Grant's Interest Rate Observer

Canada Real Estate Crash Coming?

HELOCopter money

The adage that “trees don’t grow to the sky” is being put to the test in the Great White North.   Despite a pullback in Toronto-area home prices in recent months, the Canadian housing market stands out even in this bull market-in-everything world:  The Canadian Real Estate Association’s MLS Home Price Index has risen by 130% since the beginning of 2005, more than double the 53% rise in nominal GDP over that period.  

As night follows day, rising prices are met with increased supply.  Thus, Bloomberg reported on Friday that Canadian developers are undertaking a record number of multiple-unit construction projects as they seek to participate in the boom.  Robert Kavcic, economist at BMO Capital Markets, commented that: “Canadian home building activity remains rock solid. Builders in the biggest cities appear to be responding to supply shortages as best as possible.”  The severity of these shortages, in Toronto at least, is disputable. Supply of new listings in Canada’s largest metro area has jumped by 37% year-over-year in November.

Local regulators have likewise moved to slow down the housing market’s ascent.  Canada’s Office of the Superintendent of Financial Institutions (OSFI) is introducing new regulations, set to take effect on Jan. 1, which aim to tighten lending standards. Among the new requirements is a mandate that borrowers who plunk down less than 20% of the value of the home must purchase mortgage insurance, a potentially significant additional cost. CBC News estimates that the insurance could cost buyers anywhere between 0.6% and 4.5% of the value of their home over the course of their loan. 

It may come as no great surprise to learn that the great Canadian housing bull market has been built on a foundation of debt.  Consumer debt as a percentage of disposable income has undergone a near-constant uptick since the turn of the century, reaching a fresh high water mark of 167.8% as of the end of the second quarter, compared to 144% in the U.S. in 2007.  Seth Daniels, founding partner of JKD Capital in Boston, advises Grant’s via email that the encumbrances are particularly concentrated in home equity lines of credit, or HELOCS.

HELOCs, as a percentage of GDP [13.5% as of year-end 2016], are roughly three times higher in Canada then in the US at the peak of our housing bubble in 2006. In addition to consumption (“using your house as an ATM”) and borrowing to avoid delinquencies on other debt, Canadians have been using HELOCs to fund mortgages in the shadow banking market and buy additional speculative properties—I call them weapons of mass destruction. 

In an echo of the 1980’s-vintage Japanese practice of “Zaitech,” Daniels also noted in an Oct. 16 interview with MoneyGeek.com that “People in Canada have been borrowing against their home equity line of credit - to lend to subprime borrowers directly.” Indeed, this linked piece from the Toronto Globe and Mail provides a detailed roadmap for readers who wish to use their home equity for investment purposes, in s ervice of “leveraging their real estate assets to increase their net worth.”

Back in June, executives at Home Capital Group, Inc. agreed to pay upward of C$30 million in settlements over alleged disclosure violations related to mortgage fraud in 2015.  On Nov. 30, Reuters reported that “compliance officers at the Financial Services Commission of Ontario had evidence that syndicated mortgages were being marketed and sold in ways that broke the law . . . From 2011 to 2015, senior FSCO investigators rejected or ignored compliance officers’ multiple recommendations that the agency investigate or take action to rein in the marketing and sales of Fortress [Real Developments] syndicated mortgages.” Last week, Montreal-headquartered Laurentian Bank disclosed that it will need to buy back as much as $180 million of mortgages after discovering “documentation issues and client misrepresentations.” 

François Desjardins, president and CEO of Laurentian, defended his bank: “We’re very different organizations and this is a very different situation than what happened at Home [Capital]. This, to us, is really a process and paperwork issue that we have to resolve.” This morning, Laurentian issued a follow-up press release stating that: “Given recent reports in the media, the Bank wants to clarify why it does not believe these matters are material to its business, capital, operations and funding.”

Daniels sees things differently, telling Grant’s that:

The mortgage inconsistencies reported at Laurentian Bank (the third major Canadian financial institution to fess up to this problem) underscores what we have long believed to be a systemic problem with Canadian underwriting practices. 

Canada hasn’t seen a true credit cycle in nearly three decades, which warps the judgment of market participants and regulators alike.

Time for a refresher course?