Effect of interest rates on affordability under new CMHC rules

Since April 19th, CMHC insured mortgages must qualify under the posted 5-year mortgage rate.

Here is the evolution of the five year posted rate and the five year bond yield over the past two years.
Notice that the yield has dropped around 3/4 of a point since April, but the mortgage rate has not. I guess the banks haven't passed on their savings--so far anyway.

The 5-year posted rate has changed a bit over the three months since the BIG April 19th CMHC rule change. From 6.1% we have moved down to 5.79%. What impact does that have on the maximum people can pay?

Assume the following. 100K of income. 35 year amortization. 40% total debt service ratio, here interpreted as you can pay 40% of your gross income for your mortgage. 5% down.

With these assumptions at a 6.1% qual rate, you can afford to pay $614,666, comprised of $583,933 borrowed and $30,733 downpayment.

As we have moved from 6.1% to 5.79%, what has been the impact on the amount you can pay, given the above assumptions? See the graph below.

I've put it as an index in the axis, so that percentage change is easier to calculate. I also labeled the first and last points with the dollar value. The ability to pay has gone up by 3.6 percent from April 19th to now.

This graph isn't too exciting yet--but with big swings in the mortgage rate, either up or down, this could be a fun one to look at again in the future.

I'll Just Sell

In my work, coming face to face with hundreds of people each year, discussing finances and attitudes about finances, I find it very interesting how people approach potential financial pitfalls and opportunities.


One situation I have often come across quite often is the approach toward real estate ownership and financial risk management. The risks I speak of are common to all people: Death, Divorce, and / or a Loss of Income. One of these things can happen unexpectedly at any time and how you prepare for these events is of critical importance in your and your family's long term financial health. Relating specifically to real estate ownership, what happens to the family home when one of these risks turns into reality. How will the mortgage, taxes, maintenance, fees get paid?


Death - a common answer with a couple is "I'll just sell if Bill dies." or "We'll find a way to make it work." - a poor strategy to be sure and one frought with risks. What if the sale price is below what you need? What if it takes 6, 12, 18 months to sell? Where will you live? Will you be in any state to move and uproot in a time of emotional turmoil? Will you have the financial capacity and physical capability to make the necessary payments are do the necessary maintenance? Life insurance is a more appropriate strategy and the costs of that insurance should be added to the monthly budget.


Divorce - this clearly never happens to anyone and certainly isn't going to happen to the couple in front of me! "We'd just sell and split the proceeds." is the typical answer but this is also full of pitfalls. What if one person is emotionally attached to the property? What if one person wants to sell for much more than the other person and there is a stalemate about the sale strategy (very common)? Will you be in any state to move and uproot in a time of emotional turmoil? The key to managing this risk probably lies in the mate selection process but more practical advice would be that couples shouldn't overextend themselves beyond what either of them is comfortable taking on by themselves if it became necessary.

Loss of Income - Job loss or a disability can happen any time as well and despite the loss of income, the bank, strata, government still wants to be paid all at a time of diminished capacity to meet these demands. The common answer here again is "I'll just sell." but again will you be able to sell? Or more appropriately, will you be able to sell it quickly at the price you want? This is really the key question, since you can always sell your home if price isn't a consideration, but it always is. If you lose your job or become disabled, do you have enough of a financial cushion to make all of the necessary payments for 12 - 18 months or longer? Again, disability insurance can be helpful here but it is no solution for job loss. The best advice to to have a large cushion of savings that you can draw on if necessary. Retirement savings withdrawals are possible as long as you commit to replacing the funds as soon as possible so that you do not derail your long term retirement plans.


My impression is that people are very comfortable with the fact that in the past few years real estate has been an asset with good liquidity and rising prices so these concerns seem unfounded when coming from their financial planner, especially when their friends and family are able to sell their houses quickly and for more than they were asking. The question is, was that normal? Should we expect a much different market in the future with dramatic implications for personal risk management? Many people wonder how they can build up an emergency fund, savings or pay insurance premiums when they are stretched to the limit with mortgage payments. My advice is that you should get out of that situation as fast as possible because you may not be able to sell at the price you need.

RBC, Scotiabank lift benchmark mortgage rate to 6.1%

BY JOHN GREENWOOD AND ERIC LAM, CALGARY HERALD, APRIL 14, 2010, 8:04 AM

Many homeowners face increased costs as interest rates have begun what is expected to be a series of hikes.Photograph by: Archive, Calgary HeraldRoyal Bank of Canada and Bank of Nova Scotia have hiked residential mortgage rates for the second time in as many months, likely sparking another round of increases from other banks at the onset of what is expected to be one of the busiest homebuying seasons in recent years.

As of today, RBC and Scotiabank's five-year closed fixed-rate home loans will carry an interest rate of 6.1 per cent, the highest since November. Those same mortgage products carried a rate of 5.25 per cent a little more than two weeks ago.The 25-basis-point hike, announced by RBC and Scotiabank on Tuesday, comes fast on the heels of a 65-basis-point hike by the big banks late last month. It also comes as expectations rise the Bank of Canada will raise its key interest rate earlier than previously thought.Eric Lascelles, chief economics and rates strategist at Toronto-Dominion Bank's TD Securities unit, said investors are now factoring in a 50 per cent probability that central bank governor Mark Carney will raise interest rates on June 1. Carney has pledged to keep the central bank's benchmark rate unchanged through June, "conditional" on the outlook for inflation.The first round of mortgage rate hikes kicked off on March 29, as RBC, TD and Laurentian Bank announced the cost of their mortgage offerings would rise between 40 and 60 basis points.

