Spring Mortgage Market Update (2012)

It’s time for the powers that be to pick our poison.

Do they keep short-term interest rates at ultra-low levels to protect our broader economy from the economic turmoil still raging beyond our borders, even if doing so increases the risk of a debt bubble?

Should they instead raise short-term rates (and longer-term rates, by association) to slow household borrowing and restrain house-price appreciation in major markets like Toronto and Vancouver, even if doing this could stall our still vulnerable economic momentum?

Or do they try to isolate mortgage borrowing, the area of greatest concern, by tightening regulations and underwriting standards at the risk of triggering the very house price correction they seek to avoid?    

Faced with this unenviable set of choices, the federal government and our regulators appear to have settled on a way forward and that will be a game changer for the mortgage and housing market as we know it. Today’s post, my Quarterly Mortgage Market Update, will review how we got to this fork in the road, detail what changes are coming down the pipe, and explain how all of this is likely to affect mortgage borrowers. Then I’ll close with my usual take on where both fixed and variable-mortgage rates may be headed.

The still unfolding global financial crisis started when the U.S. housing and debt bubbles burst, creating a systemic shock that tested the strength of every country’s financial system. While Canada was well positioned with a strong federal balance sheet and a well-regulated banking sector, there was no telling what the implications of the crisis would be for our economy. After all, we continue to rely on the U.S. market for about 80% of our export revenues.

Bank of Canada (BoC) Governor Mark Carney’s initial response was to cut our short-term interest rates to emergency levels while the rest of us held our collective breath. Mr. Carney wanted to stimulate domestic spending to replace lost export demand, and to encourage businesses to invest in much needed productivity enhancements. (Productivity levels are a measure of how efficiently businesses use their capital, and Canada has lagged well behind the U.S. in this measure for some time).

It worked.

Our economy hung in beautifully as Canadian consumers started spending more and our businesses improved their productivity. Canada was seen as a model of stability and investors rewarded us by increasing their demand for our government bonds, which in turn drove our mortgage borrowing costs down to the ultra-low levels we enjoy today.

But there’s another side to the potentially Faustian bargain Mr. Carney struck at the outset of the financial crisis, because the economic growth that was fueled by our dirt cheap interest rates also spawned some potentially destabilizing side-effects: record consumer debt levels and sharply increasing house prices.

Governor Carney’s balancing act was made even more difficult because while he controls the best single lever for stimulating economic growth (lower short-term interest rates), he has always expressed reluctance to use that same lever to raise rates in order to reign in household borrowing. Mr Carney has long stated his belief that this approach would over-tax our still-vulnerable economy and that increased regulation of the mortgage market by the federal government is instead a better and more targeted response.

Enter Federal Finance Minister, Jim Flaherty, who has made three rounds of changes to the guidelines used by the Canada Mortgage and Housing Corporation (CMHC) over a three-year period ending in 2011. (CMHC is the dominant provider of mortgage default insurance, which is mandatory for all borrowers who have less than 20% equity in their property). These changes were substantial, and while I am no fan of government attempts at regulation in general, I had to (and did) hand it to Mr. Flaherty – his changes were intelligent, necessary, and while material, were not over-reaching.

Unfortunately though, these carefully thought out changes have not yet produced the desired result, largely because unprecedented demand for our government bonds has kept our bond rates (and, by association, our fixed-mortgage rates) at ultra-low levels. This continued demand creates the ideal conditions for rising debt levels and increased house prices.

Which brings us to today, and the draft paper with the boring name that was recently published by the Office of the Superintendent of Financial Institutions (OSFI) called “Residential Mortgage Underwriting Practices and Procedures”. (OSFI is Canada’s banking regulator and the quality of their oversight is the main reason why our financial system did not go off the rails when the U.S. debt bubble was in its approve-everyone-for-as-much-as-you-can-as-fast-as-you-can-mode.) The paper recommends some dramatic changes to the way mortgages are underwritten by our lenders, and while I think many of the recommendations are appropriate under the circumstances, I think that others will unfairly penalize certain borrower sub-groups and could even destabilize our real-estate markets at the worst possible time.

