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
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.