AUGUST 03, 2012
A research note for my faithful readers. This was first sent to clients in mid June, so some figures are slightly dated, though the numbers out of Vancouver ain't getting prettier. It has been shortened and edited slightly, though the message remains the same. I hope to touch on the Toronto condo market next week.
Vancouver crash would be major macro event with implications for Canadian banks:
As I warned clients back in October, Vancouver (and the entire province of British Columbia) would be the first major Canadian market to begin declining. Now, amid rapidly rising inventory and dwindling sales, price declines in the city in the past few months have been significant, with the once-hot detached segment down over 12% Y/Y. The point of this report is to once again hammer home just how ugly the fundamentals really are in this city (and subsequently how far prices could conceivably fall) and to reiterate that a crash in Vancouver house prices has the potential to be a major macro event that will impact Canadian banks.
Vancouver is the third largest Canadian metro, home to 2.3 million people or 7% of the total Canadian population. For reference, the state of New York represents just over 6% of the US population. The entire province of BC accounts for over 13% of the Canadian population, larger than the state of California’s contribution to US population.
As can be seen below, chartered Canadian banks have created a credit bubble in BC and now have significant exposure to a housing market on the brink:
The following chart shows the percentage of each loan type originated in BC:
Canadian bank aggregate balance sheets are quite exposed to a housing-induced recession, though there is a great deal of variation within individual names. Some are much more exposed than others.
At 2 times book, Canadian banks remain the most expensive banks on the planet. I'm quite happy to discuss why the banks' insured mortgage books are NOT as good as sovereign and why it would not be inconceivable to see them trade to book before the Street begins to question even that value.
2) Fun with anecdotes:
Before diving into the data, consider this fun anecdote: There are currently over 5,000 homes in Vancouver metro area for sale for over $1 million according to MLS.ca. In comparison, the NAR reports that in April, just over 7,000 homes sold in the entire US were sold for over $1 million. And this despite the fact that the US population is 135X greater than the metro Vancouver market, the average personal disposable income in the US is 20% higher than the Vancouver average ($37,100 vs. $30,800) while US per capita GDP is higher than the average for all of BC.
3) Overview of market fundamentals:
These charts need no commentary, though I would draw reader’s attention to the second chart in this section showing Vancouver ownership costs as a percentage of household income. Note that this chart is courtesy of RBC and assumes a 25% down payment on a typical Vancouver property. How exactly this is even possible is a bit of a mystery, though I offer some suggestions a little later in this report. At the very least, it highlights how stretched the budget of the typical Vancouver household must be to maintain any standard of living. This is at least partially reflected in the fact that BC in total has had a negative savings rate for over 10 years now. The bottom line is that I’m confident that there are many households now reliant on home equity extraction to maintain their current lifestyle and likely to continue making timely payments on debt obligations. I suspect that when the tide goes out, we’ll be shocked at how many Vancouver households have been swimming naked:
4) Recent sales trends:
May sales were the lowest total for the month in the Vancouver area since 2001 and were 21.1 per cent below the 10-year May sales average of 3,617. Total inventory is at all-time highs for the month.
As we’ve noted several times before, the last time the supply/demand imbalance was this great was during the GFC when confidence and liquidity suddenly disappeared. This time we don’t have the luxury of a 400 basis point BoC rate cut over 15 months to stimulate demand. And rather than the Insured Mortgage Purchase Program pumping $70B in liquidity into the Canadian banks, we are now facing broad credit tightening as CMHC tightens credit availability as it butts up against its $600B cap while OSFI leans on the big banks to tighten their lending standards.
5) Supply and demand snapshot:
While Toronto garners much attention for the massive condo boom, it’s worth noting that completed but unsold condo inventory is six times higher in Vancouver once adjusted for population. There are now 20,000 new residential dwellings under construction in Vancouver.
It’s still commonly suggested that land constraints in Vancouver have played a major role in supporting high prices. Setting aside the reality that if this were true, we would also expect rents to command a comparable premium, which they are not, instead I would point to the rise in residential dwellings in the city relative to population change. This alone strongly argues against the land-constraint argument.
Since 2001, Vancouver has added 326,000 people to its population. During the same time, it has added 163,000 new residential dwellings to its housing stock. This ratio of one new dwelling built for every 2 people added to net population represents one of the highest construction rates of any large city in Canada over the past decade. Note from the chart above that single family housing starts are only slightly below decade averages. This certaqinly behooves a question: If builders are constrained in their ability to bring inventory to market, why is it not showing up in the data?
As can be seen in the following charts, population growth in Vancouver is far from impressive from a historical perspective.
6) Changes to low ratio insurance availability sapping demand.
It’s been my unconfirmed suspicion for some time now that because banks could easily buy after-market portfolio insurance on low ratio loans and underwrite these loans with very little oversight from CMHC, Canadian banks have been very loose with this form of lending. In turn, buyers who could come up with a 20% down payment to avoid CMHC fees could easily get a mortgage which pushed affordability beyond what would normally be allowed. In fact, banks had the capacity waive income confirmation based on credit score if a borrower was putting 20% down, a practice that has come under extreme pressure from OSFI.
With affordability still off the charts in Vancouver, I’ve suspected that many new buyers have been getting into the market through gifts or loans from equity-rich parents eager to help out their children. If a new buyer could borrow or be gifted the 20% down payment, getting financing that pushes the envelope of affordability has traditionally been relatively easy.