RBC was the first to announce on that day as well.A day later, Scotiabank, Canadian Imperial Bank of Commerce and National Bank of Canada did the same.The banks say they are raising their rates because their own cost of funding is going up as investors demand higher yields.Canada's real estate market has been booming since the economy emerged from recession last year as consumers take advantage of some of the most favourable mortgage rates in decades.

Homebuyers are facing hurdles on other fronts as well, with more stringent mortgage lending rules set to take effect on April 19 and the looming introduction of the harmonized sales tax in Ontario and British Columbia.Many homebuyers are expected to try to rush to make their purchases ahead of the changes to keep their costs down.

"Mortgages are tied to the bank's funding costs, which change from day to day," said Gillian McArdle, a spokeswoman for RBC."Our long-term funding costs have gone up considerably since mid-December and it is now necessary for us to increase . . . fixed-rate mortgages."

© Copyright (c) The Calgary Herald

Rational Thought Not a Factor in Home Purchases

By The Canadian Press

Referencing RBC Study.

TORONTO - Recent first-time homebuyers say they felt pressure to enter the market as they contended with jitters about rising home prices and higher mortgage rates.

The Bank of Montreal says as many as one-third of respondents in a homebuyers survey believe their expectation that housing prices would increase, and interest rates would soar, left an impression on their decision to make a purchase in the short term.

"There's definitely a sense of urgency among home buyers," said Lynne Kilpatrick, senior vice-president of personal banking at BMO.

"While we encourage Canadians to pursue their home ownership dreams we recognize it's easy to get caught up in the emotions of the purchase and this can lead to stretching one's budget too thin."

The results come as Royal Bank released its own homeownership survey on Wednesday which showed that a majority of Canadians expect to see higher mortgage rates over the next year.
RBC's annual homeownership survey said 64 per cent of Canadians expect high rates, with about the same number of mortgage holders concerned about higher rates.

Economists expect the Bank of Canada to raise interest rates by between half a percentage point and a full point over several months beginning this summer to fight inflationary pressures in the economy.

With many Canadians taking on larger and larger mortgage debt in expensive markets across the country, higher rates could create financial problems for some homeowners.

In the Royal Bank survey, three-quarters, or 73 per cent of homeowners, feel strongly that homebuyers need to think ahead to ensure they will still be able to make their mortgage payment if rates rise.

The bank says six-in-10 mortgage holders say they have taken advantage of current low interest rates to pay more principal on their loans.

Eighteen per cent of homeowners say they've made a lump sum payment on their mortgage and 16 per cent have doubled their payment to reduce their principal.

While 84 per cent of mortgage holders believe they are doing an excellent or good job of paying down their mortgage, 49 per cent say their mortgage is larger than they thought it would be at this stage in their life.

Marcia Moffat, RBC's head of home equity financing, says the best advice for homeowners is to review their mortgage holdings with a financial adviser to position themselves for any changes.
BMO's senior economist Sal Guatieri added that a cooler housing market is "just around the corner."

Underwater, but Will They Leave the Pool? NY Times

http://www.nytimes.com/2010/01/24/business/economy/24view.html

Economic View
Underwater, but Will They Leave the Pool?
By RICHARD H. THALER
Published: January 24, 2010
Even if they owe more on their mortgages than their homes are worth, many people feel obligated to repay their loans. But what if those borrowers walked away?

Financial Post - Mortgage shoppers opt for caution

Garry Marr and Paul Vieira, Financial Post

Published: Thursday, January 14, 2010

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• U.S. home refinancing demand soars first week of 2010

• Online investing's changing face

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• CIBC World Markets Corp.

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• Canadian Association of Accredited Mortgage Professionals

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Peter J. Thompson/National PostA survey commissioned by the country's mortgage brokers suggests Canadians are exhibiting prudence when borrowing from a home.

The housing industry fired back yesterday at comments from Ottawa that the sector might be overheated with a new report that shows Canadians have become conservative in their mortgage choices, leaving little chance for delinquencies.

The Canadian Association of Accredited Mortgage Professionals surveyed its members, who issued more than 40,000 mortgages totalling $10-billion during 2009, and found 86% of loans went into fixed-rate mortgages. Of those, more than 70% had fixed rates for longer than five years.

Jim Murphy, chief executive of the Toronto-based group, said the report's results show the risk in the marketplace "is clearly manageable." He left little doubt about one of the reasons his group compiled the research.

"It was done in response to some of the musings at yearend by first the Finance Minister and then governor of the Bank of Canada," Mr. Murphy said.

Mark Carney, the Bank of Canada governor, has warned about rising levels of household debt, which is reaching record levels. He has said consumers may be failing to account for higher interest rates in the foreseeable future, leaving households "increasingly vulnerable" to any economic shocks.