Here are the highlights of the report’s proposals with my comments in italics (Rob McLister at Canadian Mortgage Trends first broke this story and he wrote a first-rate article on the coming changes that you can find here.):

• Home-equity-line-of-credits (HELOCs) should be limited to a maximum of 65% of the value of a property (down from 80% today) and they should be amortized over a reasonable period (instead of requiring interest-only payments, as they do today).

I’m going to disagree with the vast majority of my mortgage broker colleagues on this one. The consensus view is that this change unfairly punishes the many borrowers who use their HELOCs responsibly in order to protect our financial system from the minority of HELOC borrowers who do not. 

We simply cannot ignore the fact that HELOCs were the poison chalice for U.S. borrowers and if we do not learn from history we will be doomed to repeat it. We have already seen an alarming rise in HELOC debt as a percentage of our total debt outstanding, and since these loans are non-amortizing (which means borrowers are only required to pay the interest due each month), HELOCS pose the mother-of-all payment-shock risk.

While I agree that most borrowers use HELOCs responsibly, markets are made at the margin and we can’t ignore the potential damage that a small but significant subset of irresponsible HELOC borrowers can inflict on our real estate markets and broader economy. I don’t know if limiting HELOCs to 65% is the right number (who does?), and I wish lenders had decided to price their HELOCs with sliding interest-rate scales based on loan-to-value (which would have created a strong disincentive against using them so freely), but based on where we are today I think OSFI is at least moving in the right direction with their HELOC proposals.  

• Stop allowing borrowers to use cash backs as down payments. (Cash backs are loans where lenders literally hand borrowers cash on the day of closing and charge a much higher interest rate in exchange).

Good riddance. If you can’t come up with 5% of the value of the property then you’re not ready to buy a house. This change is long overdue.

• Financial institutions who buy and pool mortgages from third-party lenders will need to ensure that those lenders are underwriting their loans properly.

Yes. Another lesson learned from the U.S. debt bubble: When mortgages get passed like hot potatoes it is very easy for lending standards to slip (see: moral hazard).

• Use the Bank of Canada’s benchmark rate (defined below) for qualifying all variable-rate mortgages and for fixed-rate mortgage with terms of less than 5 years. (Today only insured mortgages where the borrower is making a down payment of less than 20% must meet this standard.)

I agree that some kind of test for borrowers who could see their mortgage payments fluctuate, or who will have to renew their initial fixed rate in less than five years, is prudent. But I wonder if we’ve put enough thought into why that rate should be based on the average five-year posted rates at Canada’s largest six banks.

Posted rates are almost never used for actual lending (they are mostly used for inflating mortgage penalties in my experience) and basing such an important standard on the arbitrary rates of industry players who may at different times have a vested interest in the qualifying rate’s rise or fall creates plenty of potential for conflicts of interest. I think the qualifying rate should be based on a set spread over the five-year fixed rates that lenders actually use, and that the rate should be derived from a broader group of lenders than just the Big Six.

• Heavier regulation of “stated-income” loans, where a borrower’s income is not verified using traditional methods.

Stated-income loans have been around for longer than I have. While they come with an increased level of risk, lenders know how to mitigate that risk if other factors are present, such as high credit scores, substantial amounts of borrower equity in a property, additional liquid assets, strong business incomes and by using a reasonability test for each borrower’s stated-income amount.

While I think OSFI is right to monitor stated-income loans closely, I worry that the regulator is determined to eliminate this kind of lending altogether. That would unfairly resign many of Canada’s almost three million self-employed borrowers to higher-interest rates or lock them out of the lending market altogether. 

• Requiring lenders to update the appraised values of mortgaged properties at renewal.

