One week after we channeled Deutsche Bank's Torsten Slok, who two years ago warned that "Canada is in serious trouble", a warning which was especially resonant after last week's rate hike by the Bank of Canada - the first since 2010 - which we argued threatens to burst Canada's gargantuan housing bubble...
... resulting in dramatic negative consequences for Canada's construction-heavy economy...
... Goldman has released a report titled "Does Canada 2017 = US 2007?" seeking to answer whether Canada's economy is indeed on the verge of a housing bubble burst and which - considering it was the most read piece on GS360 this morning - touches on a question many investors the seeking the answers, especially after the IMF echoed our concerns last Thursday, when it issued a report in which it warned about the "danger of a sharp correction in the housing market."
By way of background, Goldman notes the following:
"nominal home prices in Canada have grown by 13% over the past year, and by 200% since 2000. These sharp increases in home prices in Canada have invited comparisons with the US housing market in the period leading up to the Global Financial Crisis (Exhibit 1). A large downturn in the Canadian housing market in 2017 would seem particularly untimely given the likelihood of rising mortgage rates in Canada. Most Canadian mortgages have 25-year amortization schedules but 5-year terms, and so borrowers typically have to re-qualify for new mortgages every 5 years. Under our rates view, many Canadian mortgage borrowers may be forced in the coming years to refinance their loans at higher mortgage rates.
To frame Goldman's take, the bank's housing strategist Marty Young writes that "given the potential risks that a housing downturn could pose to the Canadian economy, we address here the questions (1) “is Canada’s housing market in 2017 comparable to the US’s in 2007?”, and (2) “will rising interest rates lead to significant payment shocks and mortgage defaults among Canadian homeowners?”.
Young's answer to the first question is as follows:
Our answer is “in some respects, Canada in 2017 and US in 2007 are similar, but in many respects they are not”. One important difference is with respect to the mortgage lending standards prevailing in the two times and places. Exhibit 2 charts an indicator of US lending standards vs. the US house price index, showing that standards were still loosening during 2005-2007 even as house prices were approaching a peak. In 2006, over 40% of US mortgages were funded via the non-agency RMBS market, where no-doc and low-doc lending and usage of “exotic” loan products such as negatively amortizing adjustable rate mortgages were most common.
By comparison, Canadian banking regulators have generally tightened lending standards since the financial crisis, including reducing maximum LTV ratios and amortization terms, and, more recently, Vancouver and Toronto have introduced foreign buyer taxes to dampen house price growth... Canada’s mortgage delinquency rates have remained structurally lower than the delinquency rates in the US for the past several decades (Exhibit 3). These lower delinquency rates reflect a combination of more conservative underwriting and more lender-friendly mortgage foreclosure laws in Canada. The lower baseline mortgage default rates in Canada, combined with stronger bank capitalization, suggest that a house price decline in Canada of the magnitude experienced in the US during 2007-2011 would likely pose smaller systemic risks than were realised in the US during the financial crisis period.
Another argument from Goldman: household mortgage debt service ratios remain low.
Exhibit 3 shows that delinquency rates in the US had already started trending up by 2007, whereas delinquency rates in Canada remain low, suggesting that Canada’s mortgage market is at least not yet at the same distressed stage as the US’s was in 2007. Similarly, Exhibit 4 shows that the mortgage debt service ratio in US was historically elevated by 2007, whereas the comparable ratio in Canada remains near historically normal levels. Rental vacancy rates and unsold housing inventories are among the other indicators that were already showing stress in the US by 2007, but which still appear healthy in Canada as of 2017.
To this, however, once can simply respond that while mortgage debt service ratios remain low, simply due to sticky low rates, total Canadian household debt service is substantially higher than in the US:
Putting the above together, Goldman says that while a Canadian housing bubble burst would be bad, it would not be quite as bad as what happened in the US a decade ago.
As for the second question, will rising rates leads to payment shocks and a spike in mortgage defaults, here Goldman is less sanguine, even if it contends that the outcome would not be "disastrous":
Whereas backward-looking indicators of the Canada housing market may still appear relatively benign, market observers have expressed concern that rising interest rates will lead to significant stress, since most Canadian mortgages have only 5-year terms and thus will need to be refinanced at higher rates. Our calculations suggest that this risk, while non-negligible, may not be disastrous. As an example, a borrower who took out a 25-year amortization, 5-year term, 4% mortgage for $300K in 2013 would have been paying a monthly principal plus interest payment of $1,584. If this borrower is forced to refinance the remaining $262K balance in 2018 at a higher 6% rate – a fairly extreme scenario – and takes another 25-year amortization loan, the monthly payment would increase to $1,688, just a 7% increase relative to the original loan payment.
The payment increase is relatively modest because (a) the rising interest rate leads to a higher interest payment but also to a smaller monthly principal payment; and (b) the original 2013 loan was scheduled to fully amortize by 2038, but the new 2018 mortgage is not scheduled to pay down until 2043. By extending the final amortization date, the payment shock is partly mitigated. We thus do not expect a large pickup in mortgage defaults due to higher payment burdens among existing borrowers.
So while the modest - for now - rate increase won't lead to a payment "shock", and induce a surge of defaults among existing borrowers, Goldman admits that "higher rates can negatively affect housing affordability for future potential homebuyers" adding that "our previous research in the US and other international housing markets has suggested that if higher rates are associated with a strengthening economy or stronger inflation, then the overall impact on house prices can be limited, but if higher rates are driven by an adverse policy shock, the impact may be more negative."
Considering that Canadian hourly wages have plunged in recent months, it is difficult to make the case that the BOC's rate hike was warranted, and may indeed by interpreted as an "adverse policy shock"
Goldman tries to spin the reality, suggesting that "In the case of Canada, we expect rising rates to be correlated with a stronger labor market, and thus expect the negative impact on housing affordability to be real but manageable." That said, this "stronger labor market", at least in the form of rising wages, has yet to emerge.
The recent rapid rise in house prices in Canada presents a risk of eventual over-heating. A model of bust risk that accounts for house price-to-rent ratios, past changes in real house prices, investment-to-GDP ratios, real GDP growth and inflation puts the probability of a 5% or larger downturn in real house prices over the next 5-8 quarters at around 30%. At the same time, we see significant differences between the US housing market in 2007 and the Canadian market in 2017, and for this reason we think it may be early to look for a downturn in Canadian house prices of close to the magnitude seen in the US before the financial crisis.
It was not immediately clear if it is "early to look for a downturn" because of Goldman's infamous, chronic sellside overoptimism about, well, everything (recall the bank had initially forecast US GDP would grow just shy of 3% by the end of 2018, and now a 2% print appears optimistic), or because Goldman needs some more time to put on Canadian housing shorts for its prop group and its best clients.