Shortly after Mr. Carney's remarks, Jim Flaherty, the Minister of Finance, was asked by reporters whether he was considering tightening mortgage requirements.

"If we had to we could, and it is something that we are watching and monitoring. But so far there's relative stability in the sector," Mr. Flaherty said.

The CAAMP survey addressed the overall debt concern and found "the vast majority of people who took out their first mortgage last year borrowed less than they could afford to, as their gross debt service ratios are far below allowed maximums, even at the higher interest rates that are used to qualifying them for their mortgage."

Mr. Murphy said his group's report has been forwarded to the Minister's office which continues to look at whether it should apply any brakes to the housing market. About 18 months ago, the government did limit the maximum amortization period to 35 years and demand consumers have 5% down on all government-backed loans.

Stephen Dupuis, chief executive of the Toronto-based Building Industry and Land Development Association, said the study by the mortgage brokerages confirms conservatism is still ruling the housing market. He said first-time buyers, the most vulnerable to any change in rates, continue to overwhelmingly get long-term fixed-rate mortgages. While rates may be much higher in five years, he said the income of first-time buyers tends to climb by the time they get their second mortgage. "There has been a massive overreaction," Mr. Dupuis said, about calls to shorten amortization periods and increase down payments.

Mr. Dupuis added that while 2009 purchases in the Toronto area rebounded sharply from 2008 lows, sales are still well off levels reached in 2007. The same is true for much of the country. There is little doubt any move to tighten regulations will have negative consequences on the market, said Benjamin Tal, senior economist with CIBC World Markets. He estimates at least 25% of the new purchases would be affected by a change in the down payment.

"The industry is fighting back and asking the government to look at the data before making any decision," Mr. Tal said, referring to the latest salvo fired by the mortgage brokers.

---------

FINDINGS

- Eighty six per cent of these home buyers chose fixed rate mortgages.

- Among borrowers who chose fixed rates, a significant number opted for longer terms

- less than 5% chose terms of two years or less.

- Twenty per cent took three year terms, 5% four years, leaving 70% with a fixed rate for five years or more.

- The vast majority of people who took out their first mortgage last year borrowed less than they could afford to, as their Gross Debt.

Source: CAAMP

Read more: http://www.financialpost.com/news-sectors/story.html?id=2445180#ixzz0ch64D7Yd
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TD Economics - Real Estate Trends Could Impact Future Path Of Canadian Monetary Policy

I suggest you read this TD Economics report released today. It contains some interesting thoughts about monetary policy and the real estate market across Canada.

Personal Finance and Buying a Home

Something that I haven't quite got my head around is how so many (thousands per month) people can seemingly 'afford' to purchase homes in the Vancouver area considering the prices at which local homes seem to be sold at. Greater Vancouver benchmark for all dwelling types is just about $520,000 as of June 2009.

Let's look at a sample first time home buyer.

Let's imagine John and Jenny want to get started on the property ladder after getting married last year. They have saved $10,000 over the past couple years and they have about $25,000 in their RRSP accounts which they intend to use toward a property purchase under the Home Buyer's Plan. Jenny's parents have offered to help them purchase their first home as well with an extra $20,000 'loan' to be used toward a down payment that may never need to be paid back. They don't have any credit card debt but are making payments of a combined $900 per month on two car loans which have 3 years left on them. Combined down payment = $55,000.

John makes $60,000 per year working in the technology field and his job prospects are very good given his education and work experience. Jenny works in sales and her income has averaged $50,000 per year over the past two years. Although she does okay at work, her job prospects are sketchy as the company she works for has seen business drop off considerably and has laid off a few people in the last few months. Gross Annual Income = $110,000. Net Monthly Cashflow = $6,000.

They are wondering what they are able to afford (apparently they don't have a budget) so they go talk to a mortgage broker about their situation. The mortgage broker punches some numbers into the computer and comes up with a preapproval amount of $430,000. John and Jenny are amazed, they wonder what they have done to make the bank love them so much! This pre-approval emboldens them.

They call up a realtor and begin looking at homes in the $400,000 to $500,000 price range. The realtor shows them several condos and a few townhouses which meet their criteria and they settle on a nice townhouse and make an offer for $450,000 which is accepted and the deal is drawn up.

John and Jenny put $45,000 down by using the parent's money and withdrawing from their RRSP accounts under the Home Buyer's Plan. They have paid CMHC and legal fees of $9,000 which gets added to their mortgage so they owe a total of $414,000 and they have decided to amortize over 35 years (they will be 65 when it is finally paid off if they stick to the original plan with the original rate) with a 5 year term and a rate of 4.5%. They will be making principal and interest payment of $1,950 per month, they have added life insurance to the mortgage ($50) and are paying property tax monthly with their mortgage payment ($200). They now get to pay strata fees of $200 per month as well.

Let's have a look at John and Jenny's monthly budget.

