|Co-author: Paul Borean|
Housing market affordability stretched, downside risks increase
The wave of unconventional monetary policy accommodation that followed the global financial crisis gave rise to a pronounced easing in financial conditions, particularly in those economies with less vulnerable financial systems at the time. Managing to avoid the use of more extreme policy prescriptions such as asset purchases, the Bank of Canada (BoC) resorted to record-low policy interest rate settings and a brief commitment to keep rates low to help see the Canadian economy through the worst days of the crisis and the subsequent lacklustre recovery. In turn, this loosening of financial conditions has prompted the building of bubbles in asset markets and introduced new economic and financial stability risks. The Canadian housing market has become a poster-child example, with reports littering the press over the post-crisis period, citing the eye-watering price gains and ever-increasing household indebtedness. In particular, the national aggregate MLS Home Price Index has risen a stunning 50.2% over the five years to June 2017, featuring a substantial 12.1% advance during the first half of this year alone. Commensurately, affordability has deteriorated sharply, with the overheated Greater Toronto area and Greater Vancouver area markets being the most concerning. Home ownership costs were estimated to consume some 45.9% of household income at the national level in the first quarter of 2017, virtually matching their pre-crisis highs, while the same figures for the Greater Toronto area and Greater Vancouver area are much higher, at 72.0% and 79.7% respectively. Ultimately, this stretch has resulted in households being heavily indebted, with the household debt-to-income ratio reaching 156.3% on an internationally comparable basis, handily exceeding both the US and the UK. The list of metrics that highlight troubling housing market conditions extends beyond those noted above, making it evident that the risks of a correction have increased appreciably.
Regulatory policy response gradual
Macro-prudential policymakers have been gradually tightening housing-related regulation and legislation in a targeted fashion in response to the precarious housing situation, freeing the BoC’s hands to stimulate the broader economy over much of the post-crisis period, albeit with the blunt instrument of policy interest rates. Involvement of the Canadian Mortgage and Housing Corporation (CMHC) provided a starting point for such efforts, placing progressively more restrictions surrounding eligibility for federal government-backed mortgage insurance, and later following up with higher guarantee fees and lower annual securitization limits. The Office of the Superintendent of Financial Institutions (OSFI) has also been a key player, introducing more stringent guidelines for residential mortgage underwriting, including additional stress testing and capital requirements for mortgage books (for further non-exhaustive details, please see pages 24–25 of the June 2017 edition of the Bank of Canada Financial System Review). Federal and provincial government legislation in British Columbia and Ontario rounded out the response, most recently by imposing additional costs specifically on non-residents, including a 15% tax on real estate purchases in the hot Vancouver and Toronto markets, and ending tax exemptions on property transfers and capital gains for principal residences. Collectively, all these measures have weighed on resale activity more so than on housing prices.
Monetary policy stance raises risks
The BoC has continued to flag the risk of a housing price correction as materially negative for the financial system and the economy as a whole. With the Bank now embarking on policy tightening, however, their assessment of the risks of such a correction warrants re-evaluation. The reality is that the BoC is raising policy rates out of a desire to get ahead of a predicted closing of the output gap and higher projected inflation, and higher rates taking steam out of the housing market seems a secondary consideration. An imminent return to the 2% inflation target that the Bank has forecast is by no means assured, however, and the Bank risks making a policy mistake if it continues prematurely with a significant and accelerated rate hiking cycle in a subdued inflation environment. Without a continued recovery in economic activity and inflation, such action from the monetary policy sphere would likely prompt the realization of the very housing market downturn that the BoC itself has repeatedly warned about. Indeed, virtually all historical episodes where real house prices fell by 5% or more were preceded by a material increase in policy interest rates.
So what does this all mean for Canadian banks? It is pretty clear that a significant shock to the housing market will be negative for the Canadian banks in a number of ways. Not surprisingly, Canadian banks have been the biggest lenders to the domestic housing market. Canadian residential mortgage balances at the Big Five banks reached C$925B at Q2 17, making up an average of 38% of the total outstanding bank loans. In terms of the Canadian loan book, mortgages represented 54% at the end of 2016. The portfolio presence is wide spread, but most growth over the last few years has been in British Columbia and Ontario.
One of the main risks for banks is the potential spike in credit cost losses as interest rates increase and with them mortgage loan payments. With the BoC’s first rate increase in seven years, borrowers are finally faced with higher interest payments. As mentioned above, the likelihood of a gradual rate increase makes us confident that mortgage cost of borrowing might increase over time but at a manageable pace. In addition, as can be seen in the chart below, only 25% of total mortgages are variable rate mortgages, which mean the impact of higher rates will not be immediate for most people.