Now that OSFI is closely monitoring low ratio mortgage lending and CMHC rationing after-market insurance, banks are having to actually underwrite these mortgages. As noted in a recent Globe and Mail article:
Realtors say the slowdown (in Vancouver) appears to have resulted from a combination of tighter lending practices by local banks, which now want proof of income to service large mortgages, more restrictions on how much capital can be taken out of China, and fewer immigrants.
“Banks are now requiring borrowers to disclose incomes and assets before mortgages are approved, as of the last six weeks,” said west-side realtor Marty Pospischil, who specializes in selling single-family homes owned by long-term residents.”
It’s impossible to say how prevalent this has been, but a TD survey released today does add some insight:
“42% of B.C. residents find it a real struggle or impossible to save, so to cover major purchases many rely on loans, lines of credit or credit cards”
“Just under half of British Columbians admit they would rely on a loan or line of credit to finance a deposit on their first home”
With that option now off the table, it’s no surprise that sales have withered.
7) “Hot Asian Money” slowing?
One popular explanation for high house prices in Vancouver is the prevalence of foreign buyers, mostly from China. I’ve noted previously that I don’t believe that this is the fundamental driver of the market, though abundant anecdotes suggests it does seem play a role in certain areas and certain market segments, most notably detached single family homes in Vancouver’s west side. Interestingly, it is this market segment that is now the weakest.
From the Globe and Mail:
[…] West-side realtor Marty Pospischil…specializes in selling single-family homes owned by long-term residents. Last year, he says 90 per cent of his 100 house sales were to “offshore buyers” – people not living here yet, who flew in to buy. This year, it’s less than a tenth of that. “We’re now seeing a 50-per-cent collapse rate in deals, when it’s usually more like 5 per cent,” he said.
As with any asset bubble, this one needs a story to convince otherwise sensible people to take on obscene leverage. BoC governor Carney expanded on this very thought in a speech in Vancouver last year:
"Domestic demand factors are not the only forces at work. Some Asian wealth is being invested in selected international housing markets as those investors seek out diversification and hard assets. This has become a familiar phenomenon in this city. Partly as a consequence, the average selling price of a home in Vancouver is now nearly 11 times the average Vancouver family’s household income, a multiple similar to those seen in Hong Kong and Sydney—cities that have also become part of a more globalized real estate market. Such valuations are extreme in both Canada and globally"
[…] "Given such developments, one cannot totally discount the possibility that some pockets of the Canadian housing market are taking on characteristics of financial asset markets, where expectations can dominate underlying forces of supply and demand. The risk is that expectations become extrapolative, prompting the classic market emotions of greed and fear—greed among speculators and investors—and fear among households that getting a foot on the property ladder is a now-or-never proposition."
Last June, OSFI announced that they would begin looking into the role of foreign capital inflows on the Canadian housing market. The next day, the Immigrant Investor Program, which allows wealthy immigrants a quicker route to citizenship if they meet certain criteria, the most significant being a net worth of at least $1.6 million and the ability to make a $800,000 'investment' in Canada (essentially an interest-free loan to the government) was capped at 700 annually. This represented an 80% reduction from the amount of high net worth individuals entering Canada through this program. The quota was filled within the week:
The exact cause in the drop in demand is likely a combination of a number of factors, including a weakening Chinese real estate market. The bottom line is that this has implications beyond simply a reduction in sales. Headlines detailing falling demand from Asian investors will weigh on market psychology and the speculative mindset necessary to keep this market from imploding.
8) Economic impacts of a housing bust on the province of BC:
BC had better enjoy its AAA credit rating while it still can. BC has net provincial debt of only 16% of GDP but has an economy very reliant on real estate related industries. Annual MLS resale dollar volume alone is equal to 20% of GDP. As one analyst friend of mine recently noted, the best parallel to BC’s current predicament is Spain:
There are parallels to BC's predicament, the best and most chilling one is that of Spain. Several years ago Spain had the following: large trade deficit, dependency on construction employment, foreign capital investment (vacation homes), and relatively benign government debt. Now Spain has: severe construction recession, ballooning government debt, high unemployment, insolvent banks. BC looks awfully similar to Spain a few years ago and my fear is that it is in danger of being hamstrung by a slowdown in construction activity due to lower dwelling formation. With household debt levels already near a point of no return, there aren't many options left to fill the void save substantial foreign investment and government spending, both of which are not guaranteed to continue ad infinitum.
A real estate correction would hit BC in several ways:
1) Personal income taxes: 15.2% of revenues
2) Corporate taxes: 4.8% of revenues
3) Sales taxes including taxes on new dwellings: 14% of revenues
4) Property taxes: 4.6% of revenues
5) Property transfer taxes: 2.2% of revenues
Deposits at federally regulated financial institutions are insured by the Canadian Deposit Insurance corporation, a federal crown corporation. However, deposits at credit unions are guaranteed by the provinces. Credit unions in Canada are not as tightly regulated as federally regulated banks yet they are very active in the mortgage market, particularly in BC and Quebec.
Few analysts cover them extensively since they aren't publicly traded but all analysts I’ve spoken to express some concern about the fate of credit unions, particularly in BC, in the event of a sustained housing correction coupled with rising unemployment and delinquencies. This is particularly concerning once we consider that BC guarantees $45B in insured deposits, the equivalent of 23% of GDP.
We once again urge clients to consider how best to position themselves to strategically position their portfolio in light of the high potential of a significant housing correction in Canada, particularly in BC. We’re always happy to discuss potential long, short, and derivative trades with clients.