John and Jenny's total monthly obligations are:

Mortgage - $1,950

Life Insurance - $50

Taxes - $200

Strata - $200

Car Payments - $900

Food - $600

Fuel - $400

Home and Auto Insurance - $400

Telephone/Internet/Cable - $300

Clothing/Other/Misc - $300

Entertainment/Vacations - $500

RRSP contributions - $200

Total = $6,000

This couple can have a 'reasonable' lifestyle based on these numbers but let's look a little closer. Let's test this for several common risks:

Death - The mortgage is life insured, the survivor would be financially okay so long as the life insurance remains in place.

Divorce - They are in bad financial shape if this happens. Neither one of the two could afford the townhouse if they split up and the townhouse would need to be sold quickly.

Children - They are in bad financial shape if they have kids. Not only would they have extra monthly expenses, which they don't have room for in the budget, they would also have less income for a period of time as it is typical for the mother to take some time off work after giving birth. Even if mom went back to work there are daycare costs, which are not small.

Job Loss - They are a financial disaster if one of the two loses employment of any extended period of time. They would be forced to make some significant life changes and likely sell the home.

Interest Rate Rise at Renewal - If interest rates rise by 100-200 basis points they would be extremely rough financial shape. Unless they had an increase in income, they would likely be forced to re-amortize the mortgage and/or make other lifestyle changes. If rates increased more than 200 basis points, they would not be able to maintain their current lifestyle in any shape or form.

1) 100 basis point rise to 5.5%, maintain original amortization, payments rise to $2180 / month

2) 200 basis point rise to 6.5%, maintain original amortization, payments rise to $2420 / month

3) 300 basis point rise to 7.5%, maintain original amortization, payments rise to $2670 / month

Time - This is the most insidious risk of all and the least recognized. As a financial planner, I see many people who have put themselves into this type of scenario and they manage to muddle through life, manage to pay off a modest home by retirement and save a very modest sum of money. They retire at 65 and have a fairly low standard of living since they have no real significant savings and no pensions. If none of the above risks occured and they both managed to work a full career, get regular raises, contribute to CPP, receive OAS and have some modest RRIF withdrawals, they would make it through life without severe financial hardship but as a debt slave. The bank would have made over $400,000 from them in interest payments and they would have never saved much. They would live month to month their entire life and financial freedom would be a mere dream as they play the lottery each week hoping their number is drawn.

The reality is that the risks noted above are very real and for John and Jenny's situation to work out they need everything to work perfect, with no hitches, glitches or problems. This seems unlikely to me. It would be far better for them financially to leave themselves more room in their monthly budget so that they could:

1) Live / survive with only one income

2) Maintain mortgage amortization if interest rates rise

3) Speed up mortgage pay down by making extra payments as they receive raises if things work out well.

4) Increase their personal savings to RRSP and/or TFSA to ensure they have money for the unexpected and for retirement.

There are only two ways for John and Jenny to make the above work in a sustainable manner:

1) Continue renting and saving aggressively

2) Buy a much cheaper home and aggressively pay down the mortgage

What are your thoughts? Do you know John and Jenny? I do.

Your Home and Other People's Money

One of the many arguments surrounding real estate investment, whether as a true financial investment, or as a lifestyle investment for personal residence, involves using "other people's money" to finance the purchase. That is, use leverage through mortgages and secured lines of credit to provide the necessary financing. This is often touted as a benefit of real estate investing -- lever up and a small investment of $20,000 turns into $200,000. Fancy terms are thrown around by financiers showing double-digit returns on initial capital invested. Wow. But don't sign me up just yet.

Let's look at a simple case of me with a business idea. I want to open a store selling popcorn. I think have a decent business case but, unfortunately, no money with which to carry out my fancy plans. I need to find some capital through investors. One place I can go is the bank which has boatloads of money. I can also see if some of my business contacts are willing to pony up the dough for my venture.

The thing is, when I use "other people's money" they have a funny way of wanting a cut of the returns for use of their money. The bank manager sees me and looks at my business case, offering me a loan at 10% annual interest. My business partners are willing to invest but want an equity share of the business. Some even offered to fund it and have me work as an employee. No matter how I slice it, I have to give up some of my potential returns in exchange for the use of capital.

Now we can turn to real estate and housing. When my family walks into a bank interested in applying for a mortgage, there is little difference between this and my popcorn investment. Sure popcorn is a bit more risky than housing, but for the bank, which has access to a fixed amount of capital, both are considered pretty much equally, adjusted for risk. The bank needs to maximise its returns and manage risk.

It may not seem like it, but when the mortgage specialist fills out the online form including your income, assets, liabilities, credit history, et cetera, she/he is but filling out a streamlined business plan on our behalf. We can sometimes lose sight of this with the big rosy smile on the broker's face and McMenus of financing options.

Mortgages are, in their essence, nothing more than business ventures. The most important thing to realise is that, like most business ventures, you are passing on some of the profits to the initial holders of the capital. Unless you are speculating and benefit from unsustainable capital appreciation, your returns will, on average, be less with borrowed money than they would should you have your own money to invest instead. There is nothing absolutely wrong with this -- one may forgo future savings for present day benefit and borrowing capital is often necessary for a venture to happen at all; both are usually the case with owner-occupied real estate purchases.

