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Canadian banks question


bargainman
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In a recent post someone (I think it was Dazel) stated that the Canadian banking system was one of the strongest in the world.  Is this really the case?  I was a bit surprised when I read that.  I've been doing some research into Canadian real estate (Vancouver for example), and my feeling is that it's very much hanging by a thread, propped up by the Olympics, a constant, but not guaranteed, influx of immigrants, and the CMHC funding sketchy loans.  I was also looking at the Canadian banking system a bit and found articles like this:

 

http://www.greaterfool.ca/2009/10/16/ottawas-bubble/

 

and this:

http://www.demographia.com/dhi-ix2005q3.pdf

 

Which talk about CMHC, and how it's basically acting like the AIG of Canada selling insurance against first time buyers and making the risk premiums for those buyers incredibly small.  It sounds like a disaster waiting to happen.  On the other hand there is this sentence:

 

"The answer’s simple: the banks don’t take any risk. It’s all on the taxpayers, thanks to CMHC.

 

And these days, Canada Mortgage and Housing Corporation is turning into a financial behemoth, as Ottawa uses it to fuel a housing boom that’s clearly turned into an asset bubble. Last year alone, CHMC  did 919,780 deals worth a staggering $148 billion, or about twice what it had planned. To accommodate that, the feds have raised its allowable insured mortgage limit to $600 billion, or about double what it was two years ago.

 

Here’s how CMHC and the federal government are inflating the real estate bubble:

 

CMHC provides insurance to the lender (the bank) for the entire amount of any mortgage it makes when the purchaser has less than 20% to put down. These days, that’s virtually every new deal.

If the homeowner defaults, the bank gets 100% of its money. The taxpayer’s on the hook for the loss.

This insurance means the banks face no risk lending money to people with little or no credit rating and virtually no equity, so they charge no rate premium."

 

etc.

So I'm wondering.. this says the bank takes no risk..  but what happens to the price of real estate when prices collapse?  Don't the banks end up having to mark down assets when this happens?  Is there a risk for the banks that could trigger something like what happened in the US if the Canadian real estate bubble deflates?

 

Any thoughts?

Thanks

 

Bargainman

 

 

 

 

 

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The main difference between the situation in the 2 countries (US and Canada) is that in Canada most mortgages still required a minimum equity by the borrowers. There were no subsidies by governments like mortgage interest deduction or "teaser" rates by the lender. As a result the overbuilding and overreaching generally were not present. There is not a huge inventory overhang in the country (even Downtown Vancouver). Supply and demand fundamentals in most regions tend to be more in balance.

The Canadian government and the Bank of Canada have managed to shift mortgage risk from the banks to the government (this means you) with little or no fanfare or fuss...even the CPP fund has purchased mortgage pools from the banks, to bolster bank assets.

It is believed that the quality of these assets are higher than the US counterparts... they are performing loans and have no need to be "frozen" for accounting purposes.

As long as these existing mortgages continue to perform, the real estate market and the banks themselves will continue to operate "normally".

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If you socialize losses on a constant basis over the years, as opposed to the US model that does more of a bailout IF and when a crisis develops from time to time, it would seem that you are pretty much trading volatility for a smoother return in the economy. Of course, volatility is better for investors to take advantage of the madness but not so hot on the citizens of your country. I'm not sure which model, in the end, is more expensive or if they are equivalent. But the common thread is that taxpayers over time are always subsidizing an economic crisis, either once every five decades or a little bit each year.

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So I'm wondering.. this says the bank takes no risk..  but what happens to the price of real estate when prices collapse?  Don't the banks end up having to mark down assets when this happens?  Is there a risk for the banks that could trigger something like what happened in the US if the Canadian real estate bubble deflates?

 

 

All the riskiest loans are insured by CMHC, so that gets paid by Ottawa.  But, there are still some loans on the banks' books which could go "up-side-down" if house prices really tank.  In particular, there are probably a great many mortgages where equity is currently .60<x<0.80 that are at risk of going up-side-down in some markets.  How realistic is this?  Well, prices are high enough in Vancouver, Calgary, Regina and Toronto that a 20-40% correction is entirely conceivable (IMO).  That is a very good sized chunk of the Canadian real-estate market.

