TAA Vol. 1. Iss. 6 - CMHC the Elephant in the Room

8/6/2019 TAA Vol. 1. Iss. 6 - CMHC the Elephant in the Room

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The Aspiring Analyst Vol. 1 Iss. 6

CMHC The Elephant In The Room [email protected]

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Dear readers, were back! Happily married, your analyst is back to writing and analyzing about

economics and finance.

A member of our immediate family stumped us a few weeks ago when she asked what region of the

world we would be invested in right now. We did not have a good answer. Starting from out East, we

see recession and deflation in Japan, combined with government debt/GDP of over 200%. In China, wesee a central government hell-bent on clamping down on runaway inflation and social unrest. In Europe,

we see European governments deluding themselves that Greece can avoid default by coming up with

convoluted restructuring plans that is a default in everything but name. In the Middle East and Africa,

we see continued political unrest as governments are toppled one after another. In the U.S., we see a

government run by men and women in constant campaign mode who are more interested in sound-

bites than actual plans to solve problems. In Canada, we see a resource-driven economy that lives and

dies by the price of oil, gold, silver, copper, iron ore, etc. Everywhere we looked, we see macro issues

that will impact micro investing returns.

Q2 was not a good quarter for us. Our portfolio lost 5.2% in the quarter, marginally better than the 5.8%decrease in the TSX Composite. Adjusting for our cash position, we would have underperformed the

index by a wide margin. We held 44% cash in our portfolio as at the end of the quarter.

We digress a little in this months newsletter by focusing our analysis on the reason why we think

Canadas housing market emerged from the latest recession relatively unscathed.

The reason is simple when the government, through CMHC (a crown corporation), provides financing

for over 50% of real estate transactions, it is not difficult for prices to keep going up. The question is

what happens when the CMHC reduces its support? Will the Canadian housing market be able to stand

on its own two feet?

We dont know the answer, but as value investors, we would recommend against investing in real

estate.

Jason Chen

The Aspiring Analyst


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Canadas Housing Market Has Outperformed

Much has been said about the strength of Canadas housing market, as the Canadian housing market did

not see the same level of price correction as as other countries such as Ireland, Spain, and the U.S. In

fact, while American house prices have fallen precipitously since 2006, Canadian house prices have

continued to rise and is now a double from 2000 levels:

Figure 1: S&P Case Shiller Index vs. Teranet-NB Index, both scaled to 100 in January 2000.

Source: S&P, Teranet, The Aspiring Analyst

Thus Canada has garnered a lot of attention and acclaim, with many pundits and industry watchers

claiming that the Canadian system is different, that we have been more conservative in our lendingpractices, and that there is absolutely nothing to fear from house prices which are more than 5x median

household income on a national level, 8x in Toronto, and 12x in Vancouver.

Perhaps there is some truth to those claims. We do not deny that the Canadian subprime market is far

smaller than the American one, with higher underwriting standards. Nor the fact that with mortgage

interest being non-tax deductible (unlike the U.S.), there is less incentive for Canadians to borrow to the

max, although, recent statistics beg otherwise as Canadian debt-to-income ratios are at all-time highs

(but debt service ratios are still manageable as interest rates remain at rock bottom):

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Figure 2: Debt Service Ratio vs. Debt/Income Ratio

Source: Statcan, The Aspiring Analyst

However, we do not subscribe to the consensus that Canada avoided a housing crisis purely based on

our better system. We believe a combination of historic low interest rates (controlled by the Bank of

Canada) and government intervention (through the CMHC) played a huge role in propping up the real

estate market in Canada. While it is possible and likely that the Bank of Canada and CMHC will continue

to support the housing market, their support should not be taken for granted as there are increasing

signs of strain and stress in their language and actions.

CMHC Is The Elephant In The Room

We admit we take a slightly more cynical view. For better or worse, we believe the Canadian Mortgage

and Housing Corporation (CMHC) played a major role in the levitation of house prices.

First, a little bit of history. The CMHC is a crown corporation created in 1946 to house returning war

veterans and to lead the nations housing programs. Over its 65 year history, CMHC has provided

innovative financing solutions to Canadian homeowners and in some instances, the CMHC has provided

direct subsidized loans to low-income Canadians. In recent years, CMHC is chiefly known for providing 1)

housing related research and data, 2) mortgage insurance to lenders (there is a misconception that

mortgage insurance protects homeowners; in fact, mortgage insurance protects the lender, not the

homeowner as in the event that the homeowner default on her mortgage, the lender is made whole by

CMHC; the benefit to homeowners is that with CMHCs credit guarantee, those homeowners with less

than 20% deposit benefit as lenders are enticed to offer lower mortgage rates than they otherwise

would) and 3) securitization trusts that package insured mortgages (backed by the CMHC or private

insurers) into mortgage-backed securities and bonds (NHA-MBS and CMB Bonds), freeing lenders

balance sheet to provide additional mortgages (and again, lowering mortgage rates in the process).

