A look at household balance sheets: Is Canada really that much better?
AUGUST 23, 2012
Below are some thoughts on a chart that seems to keep showing up in every bank report on housing in Canada. I also wrote an Econowatch article for Macleans on this topic, which is free of some of the jargon contained in the article below as it was intended to be accessible to a wider audience beyond the econo-nerds who frequent this site. Note that this is NOT an exhaustive analysis of similarities/differences between the housing and mortgage markets in Canada and the US. Volumes has been written on these topics on this site. This is simply addressing the shortcomings of one chart which seems to have formed a central pillar in the "it's different here" thesis.
Thoughts on Canada vs US owner equity positions:
One of the central tenets of my macro thesis is that Canadian consumers are far more leveraged, with many more families at risk negative equity in the event of a significant housing correction, than typically believed. Credit trends in Canada are grossly misunderstood and poorly reported in analysis by both the mainstream media and often by analysts at our own financial institutions.
The issue of average home equity is a perfect example of this. In the past month, several Canadian banks have produced housing market forecasts which have included some derivative of the following chart depicting Canadian vs. US owner equity:
One very recent example can be found in Scotia’s latest housing outlook in which they noted that, “Canadian household balance sheets remain in reasonably good shape, with homeowners’ equity in real estate assets averaging 67% compared with 41% in the United States.”
Lost in this analysis is the rather obvious reality that Canadian household balance sheets look to be in “good shape” only in comparison to US households and only when using a measure that uses asset values as a denominator. Simply put, it’s ridiculous to compare Canada owner equity at current levels to a post-bust US market where falling equity levels have caused this ratio to collapse.
That rather obvious point aside, we’ll assume for a moment that these numbers are indeed indicative of relative stability in the Canadian real estate market (I’ll show in a moment why they are not). Even granting this concession, there are nonetheless several important points to consider:
Considerations before examining US-Canada owner equity positions:
There are several important considerations in any discussion of US/Canadian owner equity positions:
1) Mortgage deductibility in the US makes it more rational for consumers to carry a mortgage. The average owner equity positions have always had a gap I believe for this reason. The same mortgage is more affordable in the US than in Canada based on a similar income.
2) A standard US mortgage term is for 30 years while in Canada it is for 5 years, meaning US homeowners have no interest rate reset risk but rather have a built in “put” option on lower rates that they can access via a refi. The same is not true in Canada. This represents a massive, and frankly logical, incentive for US homeowners to take on larger mortgages and not pay them off as quickly relative to Canadians who must be continually cognizant that interest rates and hence payments may reset substantially higher at their next mortgage renewal.
3) Average equity in Canada is lower today than it was in 2000 despite a very strong bull market in real estate.
This speaks quite strongly to how down payments have deteriorated over time while home equity withdrawal via refis has spiked. This phenomenon was not even observed in the US where average equity positions held steady leading up to peak. Note that these calculations do NOT include HELOC debt, which is nonetheless a claim on the equity of the home. This point is addressed in detail below.
4) The most relevant comparison is not Canada today to US today, but rather Canada today to US at peak. The green circles on the first chart highlight the US market peak. Note that Canada is sitting at roughly 67% average homeowner equity compared to 60% for US at peak. Canada is indeed marginally better when we accept the data at face value, yet a dive beneath the headline figure reveals why this is very misleading.
“Average” equity skewed by mortgage-free households: It’s the debt at the bottom of the pyramid that matters
Average equity calculations by the Fed Reserve and Stats Canada use a relatively comparable methodology which can essentially be captured in the following equation: residential mortgage debt outstanding / household real estate assets, then subtract from 1 and multiplied by 100 to give owner equity as a percentage of real estate assets.
The problem, as it relates to using this number as a proxy for housing market stability, is that households with no mortgage whatsoever are included in these calculations. Clearly these are not the households at risk of negative equity and the many socioeconomic consequences it entails.
As such, a far more indicative measure of market stability would be the equity position of the typical household WITH a mortgage. This becomes a particularly important point when we consider that significantly more Canadian households own their homes outright relative to Americans, meaning that the equity position is skewed higher in Canada and masks the potential vulnerability of those owners with a mortgage sitting at the bottom of the credit pyramid.
According to the Canadian Association of Accredited Mortgage Professionals, an estimated 39.2% of Canadian households have no mortgage at all (see the table on page 22 of the report).
Contrast this with the 2007 American Community Survey which found that 31.6% of Americans own their homes mortgage-free.
While it’s impossible to model the equity position of mortgaged households without knowing the total real estate assets held by the “mortgage-free” group, the implications are nonetheless clear: Because a higher proportion of Canadian household own their homes without a mortgage, it pulls up the average equity position higher vis-à-vis US homeowners. Said differently, if we could strip out households with no mortgage from both Canada and the US, we would almost certainly find that the gap in owner equity has narrowed substantially. And it’s this group, after all, that we are most concerned with.