Using "other people's money" is not free, especially if other potential non-real estate investments are producing decent returns, such as in the late '90s. I asked a few people why they didn't invest in properties ten years ago that were netting 7-8%. The answer: there were lots of other investments doing better with a lot less overhead. In fact, mortgage rates of the day were over 7%, reflecting how competitive other businesses were for available capital. It seems the trough of money is not bottomless after all, especially when business is booming.

Disagree? Do you think you can always do better with borrowed money? Let's hear it.

Dr. Strangedebt - How I Learned to Stop Worrying and Love My HELOC

This post is brought to you by the Joneses.

Yeehaw!! I love my Home Equity Line of Credit - HELOC.

On the path to financial self destruction, I use my HELOC to buy cars, cool gadgets, vacations, consolidate credit card debt, etc. You name it, and I've spent borrowed money on it.

My friends all think I make $150,000 per year but I only make $50,000 but I'm not going to tell them. I'm living the high life, drinking Hennessey, weekends in Vegas, new car every couple years. I'm going to keep doing it too until I collapse under the wieght of all the debt and declare bankruptcy or I'm forced to sell my home and pay off my debts. Every time I go to the bank, they offer me more money and my rates keep going down so it frees me up to do more cool stuff with money I don't have. My house is making me rich because I can just keep getting more money because my house went up in value. I bought my house for $300,000 a few years ago, had a $250,000 mortgage, and now the house is worth $600,000 and I have a $480,000 HELOC. I'm lovin' it. I just keep making those interest only payments of $1500 per month and its all good.

Strange thing happened though, I went into the bank last week to increase my HELOC because my 2007 Lexus RX is getting a little old now and I really want a new one so I need a little bit of money ($25,000) to pay the difference between the trade in and the new car but the mortgage rep at the bank told me that there was no more money and that they wouldn't increase my HELOC - the nerve. I was pissed because I work hard and I deserve that new car. I told her that I was going to take my business elsewhere if she didn't find a way to do it. She laughed at me and wished me luck. I thought to myself 'that was a little strange - that's never happened before' and I went to another bank. I couldn't get an appointment for like a week and today when I went there, they laughed at me too.

I'm starting to get concerned because I can't put up with driving this old clunker around for much longer. Any advice for this poor soul!?

What Mortgage Rates are Saying

Looking at the latest posted mortgage rates, a 5 year fixed rate mortgage is between 4% and 5.25%. If you are a long-time reader, you remember the back-of-the-envelope NPV formula used by mohican (I derived it here), used to calculate a “fair” value for a property, given the net rental income and the 5 year mortgage rate:

NPV = (RENT – EXPENSES)/(5 YEAR MORTGAGE RATE)

If the mortgage rates are approaching 4%, does that mean that many of today’s prices are fairly valued? Is this formula valid in today's environment?

What low long term rates are saying, translated into mortgage rates, is that the market does not expect inflation to be a concern for the next while. That means two things for real estate investors: incomes and rents are unlikely to increase in aggregate and could even fall in the short term. The above NPV calculation, if derived from discounted cash flows, accounts for rental inflation by offsetting the denominator against inflation. We are left with a denominator that should contain the discount rate minus inflation. With mortgage rates low, what are banks saying, and should we really be using the 5 year rate in the denominator?

The Data Deficit in Real Estate - The Globe and Mail takes on the CMHC

From the Globe and Mail:

Transparency would be an asset of great value to Canada as the country faces perplexing policy issues on home ownership and mortgage lending in the current recession. As things stand, however, the severity of the problems in question is largely a matter of anecdote and guesswork.
If financial institutions and other housing market participants supplied data to Statistics Canada, these issues could be lucidly discussed and resolved.

Canadians may congratulate themselves on a less troubled real estate market than that in the United States, but how much less troubled is unknown. The world economic crisis was triggered by inflated housing prices in the United States, but Canada and other countries had a housing bubble, too.

The number of subprime Canadian mortgage borrowers, for example, remains a mystery, as is the number of people who have lost their homes by power of sale and foreclosure; in the U.S., the equivalent figure is a matter of clear public record on a continuing basis.

Because of the credit crunch, some significant number of Canadians who are successfully meeting their mortgage payments, though their credit ratings show relatively high risk, are in danger of losing their homes when their mortgages come up for renewal. The lenders that accepted their mortgage applications in the first place would have to advance new cash, because they sold or “securitized” the original mortgage debts. Some of these non-bank lenders will now be unable to fund what amounts to a new loan, under present economic conditions. Moreover, the value of the security – the homes – has fallen.

From $3-billion to $5-billion in mortgages and as many as 25,000 borrowers may be affected, but these are only estimates.

Similarly, the question of whether mortgage-loan insurers should compete on a level playing field with respect to the federal government's complex guarantees in favour of insured mortgage lenders is obscured by the lack of information on its implications. Currently, the insurance policies issued by Canada Mortgage and Housing Corp., a Crown corporation, are 100-per-cent guaranteed, while the policies of private insurers, now principally Genworth Financial Inc., are 90-per-cent covered.

In July, the federal government wisely cracked down on mortgages with no down payments and long, 40-year amortization periods. But, again, the effects of the risky mortgages previously backed are unknown.

The government is rightly trying to keep credit flowing, in housing as in other sectors. It would greatly help if the size of the problem could be discerned.

