Why Rising Mortgage Rates Threaten Canada’s Banks

Wolf Richter with Jim Goddard on This Week in Money:

Interest rates will continue to rise in the US and Canada. In both countries, potential buyers face affordability issues, which puts a damper on demand. But in Canada, variable-rate and adjustable-rate mortgages dominate (while ARMs are only 6% of all mortgage originations in the US), and current homeowners have to struggle with rising monthly payments of homes they bought at inflated prices. This has already started to happen. Here’s my take:

Home-equity-loan balances in Canada per capita are now 3.3 times what they were in the US during HELOC peak before it all collapsed. Read… HELOCs in the US & Canada: As “Scarred” Americans Learned Bitter Lesson, Canadians Went Nuts  
 

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  39 comments for “Why Rising Mortgage Rates Threaten Canada’s Banks

  1. Maximus Minimus
    Sep 30, 2018 at 12:23 pm

    You made a valid and rational point about ARMs, but you hugely overestimate the knowledge and intelligence of an average mortgage taker. If this kind of mortgage should be restricted, it will have to come from above, and there is no such motion.
    The present government has already stated that they will protect the most valuable investment of the people, so you know who they will punish. If the prudent are to be protected, it will have to come from the market.

    • Sep 30, 2018 at 6:04 pm

      There are now restrictions on these kinds of mortgages, including new stress tests with higher interest rates. This has already eliminated many potential buyers because they didn’t qualify for a mortgage under the new rules this year. But these new rules and stress tests come too late for those who bought homes over the past five years or so.

    • RangerOne
      Oct 1, 2018 at 9:46 am

      I find it disturbing that people sign on for such life altering amounts of debt without fully comprehending at least most of their options and how their loans work…

  2. Crysangle
    Sep 30, 2018 at 12:29 pm

    Looking for recent data on mortgage type by country and the only set I found was 2010. There Canada was around 85% of market fixed rate medium term mortgage, and I presume that means the fixed rate adjusts every few years to the new national level…it seems that long term fixed is just not an option there? Not sure the point of it being like that, maybe it creates a tiered introduction of rate changes that is gentler in effect on the market and economy?

    • Crysangle
      Sep 30, 2018 at 12:42 pm

      I’ll partly answer own question with this, if it is still valid, which I imagine it is…

      http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/06/why-cant-canadians-get-30-year-mortgages-but-americans-can.html

      • Paulo
        Sep 30, 2018 at 5:04 pm

        @Crysangle
        As far as I understand it there are very few ARMS, unless it is a dodgy purchaser forced into using 2nd tier financial companies. When people get a mortgage here you immediately make a decision about trends. If you think rates will be going down, you contract for a variable, then lock in when you believe they have bottomed. If you think they will stay the same you lock in for a 3 or 5 year term right away, regardless of amortization. And if you think they are rising you just lock in right away and get the longest term you can wrangle. You pick your amortization with budget planning in mind, and traditionally people select their ‘time-to-pay-off’ based on the highest amount they can afford on their net for over the least amount of time. In other words, whatever it takes to get the house paid off as fast as possible is what is budgeted. This has always been a common mindset among Canadian buyers. Mortgage burning parties are traditional.

        My son just did a refi for 5 years at 5%, as I encouraged him to lock in based on QT, rising rates, etc. His house and property is worth $600,000. He owes $300,000. His bank is Bank of Nova Scotia, or Scotia Bank. I doubt they or he will be going under anytime soon as the big 5 have a virtual monopoly and mortgages are insured. Will his property go underwater? Not likely as it is worth 2X just a 45 minute drive from here. He also has the option to make lump sum payments on the principal every mortgage anniversary date.

        My sister- in-law (and husband) are building a home. They obtained financing almost a year ago with a guaranteed rate of just under 4%. They locked in and the excavator starts digging tomorrow. The rate is locked, fixed, and no payments start until occupancy.

        I hear all this doom and gloom about Canadian homebuyers debt levels. I realize I am older (63) but I do know all my children’s friends who have bought homes. They are in their 30s. None of them have mortgages beyond 3X income. Most plan to pay them off before age 50. My daughter and son both will have a paid for home in 5-7 years, well before age 50. They, and friends all have secure employment, and/or in-demand skills and seniority in the energy sector which has already gone through the latest bust and downsizing. My daughter teaches school and has 10 years seniority with a current teacher shortage, and her husband is a manager for Service Canada. Both occupations are about as gold plated secure as one can get.