OSFI was a little vague on this point but it certainly begs the question: If OSFI will now require appraisals at renewal, what happens if those revised values put a loan underwater? Will lenders be expected to ask high-ratio borrowers to make up any short fall if they want to renew? If so, is it that hard to imagine a flood of panic selling? And are we really going to force borrowers with excellent repayment history out of their homes because they can’t make up the difference?

Again, the details on this were vague but this one could be a loaded grenade if all of the implications are not taken into account.

I think the main concern for many of the real-estate industry’s stakeholders is that so many changes have been made over a relatively short period and that we can’t yet know what their collective impact will be (today’s post only highlighted the biggest changes – there were several smaller ones as well). For now OSFI deserves the benefit of the doubt because they have kept us off of the rocks in some pretty rough waters. But that said, the risk of a policy-engineered housing-market correction increases with each turn of the regulator’s tourniquet.

I think fixed rates…

still aren’t going anywhere fast. If you’re an investor looking for a safe place to park your money, Government of Canada (GoC) bonds are on a very short list of the best options available. Canada enjoys a solid federal balance sheet, our central bank has not engaged in quantitative easing, our banking sector is profitable and well regulated, our economic growth exists without rampant and unsustainable government stimulus and we have an abundant supply of the four commodities that the world can’t live without: food, fuel, forests and fresh water.

While these strong fundamentals would make GoC bonds attractive to investors in any economic weather, the unhealthy state of most of the world’s economies has fueled plenty of additional demand for our bonds since the financial crisis began. As noted above, this has driven their yields down to extraordinarily low levels and it is those same yields that are underpinning today’s ultra-low mortgage rates.

This relationship is why I think our mortgage rates will continue to stay low for as long as fear and uncertainty about the future of so many leading economies abounds (barring a systemic financial collapse that raises the cost of borrowing in every corner of the globe).

Here are the top four reasons why I think that fear will continue to dominate investor behaviour for the foreseeable future (regular readers will notice several familiar themes from my Monday Morning Interest Rate Updates):

1. The euro zone is still deeply mired in its financial crisis. The bond markets loved the euro zone’s Long-Term Refinancing Operation (LTRO), but this ‘trash-for-cash’ program only bought time (and apparently less of it than many were expecting now that Spanish and Italian ten-year government bond yields are almost back to the critical 6% level – which many experts believe is unsustainable over time).

The last of the LTRO’s more than US$1.3 trillion in cheap loans will become due and payable in early 2015, which is not that far off, and when you look at the impact of this operation in hindsight, all it really did was shift the foreign-held sovereign debt of the euro zone’s struggling peripheral countries on to the already weak balance sheets of their domestic banks. In my view, this was akin to letting these mostly underwater banks double down while trying to make an inside straight. I find it very difficult to imagine how this will end well.

2. Spain, more specifically, presents the most immediate and growing risk to the euro zone right now. It is a country both too big to save and too big to fail. Spain has 24% unemployment (50% for its youths), a huge budget deficit and a housing bubble that would make a Floridian blush. The country is now grappling with violent protests in opposition to austerity measures that seem to stretch into the future about as far as the eye can see, and at this point, is it really that hard to picture Spain going the way of Greece?

3. China’s growth rate is declining. The country’s GDP growth averaged 11% from 2005-11 and during the halcyon days of this export-led boom period, China acted as the world’s engine of economic growth. Contrast that with today, when the Chinese government is targeting only 7.5% annual GDP growth in the face of slowing export demand. That may sound like nothing to complain about in countries that are averaging 2% GDP growth, but it represents a significant loss of economic momentum for China and the knock-on effects of this reduced growth rate will have its greatest impact on commodity-based economies like ours.