Head in the Sand at the CMHC

From the Globe and Mail:

Canada Mortgage and Housing Corp. officials ignored warnings from senior Finance Department and Bank of Canada officials during the past two years that its active business in high-risk mortgage insurance could overburden consumers.

According to sources familiar with the discussions, CMHC executives did not heed the warnings and continued to underwrite larger volumes of insurance policies for risky home loans with 40-year amortizations and minimal down payments.

The sources said the federal agency's executives disagreed about the potential risks and defended the creditworthiness of borrowers who were granted insurance for the riskier mortgage products.

One senior Ottawa official said CMHC was such a significant underwriter of 40-year mortgage insurance polices that it currently accounts for two-thirds of the nearly $56-billion of 40-year mortgages that were approved by banks, trust companies, credit unions and other lenders during the first six months of 2008.

Unlike the United States, Canada does not publicly release data about different classes of mortgage debt. CMHC does track mortgage data, but its officials have declined requests by The Globe and Mail for information about the volume of 40-year and low-down-payment mortgages. In a statement issued last night, CMHC said it discussed mortgage risks with central bank officials in 2006 after former bank governor David Dodge raised concerns about the new breed of long-term home loans.

"CMHC officials took the governor and senior bank officials through the materials and discussed how the product was administered. The Bank of Canada was reassured by the fact that CMHC's product includes no change in mortgage qualification criteria and as such would not be of significant concern to the Bank. We know of no other concerns that the Bank of Canada or the Department of Finance had with our activities that in their view would threaten financial stability," the statement said.

The agency said only a "relatively small" proportion of the $334-billion in mortgages it insures are either 40-year or zero-down-payment mortgages. A spokeswoman declined to put a figure to "relatively small."

Finance Minister Jim Flaherty announced in July that the federal government was cancelling its policy of guaranteeing 40-year mortgages as of Oct. 15 in order to shield Canada from the kind of housing crash that has devastated the U.S. economy. However, according to sources, bank executives had been warning Mr. Flaherty and central bank officials since the beginning of 2008 about a dramatic and unexpected increase in demand from consumers for 40-year mortgages with small down payments.

Lenders, insurers and government officials interviewed by The Globe characterized the first half of 2008 as a period of apparent paralysis by federal decision makers. These sources said bank and insurance executives and finance officials disagreed over how to pull the plug on popular and risky mortgage products. One of the few things they did agree about, according to sources, was that there was insufficient monitoring of CMHC, which accounts for about 70 per cent of the total value of mortgage insurance underwritten in Canada.

"There is an accountability issue at CMHC," said one senior Ottawa official, who declined to be identified.

CMHC is a federal agency that has been supplying mortgage insurance since 1954, and is currently overseen by Human Resources and Social Development Canada. In response to a question about its accountability, CMHC said in its statement: "The lines of accountability are very clear, like all Crown corporations CMHC is accountable to Parliament through its minister."

When The Globe contacted Human Resources Minister Diane Finley, her spokeswoman replied: "We will have to decline and allow CMHC to respond to the questions applicable." According to people familiar with CMHC, the agency imported U.S.-style mortgage products to protect its dominant market position from large U.S. insurers who were allowed into the Canadian market in 2006. Canadian laws require borrowers with less than a 20-per-cent down payment to obtain insurance for their mortgages.

"They felt they were pushed into to this because of the new competition," said a person familiar with CMHC.

Underlying these concerns, sources said, was a federal internal study launched by the new Conservative government in 2006 to review the possible privatization of a number of agencies, including CMHC. The prospect of privatization, one source said, fuelled concerns that the agency needed to be seen as an effective competitor.

CMHC said in its statement that its decision to insure longer-term and lower-down-payment loans in 2006 "reflected the market trends for the period." Until 2006, the agency and its only rival, Genworth Financial Inc., did not insure mortgages that were amortized beyond 25 years. In February of 2006, several months before four U.S. insurance giants were allowed into Canada, CMHC introduced the country's first 30-year mortgage insurance product. What followed was a ferocious battle for market share between CMHC, Genworth and American International Group, the first of the new insurance entrants.

State of the Canadian Mortgage Market

The annual survey (pdf) from the Canadian Association of Mortgage Professionals is very insightful and I've been a reader now since they began the annual survey. This was the most interesting annual report I've seen yet and here are some of the highlights:

Home Equity Among Canadians - not an unhealthy situation overall but this does not reveal regional disparities and weaknesses.

Among home owners who have mortgages, the average amount of equity is $136,000, representing 51.7% of the average value of their homes ($263,000).

For owners without mortgages, equity is equal to the average home value of $280,000.

The total value of owner-occupied housing in Canada is estimated at $2.39 trillion. Mortgages on these homes total $664 billion, leaving $1.73 trillion in home owners’ equity. This equity is equal to 72.3% of the total value of the housing.

Mortgage Arrears - rising but historically low for now

The rate of mortgage arrears in Canada remains quite low, at 0.28% as of August 2008, which is just slightly higher than the 0.25% rate that has been typical during the past two years. The rise in the arrears rate was mainly concentrated in Alberta (from the below average rate of 0.15% a year ago to the current 0.30%, which remains close to the national average).