HELOCs not counted against owner equity: Important consideration given that Canada dwarfs US in HELOC debt outstanding relative to GDP
It’s very important to note that neither the US or Canada include home equity lines of credit (HELOCs) in estimates of owner equity, which I find odd given that they nonetheless represent a claim on said equity.
This becomes very important in Canada-US comparisons of owner equity when we consider the relative size of the HELOC market in each country.
OSFI data indicates that chartered financial institutions in Canada hold $206B in HELOC debt. Note that this does not include credit unions and other originators that are not federally regulated financial institutions. Given that the Bank of Canada estimates total consumer credit in Canada at roughly $486B, it's not unreasonable to assume that nearly half of this, or $240B is HELOC debt given that the line of credit segment has been by far the fastest growing form of consumer debt in the country over the past decade, with HELOCs accounting for the bulk of the growth:
If we use just the HELOC debt held by chartered banks, it amounts to roughly 12% of Canadian GDP. Using my estimate of all HELOC debt outstanding, it amounts to roughly 15% of GDP.
In contrast, a 2010 report by Equifax estimated that there was $649B in HELOC debt outstanding in the US. This represents less than 4% of GDP.
Simply put, Canada’s HELOC craze, which makes the US look prudent, further erodes the financial stability of Canadian households and further calls into question the validity of these headline comparisons
Bottom line:
The equity position of the typical Canadian household with a mortgage is substantially worse than the headline reading indicates, given Canada’s higher proportion of non-mortgaged households and massively higher HELOC debt relative to the size of the economy. I suspect if we could strip away all non-mortgaged households and factor in HELOC debt, we would find that the balance sheet of mortgaged households in Canada would look remarkably similar to those in the US at peak. This is particularly troubling given the incentive structure built into the US tax regime and mortgage market that arguably make it more rational for US households to carry more mortgage debt relative to their Canadian counterparts.
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- debt,
- housing,
- housing bubble
15 Comments
Glad to see you posting again Ben. Your analysis is always a solid read.
One question though... " given Canada’s higher proportion of non-mortgaged households," why is that not a solid reason (among many others) for promoting a soft landing? i.e. So many homes in Canada are owned outright, particularly in Calgary, so why would those homeowners feel any pressure to bail on their homes when things start to get tough? It doesn't make sense, especially when affordability in Calgary is relatively attractive, migration is strong, employment is the strongest in the country. The outright homeowners are in a position to ride things out, and they represent the largest chunk of the market. What catalyst will force them to sell? Garth just makes a smart-ass remark when I try to get him to be more specific about an Alberta correction. I just don't see it. With the exception of Toronto and Vancouver, I see a continued sideways chart for average housing prices in Canada.
I am not Ben, but my take away there would mean that those who DO own a house are severely in debt for the most part, far worse than the "average" statistics show.
In other words, if 39% of Canadians DO NOT have a mortgage, then the "average" debt gets shifted over to the 61% who DO have a mortgage, making them even worse. We could probably further dilute that and come out with a good reasonable number of people who are way over their heads.
IMO, when all is said and done, probably only 10-20% of home owners are in massive crap, but that is all it takes to drive a bubble to form, or break it.
Simple. RE prices are set at the margin. It should be obvious that prices are NOT set by those who are NOT selling. True, there are always people who do not need to sell because they are rich / have no mortgage / just don't need to. But on the flip side there are always some who need to sell. You can be sure that as the price turns down, it will force some owners to sell. These incremental stocks will push down prices further, which will push even more sellers to exit. I just describe a vicious cycle here. The opposite (bull run) was in grand display for the past decade, now the other direction is happening.
Hey Ben,
off topic Ben but why don't you start putting your name on these charts to prevent others from claiming it as their own.Twitter altercation was hilarious. I was at the Garth show too and saw the chart/s and I leaned over to my wife and said that I knew whose charts Garth was using.For what its worth your loyal followers know your work.
cheers!
Thank you for another great article, Ben. Just wondering, what do you think the odds are that Canada will experience a US-like financial crisis? In such a scenario, which banks do you think are the most vulnerable?
I'll answer. The chances are very small. The reason being that we don't have the private syndication of mortgage debt that brought on the crisis in the US when the mortgages defaulted.
All high ratio mortgages in Canada are insured by the GoC, which means their asset quality is unaffected by defaults.
The bad news is that we are likely to see a fiscal crisis.
To be pedantic, all high ratio mortgages held by Schedule 1 banks must be insured. There's no law stopping an unregulated financial institution (or an individual) holding a high ratio mortgage.
