Greetings all! We’re going to do something a little different today, and that’s very interesting… or at least I think it’s interesting. I’m going to take a look at the changes the CMHC made, how it affected lending and even touch on why what happened here wasn’t all that different than what happened in the US. I was meaning to get this done a bit faster, but turns out it’s a little more time consuming than I thought it would be, ’tis complicated stuff.
Before we start, I compiled this little graph as something of an all-in-one backgrounder for this post. The contents are nothing that hasn’t been discussed ad nauseam already on this blog. This is just so you can consult for reference. So here that is.
This is all concerning Edmonton. We have median household incomes, median single-family-home prices and average 5-year fixed rate mortgage interest rate. Incomes and home prices are inflation adjusted, and are in 2007 dollars. Why 2007? Well, that’s what the data set came in for incomes, and to compile the final graph I could not adjust it… and frankly it’s close enough to today’s dollars, All figures in this post are in 2007 dollars.
Enough of that, on to the good stuff. This is a graph documenting the changes in CMHC lending standards, and it’s effect on how much money a person could qualify for. These percentages hold true whether you make $1/year or $1,000,000/year, so income level have no effect on this measure.
We set our base effect (0%) as the maximum amount one could qualify for going into 2006 when amortizations were limited to 25 years. We’re using 6% as a steady interest rate through the entire period. We know in reality they float, but for theoretical and practical purposes we’ll use 6%, and as we could see in the first graph interest rates were generally right around 6% from ’03 through early ’09 (and are likely to return there once the “emergency rates” expire).
For example a person, lets call him Dave, is making $60,000 a year, could qualify for about $250,000 in financing assuming he has no debts in January of 2006 or any time early. Just for example purposes, and to use a nice round number.
In March ’06 we saw the first mandated change, and that was extending amortizations to 30 years. That change allows Dave to qualify for ~7.5% or ~$18,500 more than he did before. They also dropped the need for a 5% downpayment, unfortunately the effects of that can’t really be quantified. We’ll discuss it’s grander effects a bit later, but for our purposes here we just kind of ignore it.
So we jump ahead a few months to June. Here Harper and Co. really open the flood gates. Sure they again extend amortizations another 5 years, now to 35… but the real coup de gras was insuring interest-only mortgages. That one blew the doors right off.
Here I split the line just so we can see the effects of the amortization extensions (green line), as other wise they would be lost in the effect of interest-only payments. The move to 35 year ams would have allowed Dave to borrow another ~5.5% above and beyond. So he could now borrow 13% or $32,500 more than he could five months earlier.
We follow that green line a little further, and in November the feds started insuring 40 year amortizations. That allows Dave to borrow another 4.1% (notice the diminishing returns on the 5 year extensions?), and that’s 17.1% more than he could borrow less than a year prior. For a guy making $60,000/year, that’s another $42,750 in financing he could qualify for. No small increase.
Of course that’s nothing compared to what the interest-only option offers. That route offered 28.9% more financing (or about $72,000 for Dave). Now we consider that this financing wasn’t just available to Dave, but to everyone in Canada.
We recall that real estate in Edmonton (and Alberta as a whole) was pretty hot in ’05. It was the talk of the town, everything was selling and the economy was cooking… then we hit ’06 the feds take an axe to lending standards, and over the first six months all these hormonal consumers find themselves with greatly increasing levels of available financing.
Now go back to the first graph, and notice that is right when real estate prices start going vertical. It’s not a coincidence. Real estate was on hot, but a controlled burn and sustainable… but all this suddenly available financing just threw gas on it… and at this point it just became a perfect storm.
Obviously when available financing increases in a big way… so does the pool of potential buyers. I apologize that you need to use your imagination a little with this graph. The incomes breakdowns are only available on an annual basis, so gains made over the year really cannot be represented other than those jumps. Really we’re only focusing on 2006 though, the rest are just there for reference sake.
This is a graph of the percentage of households that can qualify for $200,000 of financing at 6% interest (again, assuming no other debts). Up until ’05 it was steadily around 57% of households as incomes were stable. Then in ’06, incomes jumped an impressive 8.5% ($4800) YoY… this yield a 3.8% improvement in households that qualify. It’s important to note that relationship. If we follow the blue line further (it’s conditions are held constant with 25yr ams) we could see another 4.2% ($2600) YoY improvement in incomes in ’07, yielding a 3% improvement in qualifications.
Now we compare that to the effects changes in lending standards had on qualifications. Extending amortizations to 30 years increased qualifications by about 2.6%… 35 years was another 2.4%… and finally 40 years was another 1.5%. So if amortizations were merely lengthened from 25 year to 40 years it would have increased qualifying households by 6.5% in total. In Edmonton that represents about 32,000 households, which is by itself a VERY big one year increase in potential demand.
But again, like the prior measure, it was the interest-only option that blew the doors off. That option rocketed up the qualifying population to 74.4%, an increase of 14.1% over what it was just five months prior, and representing an influx of roughly 69,000 households that wouldn’t have otherwise qualified for that much financing.