Speculation on Real Estate - nationally not a problem but BC has big problems and Alberta smaller problems

[A] key difference between Canada and the US is that an “investment motive” – buying based on expectations of price gains rather than based on real needs – generated a housing market bubble in the US. In 2006, resale market activity in the US was about 20% higher than it should have been based on economic fundamentals; current activity is 40% lower than it should be based on fundamentals. In Canada, there is very little evidence of an “investment motive”. Therefore, Canadian housing markets are not susceptible to the exaggerated downturn that has been seen in the US. However, there has been some investment motive in British Columbia, and BC may experience more of a market slowdown than the rest of Canada.

Equity Take Out - ALARMING - Canadians and especially BC residents have been using the increased values of their homes to cover over systemic financial problems and spend money they don't have. VERY ALARMING

The survey data indicates that 22% of mortgage holders took out equity from their homes or increased the amount of the mortgage principal within the past twelve months.

The average amount of equity take-out is estimated at $41,000.

Various findings from the survey can be combined to generate an estimate of the total amount of equity take-out by Canadian home owners:
• At present there are about 8.9 million owner-occupied dwellings in Canada.
• Next, we need an estimate of how many home owners have mortgages. The 2006 Census of Canada indicated that 57.9% of home owners had mortgages. This was an increase from 55.2% in the 2001 Census. Projecting this change suggests that at present about 59% of Canadian home owners may have mortgages, or about 5.25 million.
• 22% of home owners with mortgages have taken out equity during the past year.

Average amounts taken-out vary across the country, from about $30,000 in Atlantic Canada, Quebec and Saskatchewan, to about $40,000 in Ontario and Manitoba, $47,000 in Alberta, and $57,000 in British Columbia.

Those who took out equity were asked what they used the money for. Some people indicated more than one purpose. Therefore, the following responses add to more than
100% - on average, 1.27 purposes were given:
• 56% indicated that the money would be used for debt consolidation or repayment.
• 39% gave renovation or home repair as the purpose.
• 14% mentioned making purchases as the purpose.
• 7% mentioned investments.
• 11% mentioned “other” purposes.

From the responses, it is estimated that 40% of the (dollar value of the) take-out (or about $18.5 billion) was for debt reconsolidation and repayment. Therefore, while the amount of outstanding mortgage debt would have increased by this amount, totals for other types of debt would be correspondingly reduced.

Greater Vancouver Price / Rent Ratio

House prices in Greater Vancouver are overpriced and consequently the rental yield on properties is very low. The chart above (click to enlarge) shows the long term detached house price adjusted for inflation, the inflation adjusted rents for a 3 bedroom apartment and the price to rent ratio for the benchmark detached family home (I used a multiplier of 2 on the 3 bedroom apartment rent to represent the benchmark detached rent).

The price to rent ratio is at all time highs by a long shot with monthly rent representing 1/300th of the purchase price of a home. In some cases the ratio is much worse.


Any analysis of price vs rent would be ignorant if it did not account of the cost of capital, which is represented here by the five year mortgage rate. Mortgage rates were extremely high in the early 1980s and prices were also very high so the mortgage payment to rent ratio was extreme. It peaked in the third quarter of 1981 at 3.5 times equivalent rent to purchase the same property. In the current cycle we peaked at 2 times rent for equivalent properties. Clearly affordability was worse for a brief time in late 1980 through early 1982 compared to today.

The risk today is of course the prices themselves but the risk of mortgage rates rising is an additional risk that mortgage renewers must keep in mind. Would they be able to absorb an unexpected drop in house prices of 20% combined with a rate increase of 2-3%? Variable rate mortgage holders are in for just such a surprise over the next couple years. Fixed rate mortgage holders may dodge the bullet on the rate increase but the price decreases may leave them feeling a little trapped, especially if the payee loses his or her job.

CMHC to buy mortgages from banks.

From the Department of Finance.

The Honourable Jim Flaherty, Minister of Finance, today announced the Government will take steps to maintain the availability of longer-term credit in Canada by purchasing up to $25 billion in insured mortgage pools through the Canada Mortgage and Housing Corporation (CMHC). This action will help Canadian financial institutions raise longer-term funds and make them available to consumers, homebuyers and businesses in Canada.

This relief to Canadian homebuyers and consumers comes at no fiscal cost to the taxpayer. Indeed, these securities will earn a rate of return for the Government that is well above the Government’s own cost of borrowing. Moreover, as insured mortgage pools in Canada already carry Government backing, there is no additional risk to the taxpayer.

"It is important to underline that Canada’s banks and other financial institutions are sound, well capitalized and less leveraged than their international peers," said Minister Flaherty. "Our mortgage system is sound. Canadian households have smaller mortgages relative both to the value of their homes and to their disposable incomes than in the U.S."

"However, it is becoming increasingly clear that the continuing disruption of global credit markets, which has been severe and protracted, is making it difficult for our financial institutions to raise long-term funding. This is beginning to affect the availability of mortgage loans and other types of credit in Canada.