 

The big question revolves around the behavioural response of home owners.  IMO, Canadians still have a greater tendency to stick to the old-fashioned values of repaying debts that they owe.  Beyond that, non-recourse loans are not prevalent here, implying that you can't just walk away for the pure fun of sticking to the man.  You pretty much need to be thinking of bankruptcy to walk away from a house that is seriously underwater.  I tend to think that most of the mortgages that go underwater will still be repaid, as long as employment circumstances of borrowers remain reasonable.

 

The other element where the banks are exposed is on consumer loans and credit card debt.  If I know that I'm going bankrupt due to job loss and an up-side-down mortgage, I have a significant incentive the charge the hell out of my credit cards along the way (hey, if I'm going bankrupt anyway, might as well enjoy the last few months by charging vacations, clothes, restaurant meals, etc).  Same deal with car loans; pretty much all car loans are underwater from the day the car is first driven off the lot.  If I'm going bankrupt anyway (implying that I'll probably lose my car), the very last thing I'll do is make my car payment (just park it a couple of streets over to discourage the repo guys).  

 

Nope, on this one, it'll be Ottawa that will take the big hit.  But the Canadian banks will still take a smaller hit.

 

SJ

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For the US readers, the CMHC is not free at all for the consumers. The CMHC charges an opening fee of a few thousand $ when the consumer want's to insure plus an extra % point or two on the interest rate the consumer has to pay to the bank. I find the terms the CMHC insure the customers are very attractive for the CMHC. One day or another tough they might have to absorb a lost after 20 years or easy profits.

 

BeerBaron

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The main difference between the situation in the 2 countries (US and Canada) is that in Canada most mortgages still required a minimum equity by the borrowers. There were no subsidies by governments like mortgage interest deduction or "teaser" rates by the lender. As a result the overbuilding and overreaching generally were not present. There is not a huge inventory overhang in the country (even Downtown Vancouver). Supply and demand fundamentals in most regions tend to be more in balance.

The Canadian government and the Bank of Canada have managed to shift mortgage risk from the banks to the government (this means you) with little or no fanfare or fuss...even the CPP fund has purchased mortgage pools from the banks, to bolster bank assets.

It is believed that the quality of these assets are higher than the US counterparts... they are performing loans and have no need to be "frozen" for accounting purposes.

As long as these existing mortgages continue to perform, the real estate market and the banks themselves will continue to operate "normally".

 

You see this is where I'm confused.  In the same article I linked to it says:

 

"That was in 2007. Since then there’s every indication things have gotten worse. In fact, for people taking out mortgages today it’s estimated the average amount of equity they have is just 6%. The leaves 94% of the house value as debt. And while reliable statistics on this are hard to find, my banker buddies tell me that virtually every new loan they write these days is for 5% down, with a 35-year mortgage. After all, if you’re buying in Vancouver. Calgary or Toronto, that’s the only way banks can swing the deal."

 

I know for sure one thing.. Vancouver housing is as expensive or more so than that in the SF Bay area.  Thing is, in the bay area I know many techies who make 100K+. When I lived in Vancouver I knew no one who made that much...  On top of that mortgage interesting in Canada is not tax deductible.  The other thing that confuses me is this:  You say "There were no subsidies by governments like mortgage interest deduction or "teaser" rates by the lender."  But in Canada every loan is an ARM or close to an ARM.  There are no 30 year fixed rate mortgages.  They are either 5 year, or 10 year max fixed rate, after which there is another reset.  Or at least that's what my friend who's held several positions as personal and commercial loan manager for bank branches in BC.  So to recap:

 

CMHC is backing loans with  ~6% equity at no extra risk premium.

Canadian loans are pretty much ARMs

Vancouver's housing market is supported by thin ice not income.

I was also told that CMHC's insurance premiums are tiny so the leverage is greater than what AIG had at the peak of the bubble (But I haven't confirmed that)  "They insure something like $425 billion in assets, and have $8 billion in equity.  So, they're more leveraged than the investment banks, Fannie and Freddie, and all the others were at the height of the bubble."