The long-term solution for China seems clear: It must move its economic model away from export-led growth and refocus it instead on domestic consumer spending. But this rebalancing will be especially difficult in a country whose government emphasizes stability at all cost. Consider that today more than a billion Chinese live in households that earn less than $6 a day and that consumer spending currently accounts for only 30% of GDP (vs. about 70% in U.S.). It’s going to take a while for China to adjust and in the meantime, the world will struggle to replace its lost momentum.

4. The strength of the U.S. recovery is still very much open for debate. Over the past three years the U.S. federal reserve has tripled the size of its balance sheet while holding its policy rate 0% at the same time that the U.S. federal government has run fiscal deficits of more than $1 trillion/year. And yet these extraordinary measures have corresponded with the weakest economic recovery in U.S. history. When you consider that combined U.S. household and government debt has now ballooned to more than 200% of the country’s GDP, and that the federal government borrows 42 cents for each and every dollar it spends, one has to wonder what the country’s 2-3% GDP growth rates would look like without all of that (unsustainable) support.

As an aside, while U.S. economic data has shown some encouraging signs recently, I don’t think most stakeholders are recognizing the huge boost that this year’s abnormally warm winter had on those numbers. Seasonal work was able to start much earlier than normal, fewer man hours were lost due to weather, the average American enjoyed a substantial saving on the cost of heating and many used that one-time break to boost their discretionary spending.

These factors propped up the data and offered plenty of bull market Kool Aid to willing drinkers. But I worry that reality will kick in this summer when lower-than-normal-heating-bills are replaced with higher-than-normal gasoline bills and the U.S. employment numbers don’t get their usual boost because seasonal hiring was brought forward into the winter months already passed.

If I’m right and these four trouble spots continue to stoke investor fear and uncertainty, then fixed-mortgage rates should stay low for the foreseeable future. But there’s a catch (isn’t there always?)

In the euro zone and the U.S. (and to a lesser extent China), the governments have used massive liquidity injections to try to stimulate their way out of the trouble they now find themselves in, essentially pouring new money into their economies in the same way that you would prime an engine with gas to try to get it going again. But this ill-fated attempt at a quick-fix is a recipe for long-term inflation (and not the mild kind), and that means that rates could rise quickly when all of that money eventually moves off of bank balance sheets (where it now sits idle) and starts circulating in the economy. Put another way: We may not get a lot of warning when the low-rate party finally ends.

In today’s environment borrowers who want to squeeze every possible penny of interest rate savings out of their mortgage are opting for a short-term fixed rate mortgage that will come up for renewal before they think the next rising-rate-cycle will begin in earnest. One can only guess on the exact timing, but these types of borrowers are tending to gravitate towards three-year fixed rate promotions in the 2.9% range. Conversely, more conservative borrowers who are willing to pay a little more now for long-term security are jumping on the ten-year fixed rate at 3.84% – for what it’s worth, if I needed a mortgage today this is what I would be doing. (When you consider that the five-year fixed rate has average about 5% over the last decade, ten-year money at less than 4% looks like a steal).

I think variable rates…

Will stay lower for longer than most experts are forecasting. Last week, much was made of Mr. Carney’s most recent comments that an earlier-than-anticipated-rate-increase may be in the offing. As mentioned above, the BoC Governor is clearly worried about household consumer debt levels and he knows that his comments can move markets. That said, and with all due respect to Mr. Carney, I believe that variable rates will ride the same wave that is keeping fixed rates low for all of the same reasons.

While current variable rates are still priced too close to comparable fixed rates to be compelling, I think existing variable-rate mortgage holders with discounts of prime minus .70% or better who have a significant amount time left on their mortgages are still well positioned.

The bottom line: International financial markets are dangerously unstable and the Canadian mortgage market is undergoing considerable change. The results of this potent cocktail cannot be completely foreseen, but I believe that now is a time for caution.

As such, I think locking in today’s historically low rates for as long as possible is a low-risk move that will also offer the potential for some significant interest-rate savings over the medium term.

When the forecast calls for rain, you are well advised to start looking for an umbrella.