A few months ago I heard leading Canadian investor Eric Sprott speak, and he said a very basic thing that struck a chord. He said that you should not be afraid to connect the dots. The dots are usually in front of you, but people don’t often look beyond the single dot.
Today I am going to show six dots that we can all see. When we connect them, the conclusion is that the Canadian Mortgage and Housing Corp. (CMHC) has a realistic chance of putting the Canadian taxpayer at risk – unless meaningful changes are made.
The key piece of background is that right now, a young couple can put down $20,000 to buy a $400,000 house, or five per cent of the purchase price. Their mortgage will be insured by CMHC (the Canadian government, also known as you and I) in exchange for a fee paid by the young couple.
If that $400,000 house drops in value by 20 per cent, for example, which has happened before in Canada, it will be worth $320,000. But the couple will owe $380,000. Then the odds of them walking away from their house or defaulting on their mortgage become meaningful. Given that this young couple might be in the same position as 50,000 other young couples (about 3 per cent of the Canadian population) at roughly the same time, the odds of a surge in mortgage defaults is very real in Canada.
Here are the dots or facts that we can all see:
Dot #1: “The greatest risk to the domestic economy is household debt,” Bank of Canada Governor Mark Carney said in an interview with the CBC last week, again sounding the alarm bell on excess borrowing.
Dot #2: The ratio of credit market debt to personal disposable income rose to a record high of 150.8 per cent in the third quarter of 2011, Statistics Canada said last week, the third-straight quarter the figure has gone up.
Dot #3: Last week, Bank of Montreal offered a five-year mortgage rate of 2.99 per cent. The lowest rate offered in history. Yes, this rate is available to those interested in putting down 5 per cent.
Dot #4: Fannie Mae and Freddie Mac, two U.S. organizations started in 1968 as a government sponsored enterprise (although they became privately owned and operated by shareholders) – have a mandate to help Americans to become homeowners by increasing liquidity for housing lending, and where appropriate, taking on risk. These two organizations were bailed out by the U.S. government in 2008 after the housing market deflated and it is estimated that their bailout will eventually cost taxpayers as much as $124-billion (U.S.) through 2014. When the housing bubble burst in the U.S., the value of many houses fell by 50 per cent.
Dot #5: In November, the Economist magazine said that Canada is among nine countries in the world where house prices are overvalued by 25 per cent or more. It went on to say that Canada is one of only three countries where “housing looks more overvalued than it was in America at the peak of its bubble.”
Dot #6: CMHC is Canada’s national housing agency. Established as a government-owned corporation in 1946 to address Canada’s post-war housing shortage, the agency has grown into a major national institution. CMHC backed loans of $541-billion (Canadian) as of Sept. 30, 2011. At that time, the total equity of CMHC was $11.5-billion. This is 2.1 per cent in equity against its overall loan exposure. To put the $541-billion in perspective: If we go back to those imaginary 50,000 couples that bought a $400,000 house and put down $20,000, that represents $19-billion of mortgages.
Back in 2007, Fannie Mae backed up $2.7-trillion (U.S.) of mortgage-backed securities with $40-billion of capital, or 1.5-per-cent equity against its overall exposure. At that time Fannie Mae stock was trading at $50 a share. Today it is 19 cents.
Just because these dots or facts are out there doesn’t mean that housing prices in Canada will fall 25 per cent or that CMHC will face any major financial problems in the years ahead. However, by connecting the dots, we can see a very plausible scenario that already unfolded with Fannie Mae and Freddie Mac that cost U.S. taxpayers an estimated $124-billion. If we had a similar scenario – and CMHC is now roughly one-tenth the size of the combined Fannie Mae and Freddie Mac – it is plausible that in a major real estate downturn, Canadian taxpayers would be on the hook for several billion dollars.
The biggest risk is likely with mortgage holders who only put 5 per cent to 10 per cent of equity down when buying a property. The reason I say this is that if house prices drop by over 10 per cent, everyone in this group will have negative equity in their homes. According to CMHC, 9 per cent of their loan book (or $49-billion) is connected to mortgages with under 10-per-cent equity based on current home prices. Remember all of CMHCs equity value is $11.5-billion (Canadian). Another 18 per cent of their loans are connected to mortgages with between 10-per-cent and 20-per-cent equity based on current home prices. This is another $108-billion of loans.
What happens if Canadian houses hit their ‘proper’ value, according to the Economist magazine, and decline by 25 per cent of their value? Every one of the $157-billion of mortgages noted above will be guaranteed by the Canadian taxpayer, and every one of those mortgages will be on homes with negative equity value.
When we connect the dots and look at the real risk, the time has come for the federal government to do the prudent thing and raise the minimum equity payment from 5 per cent to 10 per cent, and at least minimize the hit from the riskiest segment of mortgages insured by CMHC.
We can’t say we didn’t know, when the dots were right in front of us.
Ted Rechtshaffen is president and CEO of TriDelta Financial Partners, a firm that provides independent financial planning advice. He has an MBA from the Schulich School of Business and is a certified financial planner. He was vice-president of business strategy at a major Canadian brokerage firm.
Follow Ted on his blog at The Canadian Financial Planner.