Sell the Banks

For many years, I wandered through life as an agnostic.  The supernatural beliefs of organized religion just didn’t make sense to me.  But lately, I have been witness to evidence which has caused me to alter my views.  There is a God, and He is a nineteenth century Russian novelist.  For who else, I ask, could devise a tragedy so bitter as the one which appears to lie ahead for shareholders of the Canadian chartered banks?

 

Singled out for praise by the IMF and even complemented by President Obama himself, the big Canadian banks appear to be an island of calm amidst this financial tempest.  We in Canada are the fortunate beneficiaries of a “conservative” banking culture and are blessed with excellent financial regulators.  As other banks around the world are wiped out or trade at a fraction of tangible equity, Bank of Nova Scotia and Royal Bank of Canada now cruise serenely at 2.2X book.  However, this comfortable situation may not persist for long.  The Canadian banking crisis has not been averted.  It is just arriving with a lag.

 

Figure 1:  Father, I think he said, “Sell the banks”

 

 

True, Canadian banks have avoided some of the sillier extremes, particularly those related to off-balance sheet leverage.  But the key problem in Canada is precisely the same as it is in the other western countries now experiencing bank solvency crises.  Home prices have grown to an abnormally high multiple of employment income, supported by a rapid expansion in mortgage debt.

 

 

Figure 2:  Peak Home Prices as a Percentage of Average Income

	Canada	US	UK
Average House Price (Peak, local currency)	C$ 319,957	US$ 230,200	₤ 192,268
Average House Price (Peak $US)	US$ 278,362	US$ 230,200	US$ 317,242
Gross National Income per Capita (World Bank 2007 $US)	US$ 39,650	US$ 46,040	US$ 40,660
Ratio of Peak Home Price to Income	7.0X	5.0X	7.8X
Date of Peak	Q2 2009	Q3 2006	Q4 2007

Sources:World Bank,US National Association of Realtors, MLS, Nationwide

 

CMHC and the Canadian Housing Bubble

 

The key difference between Canada and other markets is that in Canada

the cost of bad home loans have been socialized in advance. In Canada, we didn’t need to disguise our sub-prime excesses within dubious mortgage-backed securities.  Why create an alphabet soup of bogus AAA paper when our government provides seemingly limitless quantities of underpriced mortgage insurance?  As a formula for creating housing froth it has been virtually unbeatable.  Housing markets may be cratering throughout the world, yet one observes a perverse new high in Canadian real estate prices in May of 2009.

The key to Canada’s bubbly housing success been the CMHC .  The Canada Mortgage and Housing Corporation writes guarantees on most Canadian mortgages originated at greater than 80% Loan-to-Value. This agency has been on a massive expansion binge of late.  In 2008, a year of synchronized global recession, the CMHC expanded its mortgage insurance in force by a whopping 18%.  CMHC now guarantees $407.7 Billion of high loan-to-value mortgages and an additional $233.9 Billion of securitized mortgages.

In all, the CMHC mortgage guarantees are equal to slightly more than half of Canada’s GDP.  Against this total, CMHC has miniscule equity capital of $8.1 Billion.  How is it that more than $630 Billion of dodgy mortgages can be guaranteed by an entity posting just over 1% in equity?  This is a question that curiously appears to have escaped the notice of Canada’s top notch financial regulators.  

The role of the Canadian banks has been to commit capital to CMHC-insured mortgages as quickly as they receive applications.  It is not mortgage lending in the traditional sense, more like underwriting government bonds and taking a 150 basis point spread as compensation.  In this way, the Canadian real-estate bubble looks a lot like its American cousin.  Home loans are being written for those who likely cannot pay by lenders who pass through the credit risk to a third party.  However, in the case of Canada, the third party is our own government and not the Chinese or Saudis who snapped up American mortgage paper.

The Impact on Canadian Banks of a Bubble Burst

 

That which cannot go on forever will not.  Sooner or later Canada’s housing market will conform with that of the rest of the world and begin to decline in earnest.  What the specific catalyst will be, I do not know.  Will unemployment spike, so that buyers disappear even for mortgages with favorable terms?  Will Canadian sovereign interest rates rise, choking refinance?  Will existing homeowners decide to dump their residences onto the market en masse?  Maybe all three will occur.  But the housing mania will stop.