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Any way you look at it, the CMHC is a behemoth in the Canadian housing market. In its latest 2011

corporate plan1 (for reasons unknown, the 2010 annual report is still not available even though 2012 is

fast approaching) the CMHC states that it has $473 BB in in-force insurance, vs. total mortgages in

Canada of approximately $1 T2, or almost half of all mortgages outstanding are guaranteed by the CMHC

(note, this does not mean all insured mortgages are low loan-to-value, as the loans could have been

made years ago and hence homeowners could have accrued additional equity in the years since; also,

CMHC insure portfolios of low loan-to-value loans for a nominal fee). Moreover, Bank of Canada data

indicates that the $305 BB in NHA-MBS outstanding account for approximately 30% of total mortgages,

with the percentage rising precipitously in the last few years:

Figure 3: NHA-MBS as % of Total Mortgages Outstanding.

Source: Bank of Canada, The Aspiring Analyst

That the CMHC has a massive influence on the Canadian housing market is undeniable. The interesting

questions are 1) what role did the CMHC play in the recent crisis and 2) has the CMHC reduced its role in

the years since? We recently came across some data from the CMHC that might shed some light on

these important questions.

Did CMHC Prop Up The Housing Market?

As the issuer of NHA-MBS securities, the CMHC regularly puts out monthly statistics summarizing the

amount of MBS issuance in a given month3. Normally, CMHCs data is only provided on an YTD basis, but

for some reason, the latest R303C report provided issuance data stretching back to 1987:

12011-2015 Corporate Plan, CMHC, http://www.cmhc-schl.gc.ca/en/corp/about/anrecopl/anrecopl_010.cfm

2Banking and Financial Statistics, Bank of Canada, http://www.bankofcanada.ca/publications-

research/periodicals/bfs/3

MBS Monthly Reports, CMHC, http://www.cmhc-schl.gc.ca/en/hoficlincl/mobase/mobase_006.cfm

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Figure 4: NHA-MBS Issuance vs. CREA Average Resale Price by Year (Total $ Vol / Total Transactions).

Source: CMHC, CREA, The Aspiring Analyst

It is interesting to point out that issuance of NHA-MBS really took off in 2001/2002, coinciding with the

beginning of the current housing boom (some call bubble). The extent of CMHC intervention is even

more apparent when we combine MBS issuance with total mortgage approvals4 which shows NHA-MBS

accounted for an incredible 66% of total mortgage financing in 2008 and 54% in 2009:

4Canadian Housing Statistics Mortgage Lending, CMHC, https://www03.cmhc-

schl.gc.ca/catalog/productList.cfm?cat=55&lang=en&fr=1310310447954

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Figure 5: NHA-MBS Issuance vs. Total Mortgage Approval. Note: Mortgage Approval data series only available to 2009.

Source: CMHC, The Aspiring Analyst

Although accurate data is not available, we estimate CMHC still accounted for over 50% of financings in

20105 and 2011. From such astounding statistics, one can only conclude that CMHC was the real reason

Canada did not suffer a housing downturn in the past few years. And two years after the recession,

CMHC intervention is still near all-time highs.

So What?

Even if NHA-MBS accounts for over half of the real estate market, it does not necessarily mean trouble

on the horizon? Or does it? We see numerous problems with excessive government (CMHC)

intervention.

First, how healthy can a market be when over 50% of the market requires credit enhancement from the

federal government (NHA-MBS have the implicit guarantee of the federal government since CMHC is a

crown corporation)? Without this credit enhancement, we are certain that mortgage rates would be

much higher than they are currently.

Second, as we have seen in the U.S., reliance on securitizations create an originate-to-distribute systemwith deteriorating underwriting criteria and perverse incentives, as lenders get the benefit of residual

spreads and origination fees without having to take on the credit risk. Returning once again to the NHA-

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CREA resale volumes were $152 BB in 2010, combined with 187,000 in housing completions which are worth

approximately $60 - $70 BB, total housing transaction volumes are estimated at $210 BB to $220 BB of which NHA-

MBS accounted for $124 BB.

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MBS dataset, we see worrying signs of deteriorating underwriting standards, as shown by the increasing

proportion of mortgages with amortization periods of 25 years or more:

Figure 6: NHA-MBS Issuance 1987-Present, By Amortization Period.


Prior to 2006, NHA-MBS only included minimal amounts of mortgages with amortization periods greater

than 25 years (a conventional mortgage has a 25 year amortization period; a mortgage that has a longer

amortization period has a lower monthly payment and is generally considered riskier as it implies the

mortgagee has stretched to afford a more expensive mortgage). However, since 2007, mortgages with

amortization periods greater than 25 years have out-weighed conventional mortgages. There are several

possible explanations for this phenomenon. According to the Canadian Association of Accredited

Mortgage Professionals (CAAMP)6, although mortgagees have taken on longer amortization mortgages,

they are acting aggressively to repay their mortgages by increasing the amount of payments or making

lump sum payments, painting longer amortizations in a positive light. On the other hand, longer

amortizations could simply mean that mortgagees had stretched to afford a more expensive mortgage.

