Thursday, November 26, 2009

Canadian Real Estate Goes Wacky

Consider me one of those that never expected the Canadian RE market to rebound after property values began to sink in 2008. But as we have been reminded by numerous bubbles over the years, parabolic blowoffs can last a lot longer than most imagine. Such is the case in Canada's two primary urban markets, Vancouver and Toronto. A concoction of factors has contributed to rapidly rising prices and euphoric expectations about the future.

Of course, when one has messages like the following being printed by newspapers almost daily, it should be no surprise that Canadians have been duped into believing the unbelievable:
“People are re-entering the market – they have the confidence to take advantage of bargain-basement prices. There's been a release of pent-up demand, and that has a long time to play out. Prices have gone as low as they are going to go.”

The above statement came from Gregory Klump, Chief Economist of the Canadian Real Estate Association. Astute readers may equate those statements with those of David Lereah who held the same position with the National Real Estate Association in the US. Lereah later admitted that his analysis was greatly compromised by the position he held - or in not so nice terms, he was a paid shill for the housing industry in the US. Regardless of this unsurprising revelation, the media here in Canada have no problem quoting Gregory Klump as if he were a legitimate expert worth listening to.

But the parallels don't end there for media treatment of the Canadian and American housing bubbles. Time magazine infamously called the top of the real estate market with their magazine cover titled, "Home $weet Home: Why We're Gaga Over Real Estate."



That was June of 2005 - what later was revealed as the top of the national bubble. It continued in some areas thereafter, but the writing was on the wall. In early November, an eerily similar picture arrived on my doorstep in the local Vancouver paper The Georgia Straight.



Intrigued and terrified I proceeded toward page 19, where the feature article lay. Along the way, I was inundated with full page ads for condo developments and just as many for luxury furnishing. The story started out documenting a 24 year old Indo-Canadian pharmacist's experience in buying his first condo. That was fine. But four paragraphs in, journalistic integrity took a back seat to complete fluff. Quoting the pharmacist:
"One of my friends who I used to live with in university, he's like, 'I feel since you bought your place, you've matured. You've completely changed in the way that you are. Before, we used to live the student lifestyle. Now, you're always cleaning your place. You have plants. You look after them. You've even got a cat now. It's like you're an adult.'"

Pass me a bucket. This reminds me of the disgusting marketing tactics used by penis enlargement pill pushers.

But that isn't all. The article goes on, defining the term "puff piece," quoting the most prominent figures in the local real estate market. First up was Cameron McNeill, real estate marketer:

...McNeill, whose company sold more than a billion dollars worth of real estate in the hot housing market of 2007, told the Straight by phone that he thinks the Olympics will keep a spotlight on Vancouver and magnify positive fundamental factors driving demand. According to him, those factors include low interest rates, a shortage of downtown land, good provincial government stewardship of the economy, and a safe investment climate.

McNeill added that it doesn't make sense to compare Vancouver-which has broad international appeal-to other Winter Games host cities. "Who wants to live in Salt Lake City?" he asked. "Lillehammer? I didn't know that town existed until the Olympics happened."

"I think the Olympics creates a euphoria, he stated. "But honestly, I don't think prices are going to spike preceding or post-Olympics significantly. I believe the real benefit of the Olympics is going to come in one, two, three, four years down the road."

Prices rose uncontrollably as soon as the Olympics were announced. It is something that has contributed to Vancouver becoming the most unaffordable city to live in in the Anglosphere with exception of some coastal paradises in northeast Australia (based on price-income ratios). McNeill also speaks of the oft-cited "land shortage." There is no land shortage - not even in downtown Vancouver. Where more square footage is required, we can build skyward, like any other city. There are blocks upon blocks of tired old buildings just waiting to be bulldozed and redeveloped. The map below is downtown Vancouver. Outlined in red is a huge chunk of largely underutilized land. Light industrial warehouses consume most of it. Century old rail yards take up much of the rest. Limited creativity is needed to see how existing land can be converted for other purposes.



Next up was Bob Rennie, another real estate marketer. Naturally, he echoed McNeill's sentiments:
..."It's after the Olympics that we're going to see the impact on real estate." ... "I don't believe that anyone ran back to Turin or Lillehammer or Salt Lake City... to buy a secondary residence or to move the family to safety or to move some money to safety. Vancouver is on the map. We're a world city. We're a brand."

