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adrw // Andrew Alexander

Principles For Navigating Big Debt Crises: 2019 Canadian Real Estate

Finance13 min read

Canada RE looks like a bubble. If it is can we short it like saavy investors in the US could?

Canadian household debt-to-income ratios are at record highs. As the US ratios dipped and have recovered to 2007 levels in the past 10 years, Canada's ratio continued up and to the right since 2007 to it's current ratio well over 1.8. Housing prices have continued to soar, in some city markets going up over 15% per year. Affordability ratios of almost every measure are higher than they have ever been in Canada. How did this happen?

Below, I've applied principles and patterns I've learned from Ray Dalio's book Principles For Navigating Big Debt Crises.

What happened in 2008?

The most direct cause of the 2008 "Great Recession" was the popping of the US real estate (and specifically sub-prime real estate) bubble starting in 2007. Mortgage affordability policy put into place by President George W. Bush had forced banks to lower their lending requirements in the early 2000s and lend to a broader spectrum of the public both by demographic, and specifically by risk profile.

The ability for issuing banks to then securitize and sell their mortgage debt on financial markets removed the consequences of increasingly riskier mortgages being issued away from the issuer and put it on to investors. These investors included investment banks, pension funds, and individuals who by purchasing the mortgage backed securities were buying the series of cash flows from the mortgages. Instead of the issuing bank, say Bank of America, keeping your mortgage payments, the proceeds from those payments would instead flow to the holder of the debt securities.

The perpetual pipeline of packaging mortgages of decreasing quality into securities went by undetected because of innacurate ratings (often incentivized by the banks) by ratings agencies like Moody's and S&P. Though their role was to do a thorough analysis of the underlying assets of every security and provide a letter rating proportional to the risk, most agencies simply rubber stamped securities as high grade (ie. AA) if they included a single high grade mortgage. The mortgage securities comprised of many, many underlying mortgages in each issuance so many much higher risk "subprime" mortgages could be included in a security that was rated as low-risk AA debt.

The collapse of investment banks like Lehman Brothers was as a result of them holding a large amount of bad quality mortgage backed securities on their balance sheets (purchased in their own investments or on behalf of clients) and the value of those securities dropping precipitously as the value of the underlying mortgages crashed. The mortgage value would crash when homeowners could no longer make mortgage payments.

Homeowners stopped making their mortgage payments for a few reasons. First, the nature of "subprime" mortgages was that they were offered to people who by any amount of common sense could not afford the mortgage. Extremely relaxed downpayment requirements and other terms meant that people with less than $50k income per year could take out a mortgage on a $1 million house, and then weeks later use that first house as collateral to take out another mortgage on another house.

Mortgage issuing institutions incentivized mortgage deal flow, regardless of the risk, because within months of issuing they could complete the securitization of that batch of mortgages and sell them to investors, offloading any of the mortgage risk from their books.

Second, as these "subprime" borrowers encountered the volatility of life and found they couldn't make house payments anymore, they would default on their mortgage, be evicted from their properties, go through the United States' much easier bankrtupcy proceedings, and continue with their life. As certain neighbourhoods became filled with vacant, foreclosed homes, the value of the surrounding homes stopped growing at the same fast pace it had in previous years, and in some cases began to drop. For homeowners who had purchased their home to speculate in the fast growing market, assuming continue large year to year price gains, they soon were unable to afford their house, or found themselves house poor. This meant that they owed more on their mortgage than their house was worth, and because of the United States' easier personal bankruptcy laws, these owners had less friction to mailing their house keys to their bank, and walking away from their mortgage.

The primary impact on the issuing banks was an enormous reduction in their mortgage deal flow. For any investors or banks that held mortgage backed securities, they stopped receiving mortgage payments from homeowners and the value of the homes that the mortgages were taken out against was dropping quickly. Because of the leveraged nature that many had invested in these securities, it didn't even take a default rate as high as 10% for the value of the securities to become near worthless.

