Reckoning day for the mortgage market?
Today’s the day that the axe falls on the 35 year amortization mortgage. As of today, being approved for a mortgage gets just a little tougher. In addition, the amount of home equity that can be pulled out is now limited to 85% from 90%.
February was the only full month that experienced the potential “rush to beat the new rules” as they were announced in mid January and take effect mid March. That being the case, I predicted a fairly strong seasonally adjusted bounce in sales in February (seasonally adjusted simply means that it takes into consideration the fact that total sales volumes picks up as the weather warms). Instead, the final February sales data from CREA, and the mid-month sales data from Toronto are nothing less than disappointing as both FELL year-over-year.
So with all this in mind, it’s worth taking a minute and reviewing the big unanswered questions surrounding these rule changes:
1) Just how significantly will this shrink the buyer pool?
I’m increasingly convinced that marginal buyers were providing the bulk of the momentum in the current housing market.
For the past six years in Canada, real estate has been largely supported by a fairly continuous loosening of mortgage terms. Sure Flaherty undid the 0/40 screw-up, but the fact remains that mortgage insurance went from a 10 percent 25 year am standard to 5/35 as of yesterday. Add in the impact of emergency interest rates and you have a housing market that has the appearance of strength while at the same time relying on increasingly marginal buyers who only a few years ago would have been forced to sit on the sidelines until they could qualify for a taxpayer guarantee on their mortgage.
Without getting into a discussion about the incredible injustices involved in asking someone to put some of their own skin on the line before taxpayers guarantee the full loan, let’s just note that these policies have had the net effect of pulling demand forward by allowing people who otherwise would not qualify to suddenly be able to access a mortgage.
In some ways the average consumer shares the same mentality as water flowing down a hill. They both look for the path of least resistance….the easiest route. Taking a 35 year amortization does not necessarily imply that a buyer is marginal. In many cases it’s just the easiest route. It frees up a bit more cash over the short term while guaranteeing tens of thousands extra in interest payments. They may not be wise, but they’re also not necessarily the buyers we’re concerned about. Just how many of these marginal buyers have just been priced out is a huge question, but it may be more than we think.
Rob Carrick wrote about mortgage broker who fully supported the rule changes. According to John Cocomile, a mortgage broker in Toronto, 90% of all new mortgages originated in his office were for amortizations of 35 years. That option is now gone.
While I don’t at all suggest that Mr. Cocomile’s experience is necessarily representative of the rest of the country, I am also certain that CAAMP’s data does not represent reality. By way of refresher, CAAMP calculated that 30% of all new mortgages were originated with 35 year ams. As I pointed out, this is aggregate data representing all new mortgages. The important data point would be the number of first time buyers accessing mortgages with 35 year ams, as pre-existing home owners who are ‘trading up’ would logically take lower amortization lengths on average.
So with the 35 year amortization option now gone, the maximum funding available to the average home buyer just shrank by 5-10% while the average mortgage payment just rose by over $100 a month. BMO Nesbitt Burns deputy chief economist Douglas Porter suggested that resale prices could drop as much as 7 per cent within the next 12 months as a result of these new rules.
Pretty hard to disagree with Porter’s statement. With stable demand and stable supply, all things being equal house prices in Canada will decline by about 5-10% just to compensate for the lack of new credit to keep prices buoyant. But that’s a huge assumption that supply and demand will remain stable. And that brings me to my next big unknown.
2) How will the new mortgage changes affect supply and demand?
The last six months have been characterized by a joint buyer and seller strike as can be seen at the tail end of the following chart.
You’ll see that new listings have fallen at a rate only equalled by the miraculous 2009 emergency interest rate-induced market. But unlike that market, which saw the return of widespread bidding wars for sparse properties, this market has not seen the same rebound in sales activity. November stats held some promise as sales rebounded, but December was a different story.
The big question is where did all this inventory go? No doubt sellers have the memory of the last great government-induced rebound in demand in the back of their mind. Perhaps they are anticipating another rebound in demand and price as the anomolous 2009-2010 housing market solidified the notion that short periods of turbulence in the housing market are to be followed by periods of great strength.
But this time is different. Rather than bailing them out, the government has slapped them upside the head. Rather than move to create additional demand, they’ve moved to destroy it.
This reality has probably not yet sunk in, but remember that mass psychology nearly assures that reversals in sentiment happen rapidly and can quickly ingrain in large swaths of the population.
