Canadian Real Estate – The Ignored Election Issue

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AJ Sull  Apr 11, 2011 – 3:17 PM ET

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As Canadians go through yet another election, politicians of all stripes are busy dusting off campaign slogans, attack ads and policy books. Each party puts forth its best ideas to fix what ails the country and what will propel it forward on a wave of prosperity.

The amazing part of this election campaign is that nobody seems to be addressing the 800 pound gorilla in the room. That gorilla is named “Canadian Real Estate”. The overvaluation of real estate(“bubble” is so overused it has lost its shock value)in many parts of Canada has been propelled by a Canadian addiction to debt and federal government policies that helped to create a runaway freight train in the form of real estate prices. Outside of the Canadian political campaigning trail the Conservatives have paid lip service to the issue through their recent series of mortgage lending restrictions, however, this tightening is only undoing the Conservative party’s mortgage lending loosening from a few years earlier. Again, both key facts are rarely mentioned by any of the political parties currently campaigning.

Some economists and even the Canadian Finance Minister have argued or proclaimed that a Canadian estate bubble does not exist. They point to the fact that Canadian mortgage lending standards are more rigorous than those that contributed to the US real estate meltdown. In part, this is true. However, the role of the Canadian Mortgage and Housing Corporation (CMHC) in helping to push real estate prices to their current levels seldom receives the attention it deserves.

The CMHC has been especially generous in ensuring that banks and other financial institutions were not hindered in making mortgage credit available to Canadian borrowers. Given its central role in the real estate markets and the potential impact on the Canadian economy, it should be an election issue that is front and center. If Canadian defaults on mortgages were to increase, the Federal government (i.e. Canadian taxpayers) would be on the hook for the bill. As Ross Perot once said about the US deficit, “it’s like the crazy aunt in the basement nobody wants to talk about”.

Given that Canadian consumer debt is at record levels and challenging the peak figures of US consumer debt before the recent recession, it does not take a generous amount of imagination to envision a scenario in which Canada may have a “Made in Canada Housing Crisis”. Canadian income growth has been dismal but record low interest rates have given many Canadians a “What Me Worry?” attitude.

Those who confront the issue are often faced with a response of, “can you prove that there is a bubble in Canada”? As with any bubble or even other unpleasant economic events such as recessions, only time will truly tell. However, in at least one Canadian market, Vancouver, the fundamentals and rate of price increases have gone far beyond what could be prudently considered sustainable.

As the chart demonstrates, Vancouver home prices have surged far beyond total British Columbia GDP growth and personal income growth. In fact, for housing prices to revert back to the GDP growth rates by the end of 2011 (assuming the BC economy grows at 4% in 2011), we would require at least a 12% and up to a 31% correction in home prices. This of course assumes that BC’s GDP isn’t linked to a housing bubble bursting. In truth, the dependence on real estate to spur economic growth has been very apparent, especially in Vancouver, and therefore a deeper correction would actually be required to find a sustainable equilibrium.

Canadians should be demanding some answers from their politicians about what they propose as a solution to this issue and to recognize that an issue does exist. If it unfolds even somewhat close to the worst case scenario, many Canadians may be left wondering “How could this happen?” The problem is that there is no easy fix to getting Canadians to ease off the debt spigot. However, we need simply look across the border to see what occurs when the problem is ignored.

Underwater mortgages: When is it OK to just walk away?

Garry Marr, Financial Post · Apr. 9, 2011 | Last Updated: Apr. 11, 2011 9:25 AM ET

Let’s just say you owed somebody a ton of money but there was no legal way to force you to pay it back.

Would you? What if it was one of those evil corporate banks that make for an easy target? Did the answer just get a little easier?

Not for 60% of Americans who say it is never okay to simply stop making payments on your home, according to a survey by Eagan, Minnesota-based findlaw.com, a free legal information website.

Another 34% say it’s okay to walk away from a mortgage but only if you can’t make the monthly payments. Only 3% of believe you should be able to walk away from a mortgage anytime you want, according to the survey which interviewed 1,000 American adults and had a margin of error of plus or minus three percentage points.

It’s an interesting survey given that U.S. law in a number of states allows consumers to simply hand over the keys to their homes without the lender going after their other financial assets -- something that is all but impossible in Canada.

That is not to say that walking away from a mortgage isn’t affecting the credit of Americans who do so. They might not be able to buy another house for years unless they do so with cash.

Despite what the survey says, Americans have been walking away from mortgages in droves because it makes financial sense.

Think about it. You have a home with a $500,000 mortgage on it. The present value of it is $250,000. Why would you not walk away, if you could?

“We just asked people what do you think of the idea, not would you do it yourself or have you thought about doing it yourself,” said Leonard Lee, the researcher behind the survey. “There is a practical argument but there’s a whole philosophical argument.”