The above statements will come across to most readers as unparalleled in arrogance. In fact, it is common sentiment here in Vancouver. This is best reflected by the Provincial Government's recent change in our provincial slogan from "Beautiful British Columbia" to "British Columbia: The Best Place On Earth." This, along with the above statements from Rennie and McNeill articulate perfectly the peak social mood this city is in. Despite 24 hour rain and eternal darkness for at least 6 months of the year, these folks can't see why anyone would choose to live elsewhere. Completely lost on them is that nearly everybody in the world is somehow passionate about where they are from, just like they are.

Don't get me wrong. Vancouver is a beautiful city. After traveling to over 20 countries in 5 continents, people ask me where my favourite place is. I answer "home." But while the combination of mountains and the ocean is my idea of paradise, I realize it may not be for others. There may be some wealthy visitors coming for the Olympics, but to contend that enough of them are going to want to buy houses to make an appreciable and lasting impact on the market is disingenuous. They will come and spend money. A tiny fraction will actually buy property, something which the market has already priced in.

But the opposite is also liable to occur. A wave of investors that have been holding supply off the market in anticipation of this event could flood the market just before the games, driving prices down and causing panic in those depending on a bonanza. Keep in mind that prices are still down in an 18 month period. This was not in the plans of investors who assumed prices would rise all the way up to the games. Now that this hasn't happened, industry promoters suggest prices will rise after the games.

The article goes on to quote more of these promoters, continually offering only one side of the story. It is never mentioned that even with mortgage rates at all-time lows, most borrowers are spending in excess of 40% of their incomes on minimum mortgage payments. And it is never mentioned that it requires up to 9 times the average household income to purchase a home in many parts of Vancouver (depending on how income is counted). There is only one explanation for statistics like these, many standard deviations from their historical norms. And it is the same explanation almost anytime we see prices divorced from their fundamental values.

Credit Expansion Fuels The Bubble

Like all other bubbles, the major contributing factor to this one is easy credit availability. In order to protect the Canadian manufacturing industry from a rapidly rising currency, the Bank of Canada has recklessly slashed benchmark interest rates to 0.25% and has left them there.

But the real driver of credit expansion can be traced back to the CMHC - the Canadian Mortgage and Housing Corporation. This is a government owned corporation which offers mortgage insurance and buys securitized mortgages in order to keep interest rates low and allow more Canadians to "afford" a home. From the CMHC's website:
CMHC plays a significant role in sustaining a healthy housing market and supporting access to low-cost mortgage financing. Generations of first time homebuyers who have limited down payments have been able to obtain mortgages at rates comparable to those with higher down payments due to our mortgage loan insurance products.

This has been the great enabler. And very much like their cousins Fannie, Freddie and the FHA down south, their very existence serves to accomplish precisely the opposite of what they intend - to make homeownership more affordable. They artificially stimulate demand, pushing up prices in the process. This fuels the notion that prices always rise, causing fearful prospective buyers to make poor economic decisions.

A revealing article was brought to my attention that confirms what we already knew. The CMHC along with the Conservative government were fueling a bubble in order to prevent the housing market from correcting to its natural level. More than $100 Billion in mortgages had already been guaranteed by the federal government, guarantees that would quickly turn into losses should prices fall considerably. Naturally, the solution was to make the problem even bigger. Guarantee even more mortgages, fix prices higher, and hope it all blows over. Murray Dobbin writes:
The facts are that over 90 per cent of existing mortgages in Canada are “securitized” -- that’s the practice of pooling mortgages (or other assets) and then issuing new securities backed by the pool -- MBSs, or Mortgage Backed Securities. That’s what happened with the sub-prime mortgages in the U.S. which (because the whole pool was so diversified) received triple A ratings by the rating agencies. Losses around the world amounted to hundred of billions of dollars.