Brad, I`m not Ben either but I will chime in with my thoughts. Without any data I can`t quantify it but it would certainly be interesting to look at all households (by region or otherwise) that have no mortgages and take a look at what debt they do have (if any). With debt levels so high in this country it`s more likely these households have debt today than they did in the past. As Ben pointed out they may be helocs or other types -who knows. How many people have paid off their homes but have a HELOC on it to pay for a down payment for their offspring or pay for something else?
Garth always asserts the danger in having the bulk of your net worth in a single asset like a house, so it would be interesting to take all the people who have no mortgages (or other debts) and look at what other assets they have. Other than things like divorce, mortgage defaults or maybe a few other reasons I can't think of anything that would motivate a seller to sell (especially if they have worked as hard as they have to pay off their mortgage) more than having all their net worth in a home while comparable homes are sold for less and less while knowing how critical that asset is to your financial health presently or in the future when retirement is looming or here already.
Ben I know how busy you are but as a side note I'd really be interested in hearing your opinion on reverse mortgages and whether you see an opportunity to invest in groups that deal heavily in them. To me, if you look at the demographics in this country in one hand and the assets people have in the other it makes sense that reverse mortgages will flourish in the next couple decades but I don't know much about the reverse mortgage business yet, at least not enough to invest money into it.
For your analysis to be complete, you would have to differentiate the share of Heloc debt from "mortgage free" households from Heloc debt of households still holding a (sometimes large) mortgage.
Good job as usual.
Owners without a mortgage can and do find other reasons to sell -- to reap profits in a rising market; to downsize/rent and invest; to move for work, family or lifestyle; to get away from bad neighbours; and so on. People make housing decisions based on multiple factors, only one of which involves the mortgage. IE paying off a mortgage isn't the goal for most; financial freedom can be, and sometimes that means selling a paid-for house. Even a paid-up home has expenses, which are fixed or can rise/surprise, so when housing prices drop, mortgage-free owners still have to compare the costs of taxes, insurance, maintenance, etc. to the costs of renting or owning something different (factoring in transaction costs in both cases) -- even as they see the value of their asset go down. It's not an all-or-nothing decision.
To Makaya's point... for homeowners with no mortgage, you need to know their HELOC. Doesn't every Canadian want to write off their mortgage interest? Doesn't that mean everyone with the means would readvance the mortgage with a HELOC that is invested and then interest written off? You just can't comment on homeowners without a mortgage unless you know their state of HELOC... for many many reasons.
You have to examine the statistics carefully, to see whether they include HELOC or not. A HELOC is a mortgage -- go down to the land office and you'll see that there's a charge on title, so the home isn't owned free and clear.
Borrowing against your house to invest should certainly be in the arsenal of every reasonably sophisticated investor, but I doubt that the myriad people who style themselves "savers" and moon about banks not paying interest, the stock markets being rigged casinos and governments inflating their hard-earned savings away can find any investments that fit their risk profile and make sense if paying 3% for money -- and there seem to be a lot of those people about. I suspect many of them are homeowners.
The stats are difficult to discern when it comes to HELOCS, Ralph. You are correct that HELOCS are in fact mortgages and are registered on title. However, unlike a mortgage, an individual with a $400,000 HELOC could owe far less than $400,000. In fact, the amount actually owed could be zero, as it is only the amount borrowed on the line of credit that requires repayment.
Unfortunately, there appears to be no definitive answer as to how HELOC debt is reported. When I queried Rob McLister over at CMT about this issue, he replied that some reports include total "exposure" meaning the full amount of the HELOC, and some reports only include the draw-down amount (actual debt) from the HELOCS, which is far more relevant.
If anyone out there knows otherwise, I'd love to hear it.
I find it interesting to compare the United States and Canadian housing bubble... Both countries really have a debt problem, no matter how you slice it and dice it. Who's worse? It could be the United States. It could be Canada. In my opinion, if there was one graph that could explain the entire RE picture in Canada for the last decade... one graph that could explain what's going to happen until 2016, it is this one - http://www.theeconomicanalyst.com/sites/default/files/u3/cmhc_total_insu...
2003-2011 = The graph shows there was a massive demand for CMHC insurace from 2003-2011, maybe lending standards went down... maybe they didn't... the graph shows that down payments >=20% were unachievable and Canadians relied on CMHC to get a mortgage.
2012-2016 = We have an obvious decline in the availability of CMHC insurance. Things really start to turn around - people won't be able to rely on CMHC to get a mortgage. From 2003-2011, the 20% downpayment was unachievable, can we assume that it's still unachievable? I believe so. The pool of buyers will drastically decrease. Supply will exceed demand. Less lending, driving sales and prices down. Isn't this how every housing bubble has blown up?
The discussion is whether it's a soft or hard-landing... but that's another horse that Ben's flogged to death. Or who can fill in the gap of CMHC?
Superb analysis Ben. Love this blog! Best one on the topic, hands down...