        The high debt ratios are Vancouver and Toronto areas. The rest of Canada will pretty much sit back and say, “I told you so”. Most will not care when the prices fall to realistic levels.

        I know people on WS don’t believe this about Canadians, but I will reiterate. The traditional goal of Canadian homebuyers is to pay the house off as fast as possible. Our mortgage interest has never been deductible. The latest debt trends arose in the bubble cities and are an anomally.

        • Crysangle
          Sep 30, 2018 at 6:13 pm

          I hope that is so.

          The difference between ARM and what Canadians have is that Canadians lock in a rate for up to 5yrs, then they must lock in whatever rate is offered at that point for next segment up to 5yrs…and so on. While rates are going down it will be beneficial, but is they go up the cost of the mortgage will increase. That can be offset to a degree by extending its length etc. maybe, but it does add to the mortgage owners costs. ARM fluctuates almost immediately with rates, with Canada just those reaching renewal will be pulled into higher rates as their contract needs updating. It also is likely to slow or bring prices down, and there can be a feedback into the wider economy from that. I am not one side or another as to what position Canada is, I don’t know the Canadian economy in detail, and Canadians are also sensible in their own way… it is just out of interest on how it all works that I am discussing this. Personally I am wary of all debt though.

        • TCG
          Oct 1, 2018 at 11:25 am

          I wouldn’t be too sure things in Toronto and Vancouver won’t affect the rest of Canada. Those two cities are 1/4 of the population of the country.

          I don’t personally know anyone who lost their home in the 2008 bubble popping in the US, either.

          It’s great that your family and friends are prudent, but I wouldn’t be too sure everyone is as prudent as you.

        • Alistair McLaughlin
          Oct 1, 2018 at 12:32 pm

          Paulo, your kids and their friends are the exception, not the rule. Household debt in Canada is now 101% of GDP – that’s higher than it was at its peak in the US in 2007. When measured against income, average household debt is $1.73 per $1.00 of income, another record, and again higher than it was in the US a decade ago.

          A person can dismiss those numbers by saying “That’s just the average”, but that misses the point. You don’t need the “average” household to go under. You just need 5% or 10% of households out at the extreme end of the right tail to start having problems and you’ve got a financial crisis on your hands.

    • Crysangle
      Sep 30, 2018 at 5:57 pm

      The question of ARM vs FRM is debated in terms of as to how the property sector is, reacts and why. In

      https://www.heritage.org/housing/report/why-federal-housing-policy-fixated-30-year-fixed-rate-mortgages

      there is a strong critique of the FRM frameworks, particularly for the US. One point I question in that is that ARM holders faired ok into the bust in the US. The reason for that might be various, from better off customers using that facility through to not actually having rates rise much before the bust. I know in Spain the whole economy was cooled as rates were lifted before the bust, mortgage holders were hurting until rates were dropped way low after. So in both those examples you ended up with borrowers ultimately benefitting from ARM because rates were eventually lowered. I think Spanish delinquencies and foreclosures were higher, though I don’t have comparative data, and anyway policy choices and means used to support prices etc. were very different. In Spain mortgages are full recourse normally also.

      So no matter what is said nor the accomodation in terms lenders try to make to offset immediate transfer of rates rises , I think rising rates with ARM is going to have some effect on mortgage holders, exactly what I do not know. The only reading that seems to correlate across the board is that going underwater has a very strong effect on how existing mortgage holders behave, even where full recourse is present if conditions are difficult enough.

      Well, that is my bit of learning for today, figured it might benefit others interested also to read and try to understand those two links.