"The Government has therefore decided to act to address the current scarcity of private sector lending to Canadian mortgage markets and lending markets overall. This is going to make loans and mortgages more available and more affordable for ordinary Canadians and businesses."

This action builds on recent steps taken by the Bank of Canada to provide increased volumes of term liquidity across a broader range of collateral. The Bank increased to $20 billion the volume of liquidity that it will provide banks and has widened the range of collateral it will accept, using the expanded statutory authorities provided in the 2008 budget legislation. The Bank also cut its overnight target rate by ½ percentage point to 2½ per cent in a coordinated reduction with five other major central banks.

The actions announced today will also supplement CMHC’s regular Canada Mortgage Bond (CMB) Program, which supports mortgage lending at affordable rates by Canadian banks and other lenders. The CMB Program has recently been expanded, including a record issue in June of this year.

"The mortgages involved in today’s initiative are already guaranteed through government-backed mortgage insurance and are high-quality assets," said Minister Flaherty. "This initiative is an efficient, cost-effective and safe way to support lending in Canada by providing secure, reliable funding at an unprecedented time of global market turmoil."

The first operation is planned for October 16, with a purchase amount of up to $5 billion. The Government will announce a schedule of future purchase dates to take place over the coming weeks. CMHC will shortly announce further details of the competitive auction process that will be used to purchase the insured mortgage pools.

Bank Raises Rates on Variable Rate Mortgages

LORI MCLEOD, Globe and Mail Update, October 6, 2008 at 8:46 PM EDT

The latest victims of the growing financial crisis could be the standard discount available to consumers on variable mortgages, and home equity loans at prime.

In a move expected to be followed by other banks, all of which have been stung by higher funding costs, TD Canada Trust is raising rates on both types of loans, effective Oct. 7.

Rates on these products will rise to 5.75 per cent, a percentage point above the prime rate. Only last week, TD eliminated the discount on its variable rate mortgages, offering them at the prime rate of 4.75 per cent. During the housing boom of the past several years, consumers could often get their bank to drop the rate by half or even up to a full percentage point.

“While TD Canada Trust has endeavoured to not pass on the increases in rates to its consumers, this change reflects steadily increasing costs of funds in the current economic environment,” the bank said in a statement.

The percentage point increase raises the term interest cost on a $250,000 variable rate mortgage by $12,247.22 over five years, according to Royal Bank of Canada's online mortgage calculator. The difference is based on a 25-year amortization, a variable rate mortgage with a five-year term and bi-weekly payments. On that basis, the bi-weekly payment amount rises to $725.90 from $657.83.

The credit crisis and economic uncertainty have caused banks to stockpile their cash. That's driving up their short-term cost of borrowing from one another, and means margins on variable rate mortgage products are shrinking.

Rates on fixed-term mortgages went up last week too, as banks have passed on fewer of their savings from falling bond yields to consumers to consumers.

“The deterioration of global credit markets is beginning to squeeze the ability of even the strongest of financial institutions to raise longer-term funds, which could limit the provision of longer-term credit in Canada to businesses and households,” federal Finance Minister Jim Flaherty said in a statement Monday.

“Hopefully this isn't a permanent shift, but a short-term reaction to conditions the likes of which we really haven't seen before,” said Gary Siegle, regional manager at mortgage broker Invis.

With a discount, some customers can still get five-year, fixed-rate mortgages at 5.55 per cent, meaning a bi-weekly payment of $707.66 on a $250,000 mortgage amortized over 25 years. This means those looking for peace of mind in the current market turmoil aren't paying a premium to lock in, Mr. Siegle said.

US Financials Falling Like Dominoes

Sept. 14 (Bloomberg) -- Lehman Brothers Holdings Inc. prepared to file for bankruptcy after Barclays Plc and Bank of America Corp. abandoned talks to buy the U.S. securities firm and Wall Street prepared for its possible liquidation.

Lehman and its lawyers are getting ready to file the documents for bankruptcy protection tonight, said a person with direct knowledge of the firm's plans. A final decision hasn't been made, though none of the other options being considered appeared likely, the person said, declining to be identified because the discussions haven't been made public.

Sept. 14 (Bloomberg) -- Bank of America Corp. agreed to buy Merrill Lynch & Co. for about $44 billion, a person with knowledge of the deal said, after shares of the third-biggest U.S. securities firm fell by more than 35 percent last week and smaller rival Lehman Brothers Holdings Inc. neared bankruptcy.

Bank of America and Merrill reached a deal in principle, according to the person, who declined to be identified because the deliberations were private. A final merger agreement hasn't been signed yet, the person said. The boards of Merrill and Bank of America approved the transaction this evening, the Wall Street Journal reported, citing unidentified people familiar with the matter.

Sept. 14 (Bloomberg) -- American International Group Inc., the insurer struggling to avoid credit downgrades, is seeking a $40 billion bridge loan from the Federal Reserve as it tries to sell assets, the New York Times reported.

The insurer has turned down a private-equity investment because it would have meant handing over control of the company, the Wall Street Journal said on its Web site, citing unnamed people. AIG may get access to the Fed's borrowing window in an ``extreme liquidity scare,'' Citigroup Inc. analyst Joshua Shanker said in a Sept. 12 research note.