 

This can't be a good thing for Canadian banks..  What if it does blow up?  Vancouver real estate did blow up in the past.  One source had the following to say:

 

1979-1981 - prices increase by 119%

1985, they're back to 1979 levels - ie loss of ~50-60%

 

1986-1990 - prices increase by 69%

1991 - decline 16% in one year.

 

So if the CMHC doesn't have enough equity, what will the government do?  Raise taxes to pay for the bad loans?  Or monetize them by printing money?  Will the Canadian public be disgusted as the US public was?  But then what will happen to housing demand, will there be a downward spiral like there was in the US? Or because the government will still support the banks, will lending standards not tighten dramatically allowing for a slow deflation instead of a sudden drop?

 

Sorry for rambling.. I just want to get a better feel for the canadian banking industry.. Thanks!

 

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Here' my two cents worth as a disinterested observer from

south of the border.  I don't think you are going to have

a general residential crash in Canada.  Here's why:

 

Vancouver may be a special case of perpetually inflated

prices because of restrictions on development,  including

a deliberate planning decision not to build a robust

freeway system that would support distant development,

compounded by the geography there.

 

The inability to deduct mortgage interest removes a huge

driver of inflated prices in Canada, compared to the US.

 

The risk being born by a government agency means that

Canadian banks are unlikely to go into a death spiral because

of forced deleveraging if residential property values decline.

 

Finally, if prices haven' crashed yet after the three year

decline in the US, commonsense would argue that any

Canadian decline would be relatively mild.

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The Canadian Banks were better buys in March.  The US and Canada are not comparable on a banking basis.  In Canada there are 5 large banks, a handful of regionals and international entrants, and a handful of mortgage companies.

 

The big Canadian Banks which is what I think we are talking about here are BMO, RY, CM, TD, and BNS.  They operate as a oligopoly.  There are large amounts of government protection in place for these entities.  Each of them offers the same cross section of services at the same rates:

- mortages

- savings and loan

- credit cards

- store fronts

 

This means there is little competition.  For example I have had an account at CM since I was 5 years old.  When I was 22 I got a Visa from TD.  I use TD as my discount broker.  My mortage is from a non-bank lender but I am not normal in that regard.  Most Canadians do all of their banking at one of the big 5. 

 

The Canadian cities I am most familiar with (Greater Toronto Area - this makes up 20% of Canada's population, and Calgary) had some speculative building but much of it was just filling pent up demand following the decade long recession in the 1990s.  I bought my house in 2004 just as prices were starting to rise.  From bottom to top has probably been a gain of 50% over 6 years.  Prior to that prices had not changed for 15 years.  Contrast this to San Diego which was in speculative fervor in 1998 that continued for 8 more years. 

 

The banks here are much safer RIGHT NOW than their international peers.  This wasn't always so and may not remain the case.  But at the moment....

 

 

 

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and the CMHC funding sketchy loans.

 

Maybe you were specifically mentioning Vancouver in this case.

 

You go to the bank, ask for a mortgage.

 

If you don't have 20% down, the bank will require that you have your mortgage insured with cmhc. You can see the schedule cost here: http://www.cmhc-schl.gc.ca/en/co/buho/hostst/hostst_002.cfm#premium

It's also worth noting that the federal government has reduced the requirement of having 5% down to 0% down in recent years for 1st time home buyers.

 

If you are dealing with a well funded credit union, they may not require you to have your mortgage insured. The credit union will self insure the mortgage.

 

Anyway, that is my 2 cents.

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It is an interesting question.  I believed back in 2007 that the banks in the US would be hit by the US real estate collapse, but wouldn't be facing bankruptcy, because they had securitized their loans, offloading the risk.  Turns out that they also owned the securities.

 

That makes me wonder if it's possible for any business to be relatively insulated from the collapse of its own industry.  I think probably not.  What's more, even if they truly offloaded the risk on the risky mortgages, the market will shrink in two dimensions when it crashes.  The average mortgage size will decline, and the volume will decline.