    • Sep 30, 2018 at 6:09 pm

      “Fixed” in Canada means “adjustable” in the US. These are adjustable rate mortgages with the first several years, up to 5 years, at fixed rate that then adjusts to a new rate. The two major mortgage types in Canada are “adjustable-rate” (which has a fixed portion early on) and the “variable-rate” mortgage, that changes very quickly. I explained this here about two-thirds down:

      https://wolfstreet.com/2018/08/18/inflation-interest-rate-mortgage-types-in-canada-house-price-bubble-variable-adjustable-fixed-rate/

    • Maximus Minimus
      Sep 30, 2018 at 7:30 pm

      I viewed the 30-year fixed as a phenomenon of a society that never experienced hyperinflation (partly due to reserve currency status). In such event, this kind of mortgage is a gift.
      However, housing can detach from the economy, and create inflation of its own. Standard economic thinking is that this could only be temporary. However, as localized global overpopulation creates hellholes of their own making, this puts a premium on real estate where life is still decent.

  3. a reader
    Sep 30, 2018 at 12:58 pm

    Wolf, your talk about the possibility of Canadian banks failing is making me nervous. By the time people are paid their FDIC-insured money back it’ll be probably worth 70-80% of what it was before the crash, if not less.

    The savers here (that most despised modern category of financial market actors) are between the rock and the hard place. The interest on savings is washed out by the inflation, not worth of locking in one’s money for a long time. Forget the stock market, especially the current one, that’s for betting men.

    I’d like to put my savings into real estate (land), but not at the current bubble levels. However, I’m not convinced there will be a crash to wait for, more likely a stagnation. Meanwhile, sitting on the cash is not a long term solution either, for the reasons mentioned above. That feels like being slowly bled to death.

    The easy credit really ruined the entire economy in the long term.

    • Srini
      Sep 30, 2018 at 1:24 pm

      Don’t central banks want you to spend the money you have? Why are you looking to invest when you have opportunity to enjoy and squander the cash you have?

    • Ed
      Sep 30, 2018 at 4:01 pm

      I remember walking into Schwab in 2007 or thereabouts and one of their advisers was telling me how weird it was, he had a customer who just put all of his money in German bonds. The adviser was not recommending it, just telling me his “interesting story of the day”.

      Over my head at the time. But in retrospect, that investor really knew how to protect his money, if not make a killing.

      • Javert Chip
        Sep 30, 2018 at 8:15 pm

        Just a data point:

        In 2007, the Euro cost $1.40USD; today it’s $1.15USD (18% drop from $1.40…

        • Ed
          Sep 30, 2018 at 9:08 pm

          Well, if he was smart enough to step aside and then to get back in 2009 after the plunge, the exchange rates hadn’t changed much. Or he hedged the currency. Dunno.

          I guess I can dream someone did it right, huh? ;-)

    • James
      Sep 30, 2018 at 4:57 pm

      > Meanwhile, sitting on the cash is not a long term solution either, for the reasons mentioned above. That feels like being slowly bled to death

      > The easy credit really ruined the entire economy in the long term.

      What is the real economy? If the current economy is distorted, does anyone know what a “real” target economy should look like? Does the Fed know what a real economy should be? Do politicians know? Should a real economy help savers? Creditors? Debtors? Taxpayers? I just don’t understand what the “gold standard” of economic policies should be.

      (Sorry, I’m one of those millenials who don’t know anything that happened before me but I’m trying to learn).

      • a reader
        Sep 30, 2018 at 6:54 pm

        I’ll just give you one example: without the easy credit, if the buyer had to put down, say, 50% cash, do you think the average price of a light truck would be pushing $40K? This used to be a work vehicle, for getting beat up. Now people load up on quad-cabs, all-leather interiors and such. Most will never pay off their trucks, i.e. they will never own them free.

        Let’s not talk about the chances of them paying off their mortgages in the amounts inflated by the same easy money.

        Other examples: corporations borrowing to buy their own shares, to make their shares go up regardless of P/E; governments borrowing ever more freely and passing the tab ever-forward.

        Does that feel normal to you?

      • Crysangle
        Sep 30, 2018 at 7:08 pm

        A real economy is considered as a free and open market, without any imposed intervention whatsoever. There is no target to it, it is the product of the combined activity and agreements of its participants. For the rest of the examples you mention those are all use and outside management of the real economy, hence you are talking as you did of policy…and you are therefore into politics, and political management and use of the real economy, theoretically to the benefit and on behalf of society itself as a whole.

        Just my 5% (pun intended for Wolf :-) )

    • Paulo
      Sep 30, 2018 at 5:27 pm

      Last comment as I will be at two for this topic.

      I am also a saver. I agree with you about savings not keeping up with inflation. However, I have always noticed that when the dust settles savers always have their money. Funny how that works.