A quick look at the chart below indicates that Government of Canada five-year rates have risen, but are currently at levels similar to five years ago. This means that five-year fixed-rate mortgages that are coming up for renewals will be renewed at rates close to previous rates.
Another factor that should soften the potential spike in credit costs is the fact that Canadian banks’ residential mortgage portfolio is partially protected by mortgage insurance. As of Q2 2017, an average of 55% of total mortgages held by the six largest banks is insured either by CMHC or private insurance companies like Genworth Canada. In case of defaults on these loans, the banks will repossess the property, sell it and any difference between sell price and what was owed to the bank will be covered by the mortgage insurers. In October 2016, the federal government launched a consultation on risk sharing for government-guaranteed lending by the banks. This might result in banks actually having to participate in losses on insured mortgages. The review is still ongoing, and we expect that any risk sharing introduced will be very gradual and will have limited impact on banks. Additionally, OSFI is considering the merit of implementing higher risk-weight floors on uninsured mortgages. Appropriate risk weights on mortgage assets remains a debate on the Basel committee, and higher risk-weight floors have been introduced in Australia and Sweden as a tool to temper systematic housing market risk. Higher risk weights would reduce capital ratios at the margin and potentially encourage mortgage price increases, which would weigh on housing prices.
What happens to loan growth?
Mortgages have been one of the main contributors to loan growth for banks. Over the past four years mortgage loans growth represented 29% of total loan growth for the banks. There is no doubt mortgage loan volumes will pull back in case of a housing correction, but it will not stop there. Residential investment (the sum of new residential construction, renovation activity and ownership transfer costs) made up some 7.7% of GDP in 2016, while for the same period, RBC Economics estimated that total housing related expenditures constituted a 25% share of the Canadian economy, although not all of this activity is vulnerable to a downturn in housing. A lower activity in the housing market will affect other lending like unsecured retail lending, SME and corporate loans. Loan growth rates averaging around 8% for the Canadian banks over the last four years might go down to around 2% as mortgage growth stagnates and the rest of the economy slows down with it.
There are no reliable statistics on alternative lenders in Canada, but after discussions with industry participants, estimates are that the market may be as big as 5–10% of the total mortgage market. Home Capital Group (HCG), with around 1.5% of the mortgage market, became the target for fears concerning Canada’s frothy housing market. Things really started to go south for the company when the OSC announced in May 2017 that the company and some of its executives broke Ontario securities law by misleading investors post an investigation into fraudulent mortgages.
The result was a loss of confidence in the company and its management causing a run on deposits, during which depositors withdrew over 90% of the company’s High Savings Account deposits, causing a severe funding crunch. It is important to remember that throughout this entire ordeal, loan quality did not experience a major deterioration.
HCG got some relief (though still faces lots of uncertainties) after announcing that Warren Buffet decided to take a 19.99% stake in the company, while also providing an alternative line of credit to replace the HISA outflows, at better terms than existing line of credit. This case highlights the vulnerability of alternative lenders that rely heavily on wholesale funding to run their businesses. We consider this case to be unique and unrelated to a potential pressure on banks for a number of reasons, including a superior funding mix for the banks and very low or no exposure to subprime borrowers.
Although the Bank is unlikely to tighten stubbornly should inflation continue to fall short of its target, it will take time before the true impact of tightening on the economy becomes clear in the data flow and the Bank reconsiders its options accordingly. In the interim, we view diversified fixed income exposure that employs government bond duration along with positions spanning a variety of spread products as an ideal way to weather the current environment. In our Signature Canadian Bond Fund, the positioning is moderately underweight duration relative to benchmark primarily via longer maturities, overweight corporate credit, and underweight CMHC and other government agency debt, while also holding positions in US dollar investment grade emerging market sovereign bonds, agency mortgages and inflation-linked bonds.
While acknowledging that Canadian banks operate in a high-return oligopolistic market and are very strongly capitalized (tangible equity to risk-weighted assets in the last 10 years increased from around 6% to over 11%), we are cautious on the potential headwinds they may face in the short to medium term. Investors are appropriately assigning a higher risk premium on Canadian banks compared to other banks because of elevated levels of consumer indebtedness in Canada and the potential for housing correction. This translates to Canadian banks underperforming global peers in the current rally in financial stocks. We at Signature, in light of the risks discussed, are currently slightly underweight Canadian banks, taking a cautious approach. We view current valuations as appealing on a long-term view and expect domestic bank resilience to be demonstrated through a housing correction. However, it is prudent to expect anticipated headwinds to weigh on valuations and risk premiums in the medium term, and conveniently, we find the valuations for domestic life insurance companies to be quite reasonable and slightly preferable today.
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