Banks began to fail because of their now worthless mortgage backed security assets and the related effects of the real estate crash rippled through the economy to cause the significant 2008 recession. The central bank, as it does during economic downtimes, reduced interest rates to incentivize investment and business activitiy but there was little improvement as the bank continued to drop rates and finally hit 0%. The last time the central bank had hit 0% interest rates in the US was at the bottom of the Great Depression in the 1930s.

When interest rates hit 0%, central banks have to turn to other strategies to stimulate the economy. The one that was employed significantly in the US was reported in the news as Quantitative Easing. It was a "monetization" strategy, or one that involved the Federal Reserve printing US currency and then using that new money to buy financial assets in open markets and free up debt laden banks and institutions from worthless assets on their balance sheets. The Federal Reserve in the US spent well over \$1 Trillion USD in the years following the initial real estate crash buying bad mortgage backed securities and other financial assets from banks in hopes that their restored balance sheets would allow them to increase lending and economic activity.

Banks following 2008 were very slow to do this and note that not every bank had their bad assets purchased. Some were allowed to go bankrupt, like Lehman Brothers and others, like Bear Stearns were allowed to fail gracefully into a merger with another larger bank, in their case JPMorgan Chase.

Therefore, as an investor who knew this was going to happen in the US before the real estate market crashed, here are a few of the strategies that would have let you profit off of the crash.

Credit default swaps, or the purchase of insurance against the default of mortgage backed securities, was a strategy employed by some smarter hedge funds and investors which let them collect insurance money when mortgage backed securities began to fail and default. Other investors who had evaluated which banks and institutions were most vulnerable to the real estate market and had the highest holdings of "subprime" mortgage backed securities were able to short the stocks of those banks and profit as their stock price tanked in fall 2008. And of course, one of the most illiquid options, you could wait for real estate markets to bottom out, purchase real estate, and then wait over the next decade for prices to recover (some areas still have not).

What about the True, North, Strong, and Indebted

The Canadian real estate market crash, if there is one, will be different in many factors including the cause, effect on homebuyers, and opportunities for investors.

In 2008 as the US economy reaped the losses of their 2000s "subprime" mortgage craze, Canadians and our oligopoly of regulated banks, observed smugly, immune from the bad mortgage debts that were taking down American financial institutions. The Canadian economy, tightly tied to the US economy, with almost half of our economic activity generated in part by the US, did suffer as did the rest of the world as a secondary effect of the domestic US economy crash.

Yet, the impact to Canada on its own probably did not justify the rate cut that the Bank of Canada did in response to the 2008 crash bringing Canadian interest rates down to 0%. While the American Federal Reserve can move their interest rates somewhat independently of other countries due to their economic superiority, world reserve currency, and dominance worldwide, the Bank of Canada has more constraints placed on how they can move rates.

The interest rates set by the Bank of Canada can significantly effect the US / Canadian dollar exchange rate meaning that any interest rate policy also has to take into effect the economic impact that a higher exchange rate would have on Canadian exporters, primarily that to American purchases, Canadian products effectively increase in price. Therefore, the Bank of Canada tends to move interest rates in parity with the US Federal Reserve to maintain stability, and generally a less than parity exchange rate, to ensure a continued price advantage to Canadian exporting companies selling to American customers.

Interest rate policy has a broad far reaching impact on the economy touching everything from consumer debt to exchange rates to business investment. The historically low 0% or near 0% interest rates seen in Canada in the years following the Great Recessions not only failed to keep the Canadian dollar from reaching parity with the US, which it did for the majority of months in 2010-2014, but also overstimulated business investment in construction and real estate.

Specifically for consumers, the historically low interest rates allowed Canadian households to qualify for larger mortgages than they could afford when interest rates were closer to their historical averages above 5%. Thus, like in the US when mortgage requirements were reduced to allow more "subprime" purchases, families were able to afford homes that in historically normal conditions, with respect to interest rates, that they could not afford.

Domestic home buyers and foreign real estate investors flooded into the Canadian markets, especially in the cities. Though many foreign investors could purchase real estate in cash, Canadian consumers continued to rely on mortgages and thus tie their financial wellbeing for the next 20-30 years tightly to the Bank of Canada interest rates and their local real estate market.