      I think for ‘property as investment’ you have to find a ‘sleeper’ location. Something currently undervalued. Maybe look at the areas people make jokes about. When mines shut down housing prices collapse, immediately. I know people who bought in Tumbler Ridge for pennies on the dollar and retired there. One lady (relative) bought 3 homes. Elliot Lake Ontario is now a nice retirement village. Gold River collapsed with the mill closing and people from all over the world snapped up the bargains. It’s like living in Switzerland, but only 10 miles form the ocean for good salmon fishing. They even have a golf course.

      These places have already ‘gone’, bought up by people who laughed at them when they bought, but there are always other places and always will be. A real score was Cumberland BC. An accountant friend I know bought 3 properties there. One old historical store to use as his office, another one is a home for his family, and one was for his mom. He paid around $25,000 each in the early ’90s. They are probably worth around $400,000 each (Each!!) in today’s market. Paint, sweat and TLC paid off, big time.
      https://cumberland.ca/
      https://tumblerridge.ca/
      https://www.goldriver.ca/
      http://www.cityofelliotlake.com/en/

      Apparently, some couple from West Vancouver just bought an old piece of sh*t house down the road from me. I figure it priced out $200,000+ more than it’s worth, but…….

      • a reader
        Sep 30, 2018 at 6:41 pm

        Paulo, I do see the merit of what you are saying, however the problem always is: what are the locals like? I do like the feeling of being somewhat accepted. (You have mentioned dealing with bad neighbours, as well as intending to buy a next door property to screen new neighbours).

        As for the savers always pulling through – that depends. Some savers in Cyprus had a different experience not too long ago. If you want go farther back in time, read “The Magic of Money” by Hjalmar Schacht (poorly chosen title; the text is available on the Web). It’s about the post-Weimar period in Germany – the savers were the ones wiped out clean.

        • Plsnot5%!
          Sep 30, 2018 at 8:31 pm

          Savings in a bank is investment in fiat invested in a bank, that is why some people choose other mediums to save with. With fiat in a bank you are usually funding others to go into debt, and if they en masse don’t repay, the physical owners of the fiat (ECB in this case), might decide how to reallocate what actual cash is left over.

          People being in debt though , well they are on a lead even though it means they get to go for a walk, Stockholm syndrome comes to mind unless they are very disciplined with their objectives. Nowadays the choice is harder still because debt is often needed just to gain entry – everything is priced towards access through leverage. Doesn’t make the approach of saving wrong though, when you make fastest repayment a priority, then outright ownership becomes the actual saving.

      • Gordo
        Sep 30, 2018 at 8:22 pm

        seems like magic, eh. take on debt to buy real estate, get filthy rich. . .it’s the canadian way, and seems (for many years now) to be working thanks to low interest rates.

        except, there are NO jobs in any of these areas that can support (in their wildest dreams) any of these home prices. walmart employees don’t buy 400K homes.

        so to justify the current ludicrous home prices the money has to come from somewhere else. traditionally from rich retiring folks from back east (ie toronto) buying (relatively) cheap properties–driving up prices.

        if you grew up in any of these markets you don’t have a hope in hell of owning a home–maybe a tent i a trailer park.

        its like the dog chasing the car tire. now your home is worth a gazillion dollars and everyone is feeling filthy rich, then interest rates go up and reflect the true cost of borrowing–in which case the dog is road kill. and the banks own the whole enchilada.

        the rat on a treadmill is the smartest rat it knows.

      • Oct 3, 2018 at 10:43 am

        I told everyone in the greater Toronto area to sell all real estate in the third week of September 1987 (which was actually the real peak) and buy homes in Elliot Lake. Real estate tanked in all of Canada except Elliot Lake where prices tripled as the great uranium boom had just started. I was never a real estate agent nor a financial advisor.

    • Max Power
      Sep 30, 2018 at 6:06 pm

      Your fears are unfounded.

      First of all, we’re talking about Canadian banks, not US banks and as such deposits are guaranteed by the CDIC, not the FDIC.

      Second, if it takes say a year for people to get deposits back, then for them to lose 70-80% of their purchasing power would mean an annual inflation rate of 20-30%. That’s extremely unlikely to happen. If anything, massive credit writeoffs have a deflationary, not inflationary effect.

