By Dan Werner and Erin Davis
Although interest rates in Canada remain at all-time lows, there are now signs that the housing market there has lost some steam as a result of the efforts of the Canada Mortgage and Housing Corporation. Nevertheless, we maintain our opinion that the housing bubble will not significantly deflate until the Bank of Canada raises rates.
In the meantime, the Canadian banks argue that their loan/value ratios on residential loans are lower now than U.S. banks' were just before the bursting of the U.S. housing bubble; however, our review reveals that the average loan/value ratios of U.S. banks just before the housing collapse are similar to those we currently see on residential loans in Canada. More important, their distribution is eerily similar. Based on 10% incremental decreases in home values, it appears that the CMHC and the banks have significant risk of losses or impairment to capital levels.
In the event of significant residential housing price declines, we think Toronto-Dominion Bank (TD) and Bank of Montreal (BMO) will be the least affected, while National Bank of Canada (OTC:NTIOF), and Canadian Imperial Bank of Commerce (CM) will be the most affected. As long as interest rates stay low, we think investors will still benefit from the strong dividend yields currently paid by Canadian banks. However, we think there is little upside to owning most of these companies. We think investors should continue to monitor the actions of the Bank of Canada for rate increases, which we think will have a significant effect on sales activity and will in turn affect pricing.
Canadian Authorities Have Been Unable to Prevent Pricing Growth
Low interest rates have continued to encourage home purchases in the country. The Bank of Canada has maintained its benchmark interest rate at 1% for more than two years. We think rates are likely to remain low until economic growth increases, but we see few signs that this is happening--while monthly GDP growth was 0.2% for January, this followed a 0.2% decrease in December. Moreover, with an unemployment rate of 7.2%, the likelihood that the Bank of Canada will increase interest rates appears weak. Thus, we think cheap funding for home purchases is likely to remain in place for some time.
This prolonged period of low interest rates has contributed to increasing home prices across all property types and geographies. Since 2001, home prices have more than doubled in Canada. Meanwhile in the United States, the impact of the housing bubble was felt as home prices dropped nearly 30% since the peak in 2006.
While the Bank of Canada has kept interest rates low for larger macroeconomic reasons, the task of trying to damp the impact that low rates have had on housing has fallen to the national housing agency, the Canada Mortgage and Housing Corporation. Among the CMHC's many functions, it manages the federal Mortgage Insurance Fund to provide protection to banks for their mortgage lending activities and controls about 75% of the Canadian mortgage insurance market. This gives CMHC a great deal of power to influence lending standards in Canada, and the agency has tightened its standards in recent years in response to rising Canadian housing prices. For a short time starting in 2006, CMHC offered insurance covering mortgages with amortization periods as long as 40 years and loan/value ratios of 100%. Since then, the CMHC has incrementally tightened standards by shortening the amortization period and increasing the required equity for its insured loans. The minimum down payment was quickly brought back to 5%, and most recently, in July 2012, the maximum loan amortization period was reduced to 25 years, which had been the norm before 2006, and the minimum equity required to refinance a home was increased from 15% to 20%.
It appears that the most recent tightening by the CMHC has had an immediate impact on residential home pricing over the past 6-12 months. Year-over-year residential price increases, which were regularly above 6% in 2011, have declined to near zero. National residential pricing has actually declined in three of the past seven months.
Since the price declines began to occur before the implementation of the new CMHC insurance rules, it appears that the housing market had already been losing some momentum. However, the pricing stabilization and declines have had only a minor impact on new listings and sales volume. The annualized rate of new residential listings had declined only 7% by February 2013, compared with the most recent peak at the end of the second quarter of 2012, just before the new CMHC insurance parameters. Similarly, the annualized sales rate has declined about 12% since the second quarter of 2012.
While sales have obviously slowed, the housing market appears to have reached a balance, as sales represent 50% of new listings with approximately six months of inventory being listed for sale, which is consistent with long-term averages.
Low Interest Rates Continue to Increase Debt Levels
We think sustained low interest rates will continue to feed cheap funding into the residential real estate sector and drive consumer debt. While renting may be cheaper, home ownership can offer intangible benefits that become increasing affordable as interest rates fall. When housing is seen as a good investment, people will generally buy as much house as they can afford (that is, take on as much debt as they can afford) based on the low rates. Hence, the level of debt to disposable income for Canadian consumer continues to rise. However, we continue to think that the growth of household debt to disposable income for Canadians is unsustainable in the long term.