If you were shareholder in a company that owned a $250-million building but kept making payments on a $500-million mortgage even though the company had the ability to walk away from the debt how would you feel? Would the executives be breaching a fiduciary responsibility?

The U.S. real estate industry even has a term for all this - strategic default. “You are asking at some point doesn’t it make more sense to walk away from the mortgage where you are unlikely to recoup your original investment,” says Mr. Lee.

Ted Rechtshaffen, president of TriDelta Financial and certified financial planner, says once you put aside the moral issues it would come down to a simple choice.

“It will impact your credit rating but from a financial perspective why wouldn’t you do it? You are getting a $250,000 head start. Another investment is probably going to be better than your current house,” says Mr. Rechtshaffen.

But Benjamin Tal, deputy chief economist with CIBC World Markets, says while it might not make economic sense, there is evidence Americans are not actually walking away from property as much as they probably would if they were listening to a financial advisor.

“Whatever the default rate is now in the U.S., people say it’s 8% and that’s extremely high. I say that’s surprisingly low,” says Mr. Tal.

“You have up to six to seven million households that could default any day, namely because there are in a negative equity position.”

What’s in it for them to keep paying? There is something to say for wanting to stay in your home where you have been raising a family and living. There is also a stigma that comes with somebody slapping a foreclosure sign on your property -- suddenly your neighbours know a little more about your financial situation.

“At the end of the day though, that’s the rational thing to do. You are talking about houses that are under water more than 20%. Based on an economics textbook, that would be the rational thing to do,” says Mr. Tal.

In Canada it’s pretty tough to do. For starters, if you have an insured mortgage, backed by the government, the bank will get paid off for their loan. But the insurance company, whether it’s Canada Mortgage and Housing Corp. or a private insurer, will go after you for any deficiency created by proceeds from the property being less than the mortgage.

It’s the case in most of the country for uninsured mortgages too, says John Turner, director of mortgages for Bank of Montreal. Rules are slightly different in Alberta and designed to protect consumers but Mr. Turner says banks can elect to go after other assets in some circumstances.

There’s also a scenario where you might have bought a condominium as an investment before it was built and put down say 20% payment. If you think you walk away should prices drop by 50% once the building is up, forget it. You’ll be sued.

“As a lawyer we can’t advise someone to break a contract. The law is not you don’t have to obey it, the law is the consequences of not obeying [the contract],” says Calgary lawyer Jeff Kahane. “You haven’t broken the law, you’ve broken your promise. Is it any different than saying why would I want to pay for a chocolate bar at 7-11 when I can put it into my pocket and steal it if I can get away with it.”

Banks boosting mortgage rates

Several of Canada's big banks are raising most of their fixed-term mortgage rates ahead of the busy spring real estate market.

Toronto-Dominion Bank (TD-T85.22-0.92-1.07%) said the biggest increases will be for mortgages with terms of five to 10 years, which will all go up by 0.35 of a percentage point starting Tuesday.

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The move was matched by Canadian Imperial Bank of Commerce.(CM-T84.67-0.22-0.26%)

Royal Bank of Canada (RY-T60.24-0.36-0.59%) raised its rates on mortgages for five and 10-year terms by 0.35 or a percentage point, and its seven-year rate by 0.15 of a percentage point.

The posted rate for five-year closed mortgages — one of the most popular types of loans for Canadian home owners — will rise to 5.69 per cent.

The three banks will also raise their rates on one-year, three-year and four-year terms by 0.2 of a percentage point while two-year terms go up 0.3 of a percentage point.

Fixed mortgage rates, which are closely tied to the bond market, tend to climb when traders shift investment activity to riskier equity assets from bonds, which are considered safer.

Time to step up the oversight of CMHC operations

BOYD ERMAN

From Tuesday's Globe and Mail

Posted on Monday, March 21, 2011 7:27PM EDT

More than two years after the financial crisis brought down banks and mortgage insurers in the U.S., it’s hard to believe that there’s still a huge financial institution in this country that’s operating in a regulatory grey zone, with little in the way of oversight.
The federally owned Canada Mortgage and Housing Corp. is bigger than some big banks and its risks are borne by every Canadian. Yet the country’s main financial regulator does not oversee it. Nor does CMHC officially report to the Finance Minister.Whether it is in Tuesday’s budget or after an election, Ottawa should improve the oversight of CMHC by fixing those flaws.

It’s one of the final but very necessary steps the government needs to take to rein in the risk to taxpayers posed by the housing sector. Finance Minister Jim Flaherty’s decision to pull back amortizations for insured mortgages from 40 to 30 years, and to increase down payment requirements for home buyers, were the right first moves, reducing not only CMHC’s risk but the risks to the financial health of everyday Canadians, without squashing the housing market (so far).

