service the mortgages.
Then there is Joanne and thousands like her in the GTA and GVA, which is why anyone who expects a soft landing in the Canadian housing is more likely to be disappointed.
416-769-1440 / email@example.com