When it stops, I expect the impact on the banks will be severe.  In its 2008 stress test (which assumed an annualized 2% decline in GDP over six quarters, co-incident with modest housing market declines) the Bank of Canada estimated that losses to the Canadian banking system would amount to only about 10% of book equity.  It would be nice if the “stress test” turns out to be accurate, but one gets the feeling that it contains more wishful thinking than serious confrontation of the problem.

 

The banks’ loan books face both short-term and long-term problems.  In the short-term, we see US housing starts down by 60% and auto sales down over 40% this year.  Therefore it seems quite possible that US GDP may shrink in 2009 by at least the 6.3% rate of the first quarter.  In the circumstances, the Bank of Canada’s “stress test” of a 2% annualized decline in Canadian GDP seems optimistic.

 

Over the longer term, the Canadian banks face the familiar “black hole” problem created around the world by the real-estate bubble.  Consumers will need to cut spending on other things in order to feed the massive debts incurred through real estate.  Government will need to raise what little private capital is remaining in order to offset its suddenly shrinking tax base and to mop up the inevitable mess being created by the CMHC.

 

Levered “only” 12:1, Canadian banks may find that loan delinquencies rise beyond historic levels.  The “good” mortgages, consumer credit and business loans all look vulnerable when one looks at individual cases with which we are familiar.  Could the market value of the loan book of Canadian chartered banks be less than 92% of its face value?  Quite possibly in my view.

 

Other business diversifications of recent years appear unlikely to offset pending difficulty in the banks’ Canadian loan book.  Will the Bank of Nova Scotia’s recent string of Latin American bank acquisitions shore up its results?  Will Royal Bank’s 2008 acquisition of a large Canadian mutual fund manager be viewed by history as a game-saving play?  How about TD’s 2007 acquisition of US regional player Banknorth? My guess is that the strategic moves made at the market top may turn out to be ill-advised.

The Way Out

 

There is of course a way out.  The Canadian state can print money to deleverage the economy.  This is hardly an un-traveled path in global economic history.  The classic formula is to withstand the shock of a brutal recession for about three years and then execute a back-door default on domestic and foreign loan obligations through debt monetization, devaluation and inflation.

 

There are banks which survive in such a meltdown, but they rarely do so at multiples of over 2X pre-crisis book equity.  Frankly, I would expect most Canadian banks to require some form of bailout in the aftermath of a bursting real estate bubble.  Given the lofty prices available now, there is only one rational move.  Sell the banks.

Comments

[daveM]

Your theory will be proven to be true in the coming months, even though we Canadians are lead to believe that we are insulated from the problems in the rest of the world.

[Bill]

There are some well supported points here. But, there are some conclusions with no supporting arguments to back them.

How does high price to income housing levels = "sub-prime excesses"? and

How does CMHC insured mortgages = "Home loans are being written for those who likely cannot pay"?

Additionally, while it is likely Canada is behind other countries in our economic cycle, and that some pain may still come, it is possible that our tardiness in pursuing the most creative and exotic mortgages may mean we miss the full wrath of a meltdown.

It is possible that as our banks were just getting going on the really bad lending, and other markets began to implode, we were able to learn from others mistakes and pull back before too much damage was done.

More good luck than good strategy to be sure.

[mike macdonald]

The article starts out sounding reasonable, but quickly veers to "opinions" which do not seem all that plausible. If the worst happened and the market collapses as forecast, most losses should flow to CMHC. At best your points suggest the Canadian banks get sideswiped by the economy.
I see no data on the mortgage to equity ratios in Canada versus the U.S.but I believe it would show Canadians own a much higher percentage of our homes. Almost all Canadian mortgages are at current rates, not impacted by "resets" that were a key factor in the U.S. collapse. Canada does not allow home owners to mail the keys back with no recourse, another U.S. factor that promotes abandoning homes to the bank.
Your argument is not that thorough or substantial.

[Jiffy Trex]

The article sounds reasonable to me but I admit I'm not that informed. If losses do flow to CMHC doesn't that affect us all anyway? Who is bailing them out? Being not that well informed makes me take a very practical look at mortgage lending these day. Anyone gone to the bank lately to get a mortgage and been told you can afford 2.5 times what you know you can? Take a look at the price of homes and who is living in them. No way can many people be living other than just making the payments and robbing Peter to pay Paul. No, no I'm not talking about all you executives and bank managers out there getting the really big bonuses and the low low interest rates, I'm talking about all us little people.

[Justin]

CMHC insures $630 billion, according to you. Lets say that the average mortgager has a 10% equity stake in these "questionable" mortages (individual varies between 5% and 20%). That gives us $700 billion real estate value, with $70 billion of the mortager's equity at stake.