But now it’s time for structural changes to ensure that CMHC operates in a low-risk manner for the people who own it. That would, of course, be you and me. That means transferring oversight of the insurance and securitization operations of CMHC to the Office of the Superintendent of Financial Institutions, and making the Minister of Finance formally responsible for it.

CMHC is by any measure one of the biggest financial institutions in the country, and it’s getting bigger every year. It has estimated its own 2010 revenue at $14.7-billion, more than Canadian Imperial Bank of Commerce, the country’s fifth-largest bank. CMHC estimates it had net income of $1-billion last year, in line with that of the No. 6 bank, National Bank of Canada.

CMHC has mortgage insurance in force that will soon exceed half a trillion dollars. Because of that, it’s the very definition of systemically important institution. That insurance safeguards the balance sheets of Canada’s big banks, and is backed explicitly by the federal government.

Who is minding this huge, crucial beast that puts taxpayer money on the line? The answer is Canada’s Minister of Human Resources – not Mr. Flaherty, despite his sway over items such as mortgage rules – and a board of directors that is largely drawn from the real estate and building businesses, with little background in banking or insurance.

That arrangement may have made sense when CMHC was primarily engaged in tasks like providing low-income housing, but now the mortgage insurance side of the business dwarfs other components and requires new gatekeepers.

The insurance and securitization business of CMHC should report to the Finance Minister directly, and it should be explicitly overseen by OSFI. The board of directors overseeing the insurance and securitization business should have a stronger background in those fields.

If that means splitting CMHC’s functions, then that’s what should happen.

CMHC says it hews to the guidelines put forward by OSFI, in some areas like capital going one better, but there’s no watchdog from OSFI ensuring that’s the case. It’s a trust-me story.

Do something dumb, or take too much risk, and OSFI has a reputation for being in your face soon after demanding a fix. CMHC should face the same real-time scrutiny.

To be clear, from the numbers we can see, there is no indication that CMHC is badly run. It has come through the recession largely unscathed.

It’s profitable, funnelling $12.3-billion into government coffers in the past decade.

The balance sheet is sound. There is a big equity cushion ahead of the mortgages that CMHC insures, on average 45 per cent as of the end of 2009, according to the company. Capital levels are at two times the level that OSFI requires, according to CMHC.

In other words, if people start defaulting on their mortgages more often, there’s a lot of home equity and balance sheet capital to take the blow before the costs start falling on taxpayers.

At least, that’s what CMHC tells us. But it doesn’t tell us as much as it probably should. Public disclosure from CMHC is basically limited to financial statements in an annual report that, while audited by the Auditor General and a private firm, tend to lag behind the times. So far, there’s no sign of 2010’s final numbers.

From the point of view of the taxpayer, OSFI regulation of CMHC isn’t perfect. OSFI’s job is not to protect the shareholders of banks and insurers; it’s to protect depositors and policy holders. That means it wouldn’t be looking out for the taxpayers who own CMHC, but rather the people who bought insurance on their mortgages.

But given what’s at stake, more oversight is better than less, and OSFI is the best option.

New mortgage rules take effect

Taken from the Guelph Mercury

GUELPH — Tighter federal mortgage rules intended to stem Canadian household debt kicked in Thursday, but local realty and mortgage specialists said the changes won’t have much impact.

Starting today, the maximum amortization period for a government-backed, insured mortgage drops from 35 to 30 years. It had been at 40 years in 2008.

Also, the maximum amount Canadians can borrow in refinancing their mortgages falls to 85 per cent of the value of their homes, from 95 per cent a little more than a year ago.

One month from today, the government will implement a third measure, eliminating guarantees on home equity lines of credit.

Federal Finance Minister Jim Flaherty announced the changes in January, one month after the debt-to-income ratio in this country reached an all-time high of 148 per cent. The rules are designed to discourage homeowners from dipping into home equity to pay for things such as cars, electronics or second homes.

This week, however, local mortgage and real estate specialists expressed doubt the new rules would impact the market.

“It’s really not going to make much of a difference,” Jennifer Lovsin, president of the Guelph and District Association of Realtors, said. “People are just going to go out and get debt anyway.”

If the government wants to get serious about curbing consumer debt, Lovsin added, it should stop credit card companies from lending at exorbitant interest rates.

While homebuyers will still have to qualify for a 25-year amortization, heavily indebted mortgagees who need help on a short-term basis will have less wiggle room, she said.

Chris Bisson, a broker with the Mortgage Centre in Guelph, said while the new amortization rule will only affect about five per cent of homebuyers, it won’t hurt, either.

“Generally the shorter the amortization, the faster people pay off their mortgages. Any time someone can pay off debt faster, it’s a good thing,” he said.

He also welcomed the refinancing rule, which he hopes will discourage people from “using their house as an ATM machine.”