Obviously that figures is theoretical, as credit scores would disqualify several, most already own, some aren’t looking, etc etc. So, you can just throw out that 69,000 figure. But assuming standard distribution the percentages should be fairly accurate over what had previously been available… in fact, if anything they’re understated.
You see, typically the required downpayment would be a limiting factor to buying. So, even if one could qualify for sufficient financing to purchase, they still needed to have a downpayment and this kept many potential first time buyers from buying… but one of the first lending requirements stripped was effectively removing the need for downpayments by allowing them to be borrowed. This not only further opened the door, but opened it to much riskier borrowers, ones without a established savings and those without skin in the game.
Obviously that effect can’t be easily quantified, but it was just one more control eliminated that allowed the housing market to bubble out of control. People no longer needed to plan or save to earn the right to buy… they could just pop down to the bank, piggyback a couple loans and have themselves a house. Hell, they didn’t even have to be able to cover closing costs.
That’s why those that argue that the mere absence of widespread “subprime” loans means we’re not in a bubble like the US is missing the forest for the trees. Look at their overall effect… they allowed people to a) borrow more money than they would otherwise have, and b) allowed more people to borrow money. So maybe we didn’t have as many “subprime” loans… instead we just kept lowering the bar for prime until it had the same effect.
They had an influx of new demand, and with it an expanding pool of available financing (of which lowering interest rates only further expanded)… that will heat up real estate markets, and then it just becomes a vicious cycle and feeds itself until all fundamentals have been so far bypassed the only thing supporting the market is it’s own momentum… and when that runs out, Wile E. Coyote meets gravity.
That’s not to say the effect of these new loans, or “innovations” should be ignored, their entrance into the market will certainly an increase in prices and new equilibrium… the problem is they also often cause overheating of the market and drastic overshooting of the that new equilibrium (remember these innovations also come with increased risk).
For example, in Edmonton prior to the boom typically 60% of households could finance and amount equal to the median home value in the, city and that number was steady for many years… at the peak even using the most exotic financing arrangements, only 39% could. If you limited to the loosest of what is offered today after the feds tightened standards that would drop to 36%. A very big shift, and unsustainable.
Today with “emergency” interest rates and prices having fallen from the peak and figuring in continued income growth the median home can currently be financed by about 50% of households. Better than it was, but still a ways to go before getting back to 60%… and interest rates shoot up much (even back to historical norms) it would take a great big bite out of that improvement (not to mention if amortizations get shortened to 30 years or tighten up downpayment rules).
The exact causes here may have varied between nations in name, but the effects were all the same. One must focus on the big picture and not tiny details. The lending bar was lowered… the amount of available credit exploded… demand explodes… supply is pinched short term… prices start rising… and the bubble becomes self feeding. Then add to that our human behavioural economics… mob mentality, speculation, irrational exuberance, etc, and it’s a lethal brew.
About the only thing that actually is different here is we don’t have to worry about our entire financial system collapsing as a result of the housing bubble popping… you see, the taxpayers have been on the hook for this one all along. Lucky us!
Great post. If you have access to population by income breakdown as it seems, would it be possible to see a graph of that? I am interested in seeing the pattern it forms.
So why did we bubble up so quickly and the not the rest of the country?
My guess would be the yoy jumps in income that where not the same across the rest of Canada. As our incomes increased by leaps and bounds, it aloud for more money to be borrowed which in turn aloud people to continue buying as demand ramped up and supply dwindled. With oil and gas companies having a great influence during this time period over peoples incomes (I'm sure you can think of a few people in your circle of friends and family who benefitted from some of the ultra high wages of oil and gas, not only that, but many businesses where increasing wages to keep competitive with those oil and gas companies) the amount of new, young, and now somewhat financially wealthy people where trying to establish themselves in this nirvana.
As the title states, it was the perfect storm.
The question now is whether or not it was actually a storm that was fueled by the federal government and local industry, and if not, will this storm pass as quickly as it came, or stick around for a little longer.
It would be possible, it'll have to wait until tonight or this weekend though
We were ripe for it. We had a hot housing market, demand was high, supply was tight, incomes growing and consumer confidence was off the charts… add a flood of cash and that's a pretty good recipe for a bubble.
Most markets were more balanced, so not everyone was horny for real estate and even those that were weren't desperate… so the effects were far more muted. But several heated up far more than they had, just not nearly as extreme as here.
December job numbers came out, and for Alberta they were pretty good. 10,000 more full time jobs!
http://www.statcan.gc.ca/daily-quotidien/100108/t100108a4-eng.htm
Nice post, Kevin. The first sign of falling prices is going to spook a lot of near 100% LTV "homeowners"
Hi,
I live in Calgary, and am recently divorced. I currently rent, but fear that even if prices go down a bit, I will still not be able to own. I have a good chunk of money saved, but if an average townhome is 350,000, then it is still unaffordable for me.