Say the real estate market plunges 35%, and lets say also that this causes 1 out of every 5 CMHC mortages to default. That leaves $140 billion in real estate value defaulting(20% of CMHC's $700 protected equity). Of that $140, the foreclosure value recovered will be 65% of $140 = $91. Add to this the $14 billion of owner's own equity leaves us with $105 billion. Add to this the $8 billion in capital reserves leaves us with $113 billion to offset the $140 billion foreclosure losses. The shortfall is $27 billion.

So, in this extreme, unlikely scenario, government would have to cover an additional $27 billion. Its not a good outcome, but I don't think it's the abandon-ship horror story you're portraying.

[Simon van Norden]

Geoff;

I'm a finance professor and I'm curious to know why you think that the ratio of peak home prices to average income is a reliable indicator of bubbles. How well has this worked in these three countries in the past? Is this a strong statistical relationship?

[Adil]

Fantastic post Geoff!

I agree 100%! I suspect that when things truly turn in the Canadian housing market & banking sector, it will be swift and severe, and I have always felt that CMHC doing some type of Fannie/Freddie meltdown would need to be a part of it.

One only needs to look at Iceland or Ireland to see how quickly a country can go from a positive model to a pariah.

Adil
http://canadahousingcrash.blogspot.com

[Jase]

Geoff, very interesting article and a viewpoint that just doesn't seem to make it into our national media. We spend so much time patting ourselves on the back and congratulating ourselves about how we are so much better than the US and that our lending practices and house Bubble is "different".

I live in Alberta and I just shake my head when I see the kind of loans that have been given out to people to buy a house. These are individuals who during normal times would not qualify for 150,000 yet they were somehow able to secure a loan for 400,000 plus? How? Through a mortgage broker? We have non stop ads running on local radio from a company called Alpine Mortgage that basically states that if you have bad credit, no income or if banks have turned you down for a loan, that they will give you a loan if you own a house. There are probably dozens of other companies running the same promotions and I just don't understand how with this going on, we can call ourselves more responsible than the US and it's system? They are more than likely basing these loans on these grossly over inflated home prices. What happens to companies like this when, not if, housing prices take their much needed nose dive?

[dave]

Justin at July 03, 2009 at 11:54 AM

Some observations on your numbers analysis.

Owners equity will range from -5% to 20% (and not 5% to 20% as you state). There were 0% mortgages available from 06-08, and also the CMHC insurance fee is usually added to the mortgage amount. Also, many times a seller will include various other fees/taxes into the purchase price and kick it back to the buyer.

Your assumption that the defaulting owners would have 10% equity (ie equal to the average) seems unlikely. The less equity an owner has (negative? 0%? 5%?), the more likely they are to default. I'll use an avg equity on defaulting properties of 6% in my calculations below

If the market has dropped by 35%, then the resale value to the bank/CMHC would be less than 60%. This is because you must consider agents fees(4%?), carrying costs (mortgage at 4%, property taxes at 2%, misc costs & condo fees at 2%, equals 8% annual) until the bank/CMHC can sell (9 months@8%=6%?), other costs(staging? unpaid prior property taxes? disrepair 3%?). My assumptions here equal 13% of the 65%. (ie resale value of 56.55%)

Furthermore, if the market drops by 35%, not all properties will drop equally. Lower value units tend to be more reliant on cheap mortgages, and owners tend to have less equity. I'd suggest that a lower avg drop in the market (20-25%) could still see a 35% avg drop in the value of defaulting properties.

Recalculating your figures using my notes:
$700b x 20%=$140b
Resale $140b x 56.55%=$79.2b (vs $91b)
Loss $140b - $79.8b=$60.8b (vs $49b)
Existing equity 6%x$140b=$8.4b (vs $14b)
Cost to CMHC $60.2b -$8.4b=$52.4b

My opinion is that we will indeed see a 20% drop in residential real estate in Canada, and we will also see a large number of defaults.

While we don't have the jingle mail of the US, we have another problem in that all mortgages in Canada are typically for 5 year terms vs the US where 30yr terms are standard.

However, I think the default rate will likely be less than the 1 in 5 (20%) in your example. I think a more likely default rate is 10%, and thus a cost the the taxpayer of $26b (ie half of the $52b in my calculations above).

[Iuliana Plesea]

hello geoff,

Just a quick question : what is your source for the numbers : CMHC capital and the total amount of insured mortgages?

Thanks
Iuliana

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