3) How will it affect credit conditions and the broader economy
One of the topics I discuss often is the role of real estate in generating massive amounts of credit that permeate our consumer-driven economy and give the illusion of prosperity and economic growth. There is a powerful feedback mechanism between house price increase, consumer confidence, consumer spending, and economic growth. I have written about this in detail on many occasions.
The bottom line is that lines of credit have become the drivers of a significant component of consumer spending in our economy. CAAMP data suggests that home equity withdrawals have goosed the after-tax income of the average family by 9%. This is money that flows directly into consumer spending. This flow of money is now under threat.
Traditional HELOCs will come under pressure as house prices adjust to the reality of less credit entering the system and are repriced to the down side. As I’ve shown many times, home equity withdrawal is highly correlated with house price movement. Here is the American experience. The bars show the amount of money withdrawn from home equity. Can you guess where their home prices turned negative?
This is a huge concern for consumer spending, which accounts for 65% of GDP. By extension, this is a huge concern for the broader economy.
The new rule changes don’t specifically target traditional, non-insured HELOCs. Rather they target the CMHC-backed products. While most institutions do not insure their HELOC portfolios, it doesn’t mean the impact will be negligible. As this article in the Globe noted:
“Gerald Soloway…The head of Home Capital Group Inc., which has about 40,000 mortgages in Canada, says the mortgage-backed lines of credit were originally intended to help people make improvements to their homes. The reality, however, is “it became an ATM for weekend recreation.”
And by extension this excess credit creation has buoted segments of the labour market that would not otherwise have flourished. Hence, unemployment is always low at the tail end of a credit bubble, but stubbornly high once it pops.
The new mortgage rule changes will not end the flow of insured LOCs, but it will strap them to an amortization schedule making them more burdensome for consumers. If demand for lines of credit drop sharply as a direct or indirect result of these new rule changes, we’ll very quickly understand the significance of unintended consequences of government policy on the broader economy.
Frankly I’m quite surprised by the weak sales numbers from the past month. They certainly give us clear indication of what the demand picture will look like going forward. It’s the supply picture that remains in question. Listings continue to be added at a relatively subdued pace. Despite this, we saw the sales-to-new inventory ratio (the red line) actually take a surprising dive downwards in February while months of inventory actually rose.
This is not a good sign. Expect the average house price to rise swiftly as the low end of the market is squeezed at the margins leaving more of the better financed buyers and trade-up buyers left to account for a larger proportion of purchases. I fully expect April sales numbers, which we won’t get to glimpse until early May, to be extremely weak.
More on the Price/Rent ratio
The price/rent ratio is one of the major, fundamental determinants of house prices. I wrote about this ratio at length in an earlier post:
As a quick refresher, remember that we are at unprecedented highs in the price/rent ratio in Canada:
With this in mind, I read an interesting article from Standard & Poors from 2009 titled, “The Rent-Price Index in U.S Housing Markets“.
Note that the Rent-Price ratio is the inverse of the Price-Rent ratio. It is represented as the rent received from a residence divided by the price of the residence. Therefore, the rent-price ratio would be at historic lows in Canada while the price-rent is at historic highs. They are the opposite of each other, but they both tell the identical story.
So what exactly is that story? Here are a few snippets from the article:
Our analysis shows that low rent-price ratios are associated with
subsequent periods of low or negative house price changes. This
implies that house prices overshoot fundamental values associated
with capitalization of future rents, and revert to equilibrium through
subsequent price correction.
If we reworded this to reflect the price-rent ratio in Canada, we would note that periods of high price-rent ratios are also followed by periods of low or negative house price appreciation.
Consistent with previous literature, we find evidence to support the view
that rent-price imbalances tend to be corrected more through subsequent price changes than through subsequent rent changes.
The experience of housing markets that have experienced significant variations in the rent-price (or price-rent) ratio is for the ratio to normalize primarily through an adjustment in prices, NOT an increase in rent. Though both typically move back towards their mean, it is the change in prices that do most of the heavy lifting in the normalization process. Further to that point, the authors note the following:
Our analysis also supports the view that house prices do most subsequent correcting, relative to rents, in the re-establishment of long-run fundamental equilibrium as measured by the rent-price index.
Once again we find ourselves as Canadians stuck as we try to explain away the unprecedented dislocation between house prices and the rents they would generate. Is our experience likely to be different from the experience of other housing markets that experienced similar dislocations? If so, why?
The five scariest words for any rational investor are “This time it is different”.