Credit is still tight in the U.S. because no private investor has the stomach for such risky MBSs. That’s because those losses were private and not back-stopped by any government. In Canada, mortgages have been securitized for years. The Canadian-issued securitizations are called National Housing Act, Mortgage-Backed Securities. Unlike the failed U.S. pools, says Lepoidevin, “In order to find buyers for securitized mortgage pools, the Government of Canada has put guarantees on them” by directing CMHC to guarantee all Canadian mortgages.
...
By the end of 2007 there were $138 billion in NHA securitized pools outstanding and guaranteed by CMHC -- 17.8 per cent of all outstanding mortgages. By June 30, 2009, that figure was $290 billion, a figure Lepoidevin says “…exceeds the total value of mortgages offered by CMHC in its 57 years of existence!” CMHC’s stated goal was to guarantee $340 billion by the end of this year and is on track to reach $500 billion by the end of 2010. Total mortgage credit in Canada will grow by 12-14 per cent of GDP in 2009.

In an effort to prop up the real estate market in 2008 (when affordability nosedived) the Harper government directed the CMHC to approve as many high-risk borrowers as possible and to keep credit flowing. CMHC described these risky loans as “…high ratio homeowner units approved to address less-served markets and/or to serve specific government priorities.” The approval rate for these risky loans went from 33 per cent in 2007 to 42 per cent in 2008. By mid-2007 average equity as a share of home value was down to 6 per cent -- from 48 per cent in 2003. At the peak of the U.S. housing bubble, just before it burst, house prices were five times the average American income; in Canada today that ratio is 7.4:1 almost 50 per cent higher.

This high-risk policy actually prevents the natural playing out of the recession -- that is, the purging of the excesses of the previous boom period. CMHC’s easy-money resulted in a 9.3 per cent increase in Canadian household debt between June 2008 and June 2009.

Even bank economists admit to being concerned about a housing bubble. In a September research note, Scotiabank economists Derek Holt and Karen Cordes said, “…lenders have been scrambling to get enough product to put into the federal government’s Insured Mortgage Purchase Program over the months, and that may have translated into excessively generous financing terms.” Holt suggested that in two or three years -- or whenever the Bank of Canada increases interest rates -- many of these mortgages would be at risk.

The banks themselves have taken on virtually no new risk. According to CMHC numbers in the two years from the beginning of 2007 to January 2009 Canadian banks increased their total mortgage credit outstanding by only 0.01 per cent. Fully 90.5 per cent of all growth in total Canadian mortgage credit outstanding since 2007 has been accounted for by Mortgage Backed Securities. Of course, the banks have no interest in saying no if you have qualified for a securitized CMHC loan -- because they bear no risk if you default.

If that sounds like sub-prime mortgages, it should. Sub prime is any loan below prime. If a bank refuses you a loan, and CMHC gives you one, the loan is sub-prime. As Lepoidevin says in his warning letter, “Every single U.S. lender specializing in sub-prime has gone bankrupt. The largest sub-prime lender in the world is now the Canadian government.”

Hundreds of billions in government backed guarantees are driving prices to unsustainable levels in Canada. Like all other interventions into the market process, this too will fail. Instead of being on the hook for manageable losses, realizing that mistake and doing away with the CMHC, Prime Minister Harper and Finance Minister Flaherty have tripled the size of the problem, making its inevitable failure as systemically dangerous for Canada's financial system.

Unsubstantiated claims by industry hucksters of "pent-up demand" and foreigner buying sprees suggest prices will forever rise into the sunset. Common sense and a little bit of digging indicate otherwise.


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27 comments:

ATP said...

Great post, as always.
It is especially painful watching the housing saga unfold in Canada. It is as if the bursting of the US housing bubble in front of our eyes meant nothing to us. I guess we're Canadians so we're different, eh?

Willy2 said...

Garth Turner has said on his blog that he senses there's a change in the (canadian) air. He thinks canadians are waking up to the fact that RE is getting too expensive. It seems canadians are becoming a little more catious.

Comfy_renter said...

Wow this is an excellent post. thanks.

Mtler said...

The blind arrogance of the Vancouver condo peddlers is incredible.

"Who wants to live in Salt Lake City?"

Try comparing to somewhere a little closer to home. Where is Montreal real estate now? Cheapest in the nation. Calgary? Without oil, it would be at Saskatchewan levels.

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