But how is the mortgage interest rate and the monthly interest portion of a mortgage determined? There are a few determining factors. They include, the Bank of Canada prime lending rate which determines the bank or lending institution's prime rate (the lowest interest rate they'll offer); the homeowner's credit score which determines how big of a risk premium lending institutions add as an interest percentage on top of the prime rate; the initial downpayment on the house as a percentage of the purchase price, if it is below 20% then in Canada there is a mandatory mortgage default insurance cost of 2.80-4.00% * of the purchase price that is added to the price of the house therefore leading to a higher principle and thus higher interest cost per month; and other factors including bi-weekly or monthly payments, flexible payback mortgage options and others.

Central banks in any given year could end up changing interest rates multiple times but does that mean that each homeowner ends up with mortgage payments changing every few months? To let homeowners better budget with a predictable mortgage payment, lending institutions give them the option to lock in an interest rate for a period of time.

Since this option acts as a bet on the direction of short term interest rates, interest rate premiums for fixed interest mortgages tend to be proportional to the amount of time that the rate is locked in, especially when interest rates are low (since surely, they will go trend back towards historical higher levels). For example, some current rate options offered include 3.5% for a variable rate mortgage (where rates are updated every 6 months), 4.5% fixed rate for 3 years, or 5.3% fixed rate for 5 years.

Note that the fixed 3 or 5 year term is simply locking interest rates in for that period of time. After which, the homeowner chooses to renew another identical length term at the newest interest rate offerings, or to change to another alternative length of time.

Almost for this reason alone, there will not be a single moment in time when we can declare a real estate crash in Canada. That is because as the housing market heated up following interest rate cuts in 2008 and 2009, many homeowners when faced with the decision on period of time to lock in an interest rate, smartly chose to try and lock in what would probably be the lowest rates they would see in their lifetime. The last time interest rates had been near 0 was in the midst of the 1930s Great Depression.

This means that all of the homeowners with mortgages signed during the prolonged low interest rates of the early 2010s will have been practically oblivious to the interest rate crunch they will soon face when their terms comes to renew. For a 2010 home purchaser on a 5 year fixed term, that means their renewal was in 2015. For a 5 year fixed homeowner who bought near the peak in 2015 though, despite numerous rate hikes in the past 18 months, they will not experience any of that until their mortgage terms are renewer in 2020.

Therefore, we are in the midst of a rolling multi year window where homeowners will be facing higher interest rates and thus higher mortgage payments.

But, how much higher? There are many factors that play into the payment curve that determines in each payment how much goes towards paying down principal and how much goes towards interest costs to the lending institutions. In almost every case though, interest payments are front loaded and principal is back loaded. Most of the mortgage payments in the first decade will go towards interest, and that ratio will gradually reverse as the mortgage nears maturity and more of each payment goes towards principal.

Why does this matter to the increase for new homeowners in their regular mortgage payment? Since it is still early in their mortgage, and interest payment is a bigger portion of every payment, interest rate increases will causes a much bigger impact than if interest rates had gone up when they were 5 years from paying the mortgage off.

In one example of a homeowner of a $1 million house that was renewing their mortgage terms at an interest rate 2% higher than their last rate, their mortgage payment of $5200 increased to $6344, a percentage growth in their monthly payment of 22% and absolute increase of $1144 per month, over \$12,ppp per year.

Now, not every homeowner who bought in the early 2010s has a \$1 million dollar house. But, would every homeowner feel the pain of a sudden 22% increase to their mortgage payment? You bet.

Defaulting on a mortgage? That’s not something we do around here

As we reviewed from the US real estate crash of 2008, homeowners that could no longer make their mortgage payment would simply stop paying, default, and return the keys to the bank or wait to be evicted forcibly.

Even homeowners who were house poor, they could still pay but because of their depressed house price owed more on their mortgage than the house was worth, would mail their keys into the bank and default on their mortgage.

This was visible in the progressively increasing mortgage delinquency rates that because of the leveraged nature of many investors in mortgage backed securities, led to the crash of financial institutions. If you could have forecast the effects of mortgage delinquency rates on those downstream institutions, you could have made a lot of money. And investors that did forecast it, did.