Local real estate agent Don Huggins also welcomed the stricter mortgage rules, adding household debt “needs to be reined in.”

When he bought his own house, mortgage rates were at 14 per cent, he said. “Now, money is really, really cheap. Our interest rates are really low.”

But the new rules won’t have much impact on the local housing market, he said, which he predicted will remain hot due to a tight housing supply, and good weather.

To address the lack of financial discipline in this country, Huggins suggested the feds regulate lines of credit, another source of consumer debt.

Bisson agreed lines of credit are a problem, and also suggested the government scale back the maximum gross debt service ratio from its current ceiling of 44 per cent. “You’re setting people up to get into credit problems when you’re allowing them that extra amount,” he said.

Many predicted a buying frenzy ahead of the changes, as happened a year ago before Ottawa raised the minimum down payment on rental properties and Ontario and B.C. implemented the Harmonized Sales Tax.

However, after a strong start to the year, national home sales edged down in February, according to the Canadian Real Estate Association. “The reality is that we’ve had a good spring,” Bisson said. “But I don’t think it’s nearly as strong as it was last year as a result of the changes.”

The New Mortgage Rules

Take from Ratesupermarket.ca

A need for change

Since 2008, the recession has hit some areas of the economy hard, among them business investment and exports. But, thanks to record low interest rates, Canada’s housing market has helped drive the economy through the worst of it. The problem: Canadian’s household debt has risen to record levels and this has many economists worried about the future of the economy.

According to some experts, for the past 20 years Canadian’s debt-to-income ratio has been climbing steadily – much faster than disposable income. Since the start of the recession, the number of households that have fallen behind on their mortgage payments by three months or more is up by nearly 50 per cent. In order to manage high-interest debt, like that found on credit cards, some homeowners find themselves refinancing to free up money.

Financial experts advise homeowners, warning that total housing expenses should not swallow up more than one-third of the total household income. Yet, according to a BMO mortgage survey, even though two in three homeowners say that they would be able to handle it if interest rates were to rise, some 18 per cent say that they might be in trouble. The consequences for the homeowner are serious and could result in loss of home, or even bankruptcy.

As a result of these concerns, Finance Minister Jim Flaherty announced a series of mortgage rule changes in January of this year. He said that the amendments are meant to address the growing concern about the substantial increase in household debt in Canada, but more specifically they are meant to reduce the total interest payments people end up paying with longer amortization periods.

What are the new rules?

After the new rules were announced, the government gave the industry 60 days to adapt.  The new system will take place this week on March 18.

The rule changes are as follow:

1. Ottawa will no longer insure home equity lines of credit.
2. For homes purchased with less than 20 per cent down, the maximum amortization period will be cut to 30 years from 35 years.
3. A tightening of mortgage-backed lines of credit mean that Canadians will only be able to borrow up to 85 per cent of the value of their homes. This is down from 90 per cent.

What do they mean for homeowners?

A shorter amortization period has its pros and cons. Some homeowners are attracted to lower monthly payments, but might not realize that they are paying substantially more in interest over time.  For those who put a down payment of less that 20 per cent, this also means higher monthly payments. Under the current rules a $300,000 mortgage at 5 per cent, with a 35-year amortization would total $1,514 monthly. Under the new rules, the monthly total comes to $1,610, a difference of $96. Doesn’t seem like a big deal, does it? Calculate the total savings over the lifetime of the mortgage and the average homeowner saves $56,139.

The reason behind tightening mortgage-backed lines of credit is understandable as well. Many homeowners are refinancing, using home equity to get out of credit card debt. Although the practice of using lower interest debt to pay off higher interest debt is a reasonable solution, it only works if you are able to maintain a certain amount of equity in your home.  Some homeowners refinance every couple of years and actually end up owing money when they sell.

For future homeowners, the new mortgage rules could have the effect of pricing them out of the market altogether, but it’s likely that they aren’t as financially ready for homeownership as they could be.

Some experts, however, don’t see the future as quite so bleak. Many first-time homeowners choose 25-year amortization periods, rather than paying the extra interest over the years and are prepared to pay down payments over 20 per cent in order to avoid mortgage insurance payments as well. In Canada, those who purchase a home with a down payment of less than 20 per cent of that home’s value are required to purchase government-backed mortgage insurance through companies such as Canada Mortgage and Housing Corporation. This can add to the monthly cost of owning a home.

While the government believes that the new rules will have the effect of lessening Canadians’ financial burdens in the long run, some economists believe that rising mortgage rates are a deeper threat to the market. Rising interest rates would make monthly mortgage payments more expensive, leaving those who took on too much “cheap debt” in trouble.

Although there’s no easy way of preparing for every financial hiccup one might experience in the future, it’s always good advise to spend within your means. The new mortgage rules, in particular the refinancing rule, will help keep Canadians on track with their finances.