 

Also, I'm sure you know this, but this thing about Canadians being financially conservative is a myth.  Canadians have a debt to income ratio of 140% vs 132% for Americans.  Almost nobody conservatively fixes their interest payments with long term mortgages; most take money for 5 years.

 

The reason the Canadian market hasn't collapsed is because the goverment intervened.  It started to collapse. Then, the government started handing out free money with low interest rates and and taking on high risk mortgages -- increasing CMHC's exposure from $300 billion to $600 billion.

 

Vancouver may have perpetually inflated prices, but that doesn't implied that the current level of inflated prices is a "normal level" of inflated prices.  In fact, they aren't.  Even if you have inflated prices, you should expect prices to be inflated in a sensible way.  For instance, there should be a reasonable correlation between the price to own and the price to rent.  Right now, it costs much more to own than rent, even at extremely low interest rates.

 

What's more, the average price to average household income ratio is insane.  3 is affordable. 5 is deemed oppressively  unaffordable. Vancouver's somewhere around 10.  Those sorts of numbers just aren't sustainable.  Though the government can sustain things for a while, apparently.

 

That said, if you don't have any assets, the right strategy is still to borrow as much money as possible and buy real estate, just as it was the right strategy in USA in 2006.  The government will give huge subsidies to you, giving you extremely low interest rates, even though you're a very high-risk borrower.  Then, if prices go up 20%, you make a killing.  If prices collapse, you declare bankruptcy, leaving taxpayers with your losses.

 

(Note: I'm not arguing that this is ethical to do, or that I would do it, just that it's the rational strategy.)

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Also, I'm sure you know this, but this thing about Canadians being financially conservative is a myth.  Canadians have a debt to income ratio of 140% vs 132% for Americans.  Almost nobody conservatively fixes their interest payments with long term mortgages; most take money for 5 years.

 

I did not know that about relative debt to income ratios... where can I find those statistics?   

 

I agree that most people in Canada take mortgages with rates that reset every 5 years. I do not recall seeing 10 year mortgage rates listed in newspaper ads until the last last year or two (my memory could be faulty). Perhaps the banks have historically under-promoted the longer term fixed rate mortgages.

 

Canadian 5 and 10 year fixed rate mortgages are 5.6% and 6.7% at the big Canadian banks right now.  The spread between these rates has sometimes been wider--reducing consumer preference to go long.  Both rates are quite a bit higher than current US 30 year fixed rates (4.8%). Can anyone tell me why there are no 25 or 30 year fixed rate mortgage products in Canada?  Do the banks in Canada consider it too risky on their part?  Is the 30 year fixed rate mortgage in the US a recent development or something that has been around for a long time?

 

nodnub

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We also need to remember that some Canadian banks have significant holdings in US Commercial real estate.  Disclosure in this area is difficult to come by.  Here is an article from today discussing TD's known exposure.

 

http://www.theglobeandmail.com/report-on-business/td-banks-us-real-estate-exposure-higher-than-thought-report-says/article1381901/

 

Toronto-Dominion Bank's exposure to the troubled U.S. commercial real estate market is significantly higher than many of its investors believe, a new report suggests.

 

The sector's continuing deterioration is fuelling concerns about the banking industry and the recovery of the U.S. economy.

 

While this has been seen as a lesser problem for Canadian banks, TD's filings with U.S. regulators suggest it has about $19.5-billion (U.S.) in exposure, versus the roughly $12-billion that the bank disclosed in a recent presentation to shareholders, says Hamilton Capital, a new Toronto-based boutique asset manager specializing in financial services.

 

The difference appears to come from the way TD classifies the loans it makes on owner-occupied premises, such as a factory where the owner has a commercial mortgage against the building.

 

In its presentation to analysts, the bank appears to deem those loans to be business loans rather than commercial real estate, which is what they're classified as in the disclosure to U.S. regulators, the report suggests.

 

A spokesman for the bank said the U.S. filings are not an extension of TD's formal corporate disclosure record.