So can we do the same with the Canadian real estate market? No, because defaulting is not something that we do here.

Seriously, Canada, though now one of the household indebted countries in the world, has among the lowest mortgage delinquency rates. As the first of those early 2010s homebuyers have begun renewing at higher interest rates, the mortgage delinquency rate has surprisingly gone even lower.

Those low mortgage delinquency rates are deceiving however, and a look at other types of household debt reveal a more accurate picture of Canadian households with increasing levels of deparation and anxiety over their finances.

The most obvious other statistic to examine is aptly called the non-mortgage debt delinquancy rate. Self descriptive, this measure tracks the failure to make payments on other non-mortgage debts such as credit cards, payday loans, or lines of credit. The rapid increases in household consumer debt in recent years has been primarily in households taking on increased debts of these forms.

For cash strapped Canadian families, their own morals to never miss a mortgage payment, has led them to take out excessive alternative debts to continue to fund their lifestyle. In the United States, specifically in the housing crash, foreclosures and voluntary defaults and bankruptcies were much more common.

This indicates not only the difference in personal bankruptcy law in the United States that makes recovering after bankruptcy much easier, but also a difference in values where families in Canada are so focused on continuing mortgage payments on their current house that they dig a bigger hole of non-mortgage debt to finance this dream.

One area of non-mortgage debt that has exploded with multi-fold year over year increases has been home equity lines of credits. Many surveyed took out their line to finance a renovation or expansion to their house on the oft repeated wisdom that such improvements are an “investment” because they increase the value of the home. Though it is theoretically true, the increased value is not something that is liquid and could help provide income relief to cash strapped household budgets the way that a similar investment in yield paying stocks or bonds would provide benefit that could be recognized without the purchase of a house.

Others have used their home equity lines of credit to supplement their cash flow negative lifestyle costs. This means that in a household earning $4000 per month in after tax income, they have cash expenses of over $4000. To cover the monthly deficit many leave credit card balances unpaid, take out payday loans, or more have relied on their home equity line of credit.

A home equity line of credit is a loan that a homeowner can take out against the value of their house. The bank determines the size of the loan largely based on the market value of house that is signed over as collateral. If the loan can’t be repaid, then the bank can take the house and use the proceeds to cover the debt.

The nature of the credit being determined by the market value of the house becomes a significant issue because homeowners at regular intervals can choose to re-finance or update the value of their house at the bank and increase their credit limit.

Thus, a cash poor homeowner living in a neighbourhood where house prices keep going up every year can stave off their insolvency by re-financing their line of credit with an updated higher appraised value of their house.

Just like in 2008 in the US, this all depends not just on prices not going down, but more so on house prices not growing as fast as they have in recent years. A home price that is no different than last year leaves a home owner with a home equity line of credit limit no different than last year.

Therefore, the non-mortgage debt delinquency rate will be one to watch as it may significantly lead indicators like the mortgage delinquency rate at showing whether Canadian households have reached their financial tipping point.

Since, the mortgage payment jumps on updated interest rates will continue slowly over the next many years, the cash flow problems that will lead to higher non-mortgage debt delinquency rates will also likely not be sudden.

If the rate of delinquency is not sufficiently high and is spread out over a period of many years, then it may not significantly cause a crash of payday loan providers or holders or payday loan backed securities for example.

If a point is reached though where families begin to downsize because of their significant financial unsustianability then a glut in the market that pushes house prices down will only serve to reinforce a viscous cycle as Canada’s sky high consumer debt begins to unwind.

Has the deleveraging in Canada already begun

Dalio in his book on Principles for Big Debt Crises, outlines different debt unwinding, or deleveraging, scenarios that include a “beautiful deleveraging” (where monetary inflation .....

Canada centrla bank did first CHMC mortgage debt purchase in December 2018.

Over indebted Canadians have not found some financial escape hatch though, but have simply chosen to

1930, 2008 were deflationary deleveraging, close to beautiful deleveraging 1920s Weimar Republic Germany was inflationary deleveraging

Canada Interest Rate Policy Next Steps

  • If Canada goes to 0 and US doesn’t
  • If Canada and US doesn’t go to 0


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