Impact of Housing Bubble on Canadian Banks
Residential lending is obviously a large part of Canadian banks' business mix, with most banks having more than half of their Canadian loans in residential mortgages. The Canadian bank regulator, Office of the Superintendent of Financial Institutions, remains very mindful of the risks of increasing consumer debt along with the banks' exposure to residential lending in this environment. Recently, OSFI designated the six Canadian banks we cover as domestic systemically important banks based on their size as well as their interconnectedness to one another and the financial system as a whole. As a result, OSFI will require an additional capital buffer to the banks' common equity equal to 1% of risk-weighted assets by January 2016. Thus, Canadian banks will be required to hold 8% common equity to risk-weighted assets by the deadline. Currently, only National Bank of Canada is slightly below that standard at 7.9%.
Nevertheless, we examined the Canadian banks' exposure to residential lending. Canadian banks, as a group, state that the major difference between them and U.S. banks just before the housing bubble is the higher level of equity, on average, that most Canadian banks possess in their residential loan portfolios. The average loan/value ratio for these companies approximates 45%-60%.
We compared loan/value ratios for both the U.S. housing market leading up to the collapse in 2008-09 and the Canadian market for 2006 and 2013. The median U.S. loan/value just before the housing bust is very similar, at 54%-55%, to the current ratios at Canadian banks. More important, the distribution of Canadian mortgage loan/value ratios in 2013 and currently insured by the CMHC indicates a higher proportion of loans in the higher-loan/value categories compared with 2006 levels. We think this demonstrates higher risk to the CMHC and banks' capital levels. In fact, the Canadian banks' proportion of loans with loan/value ratios greater than 80% is higher than for U.S. banks in 2007, just before the housing bust.
With a large percentage of Canadian banks' mortgages in the 70%-80% loan/value bucket, it would take only a 10% decline in prices to cause those loans to exceed the standards currently allowed by the CMHC on newly underwritten loans. If housing values were to fall precipitously, many of those loans would fall into the higher-loan/value categories. We also saw this with U.S. residential loans in 2009.
CMHC's Reserves Could Prove Insufficient to Cover Insured Mortgage Losses
We have estimated the potential losses for CMHC coverage claims for each Canadian bank, on average, in its residential loan portfolio. While many Canadian mortgages have low loan/value ratios because of recent home price appreciation, 28% of insured Canadian mortgages have ratios of 80% or greater. We worry that this creates a risk that CMHC's liabilities could exceed its equity if Canadian home prices were to decline. Using the U.S. experience as a possible scenario for the future Canadian housing market, we estimated that if home prices were to decline 20%, and if 20% of underwater loans defaulted and had 60% recovery rates, the resulting CAD 12 billion of losses would consume more than 90% of the insurance fund's CAD 13 billion of capital. If 100% of underwater loans were to default, we calculate that even a modest 10% decline in prices would more than exhaust CMHC's capital.
Uninsured Mortgage Losses Could Eat Significantly Into Bank Capital
For the uninsured residential loan portfolio, we think the potential losses directly to the banks could be meaningful and impair their capital bases. Again, we assume a 60% recovery of the uninsured loan balance, assuming 100% losses of the uninsured balance with losses directly impairing tangible capital. If 20% of the uninsured underwater residential loans are losses, the impact on tangible capital levels becomes meaningful with a 30%-40% reduction in pricing. In a worst-case scenario, if all of the uninsured loans were losses and residential prices fell 30%, we think nearly half of most banks' tangible equity would be affected.
Equity Isn't Fool-Proof Protection
Most bankers in Canada like to point to the equity built into the residential loan portfolios as protection to the banks' capital from significant losses. Based on the experience of the U.S., we think this argument is not fool-proof in protecting the Canadian banks or CMHC from losses. We think the distribution of the loan/value ratios is much more important to determining the impact a housing bust will have on the Canadian banks. We will continue to monitor the developments regarding Canadian residential real estate. However, we are not convinced that equity built into residential loans is enough to fully protect the banks or Canadian taxpayers.