 

 

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I grabbed the debt to income ratio from Garth Turner's blog:

 

http://www.greaterfool.ca/2009/10/22/its-that-simple/

 

Interesting discrepancy from the Globe and Mail article.  I wonder if it`s a June vs October statistics thing, or something else.  If someone truly cares, I would imagine that you can find and calculate the USA data using a combination of statistics at http://www.federalreserve.gov and http://www.bls.gov.

 

 

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Keep in mind that Cdn regulation is a lot more 'hands on' than the US, & principles based. If you're writing too many mortgages in Vancouver you will be made to sell some, & bring your exposure into line with your peers. All 5 banks (versus one) get over-exposed to Vancouver, to the extent that OSFI lets them, & they all get stress tested twice/yr. No surprizes.

 

CMHC insured mortgages generally amortize, & require substantially more CF the lower the DP. They are designed to force the mortgagee to reduce risk buy putting up more equity (amortization & new saving), & reward conservatism (lower premium). The target is 1st time buyers who really want a home.The additional financing cost, & the bank officers moral suasion, tends to keep speculation to the minimum.

 

Within Canada, debt speculation is not treated 'equally' as it is in the US. By & large the riskier end is never allowed to get off the ground, as you can't shop the oligopoly. The 'rejected' see it as 'uncompetitiveness', everyone else sees it as saving their collective arse! 

 

SD

 

 

 

 

 

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  • 2 weeks later...

Also, I'm sure you know this, but this thing about Canadians being financially conservative is a myth.  Canadians have a debt to income ratio of 140% vs 132% for Americans.  Almost nobody conservatively fixes their interest payments with long term mortgages; most take money for 5 years.

 

I did not know that about relative debt to income ratios... where can I find those statistics?   

 

I agree that most people in Canada take mortgages with rates that reset every 5 years. I do not recall seeing 10 year mortgage rates listed in newspaper ads until the last last year or two (my memory could be faulty). Perhaps the banks have historically under-promoted the longer term fixed rate mortgages.

 

Canadian 5 and 10 year fixed rate mortgages are 5.6% and 6.7% at the big Canadian banks right now.  The spread between these rates has sometimes been wider--reducing consumer preference to go long.  Both rates are quite a bit higher than current US 30 year fixed rates (4.8%). Can anyone tell me why there are no 25 or 30 year fixed rate mortgage products in Canada?  Do the banks in Canada consider it too risky on their part?   Is the 30 year fixed rate mortgage in the US a recent development or something that has been around for a long time?

 

nodnub

Here is a link to current stats from a reputable source http://www.rbc.com/economics/market/pdf/house.pdf
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In my opinion the biggest risks in Canada in order of precedence are . Private mortgage Pools there are dozens of these of various sizes in Canada are opaque as heck and first to fail if houses start falling. Credit Unions especially Van City and Genworth which is a private sector mortgage insurer. I have considered shorting Genworth but have placed it on the two hard to ponder pile and invite the deep thinkers here to have a look. I suspect that it could go to zero pretty quickly if we have a spike in interest rates and residential real estate starts to fall.

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Looks like the CMHC tap may slow down soon.

 

http://www.newswire.ca/en/releases/archive/December2009/10/c2061.html

 

In his five page letter to the Minister, Paul requested that the government immediately suspend implementation of an Advisory being proposed by the Office of the Superintendent of Financial Institutions "(OSFI) with elements" scheduled to take effect on December 31, 2009.

 

The proposed OSFI changes will significantly decrease access to affordable mortgage loans for first time Canadian home-buyers and apartment investors as the Canada Mortgage and Housing "(CMHC)" securitization program is curtailed by changes to the capital governance rules that will restrict a financial institution's ability to generate Government guaranteed loans or require an injection of capital (equity).

 

CMHC's current securitization program supports affordable housing by enabling banks and financial institutions to issue more Government guaranteed loan products, thus making it possible for these institutions to provide credit to Canadians at lower interest rates as the securitization frees up space on their balance sheets. This allows these institutions to meet the demand for more mortgage loans than they otherwise could if they had to hold all the loans on their balance sheets, which are subject to several restrictive regulatory capital leverage ratios.

 

The OSFI's proposed policy will effectively tighten the capital governance rules and reduce an institutions capacity to generate these government backed mortgages.

 

 

 

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