      As as aside on this topic…

      One interesting parallel to the lead up to the US’ housing crisis and Canada’s current situation which Wolf hasn’t covered in his articles on the topic has to do with the increase in private-label mortgages, i.e., mortgages which are not insured against default by government agencies. In the US, the share of guaranteed mortgages fell significantly in the lead up to the housing crisis. The same thing is happening in Canada now, where only 60% of the mortgages are now guaranteed by the CMHC, and a large proportion of the 40% of the remaining mortgages are in the GTA and Vancouver bubble markets. This situation could have a devastating effect on Canadian banks and private lending institution.

      Again, very similar to what happened in the US. The subsequent housing meltdown had for all intent and purposes killed off private label mortgaging in the US. Post-crisis US housing agencies and GSEs had returned to their former key role in the US housing market after the crash.

      • a reader
        Sep 30, 2018 at 6:46 pm

        “are guaranteed by the CDIC, not the FDIC”

        I’m aware, same difference.

        “annual inflation rate of 20-30%. That’s extremely unlikely”

        What do you suppose is going to happen after a major crash? I think the Bank of Canada will have to step in and help with “re-capitalising” commercial banks. AKA Ctrl-Prnt in a big way.

        • Max Power
          Sep 30, 2018 at 9:44 pm

          Recapitalization by central banks following the previous crisis in the US and Europe did not lead to hyperinflation, despite the ominous prognostications from many that it would.

      • Oct 3, 2018 at 10:45 am

        Obviously the first to go down will be the credit unions in British Columbia. You can quote me on this one as I can guarantee this will happen and they’ll be the first.

        • a reader
          Oct 4, 2018 at 9:34 am

          Are you talking about Vancouver-area credit unions or all of them? What makes you think the small town ones would be affected?

  4. 2banana
    Sep 30, 2018 at 3:17 pm
  5. Ed
    Sep 30, 2018 at 4:57 pm

    Here’s some further grist for the mill.

    http://www.themacrotourist.com/posts/2018/09/27/jesse/

    The number of Russell 3000 companies trading for more than 10 times revenue is approaching 2000 peaks.

    This was of interest to me because one of my favorite stocks has a P/E of ~40, a PEG of ~1.3, but a price-to-revenue of about 17.

    I think it’s the third number that’s alarming . . .

    • Ed
      Sep 30, 2018 at 5:06 pm

      Still invested. I think the trillion dollar deficit spending by the Federal Government — at the height of the cycle — should goose the economy for a while longer.

      (That spending is clear as day. That the Fed has gotten to the neutral rate is a lot less clear to me.)

    • James
      Sep 30, 2018 at 5:12 pm

      Interesting comparisons with the dot-com bust. But a lot of money today is hedge funds and foreign central banks/sovereign funds with hundreds of billions in management. They go plunk in a billion on AMZN because there’s nowhere else for that money to go.

      Did such funds exist in 2000 as well or are they the extra wildcard variable providing cushion today? Because really, some of those tech stocks (TSLA, NFLX) should not be trading at those levels by historic measures of P/E

  6. Prairies
    Sep 30, 2018 at 9:40 pm

    One weird thing I saw today, a mall that was supposed to be condos in Calgary.
    A guy does a walk through and sees one or 2 possible store locations leased and it is supposed to be open already.

    https://www.youtube.com/watch?v=JEt9n8BSRro

    Canadian real estate is solid…. lol

  7. Some Guy
    Sep 30, 2018 at 11:44 pm

    It’s funny, in the short term, rising rates helps the banks by widening spreads that had been compressed at lower rates. RBC recently released record results in Q3 and raised their dividend by 4%. But it looks like a bull trap to me…

    …Meanwhile another arm of RBC just put out their quarterly ‘affordability report’ the other day, which starts off, “RBC’s affordability measure hasn’t been this bad since 1990”

    Any Canadian above a certain age remembers what followed 1990, a brutal housing downturn led recession that nearly broke the country apart, reducing the governing federal party (The Progressive Conservative Party) from a majority to a 2 seat rump from which they never recovered, and forcing the country’s one private mortgage insurer (MICC) into a bailout reminiscent of the last recession in the U.S.