Is there any hope for people like me. I am 52 years old and can't start home ownership again with a large mortgage.
Will rising interest rates not still make home ownership a losing battle for me?
Thanks.
Interesting post; it will be interesting to see whether the CMHC's lending standards are tightened further, or that's just more talk to add urgency to people's house buying plans.
Just wondering… have you come across any data on the number of mortgages coming up for renewal? It may be interesting to see a Canadian version of the attached graph (with renewals rather than resets), and whether there is a relationship between number/percentage of mortgages up for renewal and sales/prices/inventory. I'm also wondering how big of a wave of renewals is following the housing boom on a 5-year lag.
One effect of the drop in interest rates in 2009 is that it increased the cost to break a mortgage (thanks to the 'interest rate differential'). So I suspect that part of last year's inventory reduction was caused by sellers pulling their properties (or deciding not to list) after they found out how much it would cost to get out of their mortgage. As their mortgages come up for renewal (or interest rates rise and thus reduce the IRD), some of these houses may come on the market. If there is a wave of renewals following the boom, we should be in a bit of a lull now, and the wave should start to hit in the next year or two.
First you need to stop viewing property ownership as some kind of validation. Shelter may be a necessity, but a house is still a consumable and must be treated as such.
Too many seem to think it's not only an investment but some kind of golden goose, but the first rule of investing is there is no free lunch, and houses aren't going to appreciate 10% every year for perpetuity just because someone parks their ass there.
First thing you need to do is sit down with a good financial planner and have a very frank discussion about where you want to be in 20 years. I'm not going to lie to you, it probably won't be a pleasant discussion, but it's one you need to have because if you don't your golden years will be a disaster.
In my honest opinion, if you bought right now and saddled yourself with a big mortgage you could probably kiss retiring goodbye. Buying now doesn't shield you from interest rates forever, that puppy will reset and at that point you'll be hit with whatever the going rate is… and with prices depreciating as rates rise, that would come straight out of your equity while what you owed remained.
You want what money you have to work for you. As interest rates go up, prices will come down, gradually. You'll need to wait out the bust (which will take at least three or four years) but hopefully by the end that money you have will either be able to buy you a place outright, or with minimal financing. You need to be patient.
But like I said, go find yourself a good financial advisor and map out the next twenty years of your life. That's a must.
I've never seen one like that for Canada, industry data about mortgage lending is sorely lacking in Canada. Other than some vague surveys from a brokers association there really isn't much info out there (other than the arrears figures from the CBA, which are quite good). We know very little about amortizations, fixed or variable, period preferences, etc.
JD,
I was wondering the same thing. The effect of rising interest rates from mid-2010 onwards will only make sense if there are enough renewals coming onto the market to be affected by interest rates. Using 2005 as the starting point of the boom in Edmonton and Alberta and accepting that the majority of buyers from 2005 onwards opted for the 5-yr fixed, we will start seeing renewals for 2005 in 2010 and continuing therefrom. What is unknown is how many renewals are coming on stream in 2010.
Further, it would be interesting to know how many of those individuals who bought from 2005 onwards did mortgage rate resets prior to interest rate increases commencing in 2010. If a significant number did resets then the problem may have been carried into the future by a few yrs. For example, a 2005 buyer on a 5-yr fixed with a renewal in 2010 who did a reset in 2009 now has a renewal in 2014. The economy may recover by that time. IMHO, the real problem with interest rates will be within the next 3 to 5 yrs and the real concern is really those renewals that are coming up in the next 3 to 5 yrs. If we have or know of these statistics we will know of the problem at hand.
Another factor Kevin is that it is a lot more difficult to walk away from your mortgage in Cda than the US. This will effectively force homwowners under water to stretch themselves beyond unimaginable financial limits to hang onto their homes. For this reason I don't expect a massive wave of foreclosures and a sudden dramatic collapse like in the USA but I expect a steady decline in prices over a longer period of time. That said, I believe (correct me if I'm wrong) that Alberta is the easiest jurisdiction to walk away from a mortgage in Canada.
Mick, part of what I was getting at is that there may be a coming increase in resale inventory whether interest rates go up in the next few years or not. I agree that if rates go up, some people will be in trouble at renewal time (or sooner if they have a variable rate). If rates stay down, then owners will stay trapped in their houses until their mortgages come due for renewal.
Since the start of the housing boom, a lot of properties have sold or been refinanced, and presumably a substantial number of them took 5-year closed mortgages. Right now we're still within 5 years of the start of the boom, so all those properties can't be sold again without a paying a huge penalty, thus reducing the amount of potential inventory. As those mortgages come up for renewal, there may be increased inventory as owners try to sell the homes they (hastily) purchased 5 years earlier and are no longer suitable for them.
Thank you for this great post. It's my first visit to your blog and I will, for sure, come again.
So it seems that the coming years are going to be tough for the residential market. We are going to have interest rates hike, possibly 30 years amortization and some kind of down payment. Considering those, is it possible that housing prices do not come down?