Another interesting finding is that in the CAAMP survey mentioned above (table 3-4 in the survey),

CAAMP states that 41% of homes purchased during 2010/11 have amortization periods greater than 25

years. Yet when we look at Figure 6 above, we see that 85% of mortgages securitized through NHA-MBS

in 2010/11 had amortization periods greater than 25 years. There are two possible conclusions that can

be drawn from the divergence between CAAMP and NHA-MBS data. Assuming the NHA-MBS data is

accurate (we believe it is, since it is supposedly drawn from documented mortgages), then either 1) the

CAAMP survey is grossly inaccurate (thus putting its other conclusions and data in doubt) or 2) an

6Stability In The Canadian Mortgage Market, CAAMP,

http://www.caamp.org/meloncms/media/Spring%20Survey%20Reportweb.pdf

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adverse selection process has occurred and lenders chose to securitize almost all of their 25-year plus

amortization mortgages. Neither conclusion is comforting.

Finally, what happens when the government eventually pulls back support? The obvious answer is that

mortgage rates will rise without government credit enhancement. But we believe there are more subtle

implications that have not been fully explored. For example, since 2008, the Canadian government hasthrice tightened mortgage lending and insurance rules. First, the government ceased insuring new

mortgages with amortization periods greater than 35 years in 2008. Then in 2010, there were many

tweaks to mortgage rules such as setting a higher initial qualifying rate (set at the posted 5-year rate

even though actual mortgage payments may be on shorter terms). Finally, this past spring, the federal

government rescinded guarantees on new mortgages with amortization periods greater than 30 years

plus additional tightening of mortgage rules.

The result is that homeowners that took out 40 year amortization mortgages will see quite a sticker-

shock when their mortgage comes up for renewal in the next few years and the 35 year amortization

product is no longer available (not a huge number overall, but we think 10,000 to 15,000 homeownerswill be affected):

Figure 7: NHA-MBS Issuance 35-40 Year Amortization, 2005-Present, By Mortgage Term.


Will Canada See A Housing Bust?

In recent months, some analysts and economists have been more vocal about the possibility of a

housing correction in Canada. For example, David Madani of Capital Economics predict a 25% price

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correction is in the cards7 if the Bank of Canada raises interest rates. The governor of the Bank of Canada

himself expects housing to slow8. And when pizza deliverymen start pitching real estate9, perhaps the

end is near.

Being value investors at heart, we will not venture into speculation a housing bubble. All we will say is

that the downside far outweighs the upside at this point in time there is no margin of safety. Here aresome of our top concerns:

With mortgage rates at historical lows, it is unlikely to go lower In fact, with headline inflation of 3.7%, the Bank of Canada may have to raise interest rates The CMHC cannot/should not finance more than 50% of the market; when CMHC dials back

support for housing, will mortgage rates shoot up?

With a weak U.S. economy and uncertainty in Europe, wage and employment growth in Canadaare expected to be slow at best

With baby-boomers beginning to retire en-masse, demographics may be a headwind againsthousing over the next two decades

For those interested in more statistics and discussion on Canadian housing markets, we suggest several

resources that may be helpful:

The CMHC Library is a literal treasure trove of statistics on Canadian housing:https://www03.cmhc-schl.gc.ca/catalog/productList.cfm?cat=48&lang=en&fr=1310334928129

Teranet and National Bank puts out a Case-Shiller styled resale price index of the 6 largestCanadian cities: http://www.housepriceindex.ca/

The Canadian Association of Accredited Mortgage Professionals puts out a quarterly survey withlots of data: http://www.caamp.org/info.php?pid=53 (although we caution this data is skewed

in favour of the mortgage broker industry and so may not be unbiased)

Ben Rabidoux keeps an excellent blog on economics and housing at:http://www.theeconomicanalyst.com/ (note, we share many of Bens views)

Finally, your analyst tracks quite a few housing related statistics and would be happy to share ordiscuss; just send an email to: [email protected]

7Rate Hike Could Trigger Housing Collapse, National Post,

http://www.financialpost.com/news/Rate+hike+could+trigger+housing+collapse+economist+warns/4217677/stor

y.html8

Moderating Expected In Housing, Bank of Canada, http://www.bankofcanada.ca/2011/06/press-

releases/moderation-expected-in-housing-market/9

Vancouver pizza boy: Sell your house now! Globeandmail, http://www.theglobeandmail.com/report-on-

business/economy/economy-lab/daily-mix/vancouver-pizza-boy-sell-your-house-now/article2074029/


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Documents

TAA Vol. 1. Iss. 6 - CMHC the Elephant in the Room