    Ironically, part of that recession was the transition (especially hard in Ontario) to the new Free Trade Agreement with the U.S. Part of this recession might be the end of that deal.

    It will be fun to see the public blame the upcoming recession respectively, in B.C., on the left leaning NDP government for bursting the bubble by cracking down on money laundering and taxing the wealthy, in Ontario, the lunatic right wing government for deregulating everything and being corrupt and scaring away investors, and federally, the Liberal government for (Trump’s madness, running deficits, too much political correctness (accurate but irrelevant), whatever).

    Meanwhile, few will connect the dots and place the blame where it belongs on the central bank for mismanaging the economy and the money supply, although in the end, as Howard Jones once said, no one really ever is to blame, since, per Minsky, there is a certain inevitability to the credit cycle. We’ve put the reckoning off for a while in Canada, but I suspect that will just make the landing harder when it comes.

  8. MASTER OF UNIVERSE
    Oct 1, 2018 at 11:05 am

    China’s Central Bank failed to contain the lion’s share of ‘hot’ money laundering out of mainland China which resulted in CANADA’s Bimodal Distribution with respect to Toronto & Vancouver, and everywhere else in CANADA too. The USA has the same problems in SF & NYC Manhattan High End RE Residential & Commercial.

    The simple facts of the Lehman debacle are such that since 08 & the onset of the Great Financial Crisis all Western Central Banking is mired in Japan style leverage on debt still held system wide on their collective balance sheets. Brussels & EU are poised to disintegrate along with the USA & USD as the Central Banking largesse plays out once again on the second leg of the Great Financial Crisis that was never resolved whatsoever since Geithner decided in haste to manufacture Too-BIG-to-Fail, Nail, or Jail.

    Building up the Wall Street Investment Banks & Bank Holding Companies into overarching market behemoths that are wholly unpredictable & uncontrollable was Geithner’s BIG mistake to begin with and that is why we can expect a second round of ever greater defaults within industries & between lender institutions which include the entire systems that lending and issuance is dependent upon for mere survival.

    Secular Stagnation rendered out of 08 and onward will be the undoing of all that is modelled off of the substrate of the shifting sands of a growth model that was dreamed up out of the same ether that allows Western Central Banking to manufacture via that very same ether. Yes folks, it looks as though we are evidencing a tautology not unlike the prototypical Money Pump examples we see in Statistics 101 in our universities across the continent.

    The money system cannot support itself if everyone withdraws cash at the same time or all at once due to run effects on banks system wide.
    The system is closed-looped and built upon extremely bad engineering principles of soundness.

    Structurally, and architecturally, the Western Banking System is only as strong as the weakest link in the long & ponderous chains of liability that GS manufactured to install The Giant Vampire Squid at the helm of the financial largesse that will eventually collapse into the very same ether that it was all manufactured from to begin with.

    Physics posits that energy is finite and not infinite. GS thinks it can game the laws of Physics with the same foolishness that brought us the GFC.

    Fraud is not a sustainable Business Model.

    Thanks, Mr. Geithner.

    MOU

  9. Dave Chapman
    Oct 1, 2018 at 3:39 pm

    The events of ten years ago showed something that we already knew: Adjustable-Rate mortgages have four times as many defaults as Fixed-Rate mortgages.

    Right there, that should be a reason to ban ARMs. Even worse, if we have a major spike in interest rates, you can get into a situation where large numbers of people get a major increase in their monthly payment and are forced to sell, which causes prices to fall, which causes the next round of appraisals to come in low, etc. You could easily get into another foreclosure crisis. I would not be especially surprised if such a thing were to happen in Orlando or Vegas.

    Similar comments regarding Teaser Rates, Option-ARMS, Broken-ARMs, VRMs, KABooms, and the rest of the cacophony.

  10. Danger Dan
    Oct 2, 2018 at 2:58 pm

    I’m not sure anything will really happen in Toronto aside from RE prices sinking further or at least staying flat for a few years. Wages have slowly begun to finally creep up and help wanted signs are out virtually everywhere. Most people understand that interest rates will rise in lockstep with the U.S., although some people still seem to scoff at the concept of normalization. In typical Canadian fashion, there will be stiff upper lips as people grind it out. They will have to, these mortgages are full recourse.

Comments are closed.