A Canadian Story of Woe

 

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A Canadian homeowner going for a relaxing swim in his mortgage…

 

One of the challenges of being a financial advisor is finding ways to convey complex financial issues in simple ways to my clients and readers. I believe I do this to varying degrees of success, and I am informed of my failures by my wife who doesn’t hesitate to point out when I’ve written something boring or too convoluted.

One such subject where I feel I’ve yet to properly distill the essential material is around the housing market. While I’ve written a fair amount about the Canadian housing market, I feel I’ve been less successful in explaining why the current housing situation is eating the middle class.

In case you’re wondering, my thesis rests on three ideas:

1. The middle class as we know it has come about as a result of not simply rising wages but on sustained drops in the price of necessities.
2. The rise of the middle class was greatly accelerated by the unique historical situation at the end of the Second World War, which split the world into competing ideological factions but left the most productive countries with the highest output and technological innovation to flourish.
3. A global trend towards urbanization and a plateauing of middle-class growth has started reversing some of those economic gains, raising the cost of basic living expenses while reducing the average income.

The combination of these three trends has helped morph housing from an essential matter of accommodation into a major pillar of people’s investment portfolios and part of their retirement plan. The result is that homeowners are both far more willing to pay higher prices for a home in the belief that it will continue to appreciate into the future, while also attempting to undercut increases in density within neighborhoods over fears that such a change will negatively impact the value of the homes. In short, stabilizing the housing market is getting harder, while Canadians are paying too much of their income to pay for existing homes. All of this serves to make the Canadian middle class extremely vulnerable.

 

Household Debt
You may be tempted to think “Wow, debt levels really jumped through 2016” you should remind yourself that this chart STARTS at 166%!!!

 

Proving some of this is can be challenging, but there are some things we know. For instance, we know that Canadians are far more in debt than they’ve ever been before and the bulk of that debt is in mortgages and home equity lines of credit (HELOC), which means much of that debt is long-term and sensitive to hikes in interest rates. We also have abundant evidence that zoning restrictions and neighborhood associations have diligently fought against “density creep”. But to tie it all together we need the help of HSBC’s Global Research division and a recent article from the Financial Times.

FT Global Leverage

Last week, HSBC issued a research paper on global leverage. Providing more proof that since 2008 the world has not deleveraged one bit. In fact, global debt has settled just over 300% of global GDP, something that I wrote about in 2016. An interesting bit of information though came in terms of the country’s sensitivity to increasing interest rates. Charting a number of countries, including Canada, the report highlights that Canadians (on average) pay 12.5% of their income to service debt. A 1% increase in the lending rate would push that up over 13%. For a country already heavily in debt, a future of rising rates looks very expensive indeed.

It would be wrong to say that fixing our housing market will put things right. There is no silver bullet and to suggest otherwise is to reduce a complex issue to little more than a TED Talk. But the reality is that our housing market forms a major foundation of our current woes. A sustained campaign to grow our cities and reduce regulatory hurdles will do more to temper large debts that eat at middle-class security than anything I could name.

This House Kills the Middle Class

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This house sold for $1,000,000 in Vancouver. Is it houses that are in demand, or land?

In the mountains of articles written about Toronto’s exuberant housing market, one aspect of it continues to be overlooked, and surprisingly it may be the most important and devastating outcome of an unchecked housing bubble. Typically journalistic investigation into Toronto’s (or Vancouver’s) rampant real estate catalogues both the madness of the prices and the injustice of a generation that is increasingly finding itself excluded from home ownership, finally concluding with some villain that is likely driving the prices into the stratosphere. The most recent villain du-jour has been “foreign buyers”, prompting news articles for whether their should be a foreign buyer tax or not.

What frequently goes missing in these stories are the much more mundane reasons for a housing market to continue climbing. That is that in the 21st century cities, like Toronto, now command an enormous importance in a modern economy while the more rural or suburban locations have ceased to be manufacturing centres and are now commuter towns. Combined with a growing interest in the benefits of urban living and the appeal of cities like Toronto its no surprise that Toronto is the primary recipient of new immigrants and wayward Canadians looking for new opportunities.

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Toronto itself, however, has mixed feelings about it’s own growth. City planners have made their best efforts to blend both the traditional idea of Toronto; green spaces, family homes and quiet neighbourhoods, with the increasing need of a vertical city. Toronto has laid out its plans to increase density up major corridors while attempting to leave residential neighbourhoods intact. Despite that, lots of neighbourhood associations continue to fight any attempt at “density creep”. Many homeowners feel threatened by the increasing density and fear the loss of their local character and safety within their neighbourhoods, at times outlandishly so. Sometimes this comically backfires, but more often than not developers find themselves in front of the OMB (Ontario Municipal Board) fighting to get a ruling that will allow them to go ahead with some plan, much to the anger of local residents and partisan city councillors.

The result is that Toronto seems to be growing too fast and not fast enough simultaneously, and in the process it is  setting up the middle class to be the ultimate victims of its own schizophrenic behaviour.

High house prices go hand in hand with big mortgages. The bigger home prices get the more average Canadians must borrow for a house. Much of the frightening numbers about debt to income ratios for Canadians is exclusively the result of mortgage debt, while another large chunk is HELOCs (home equity lines of credit). Those two categories of debt easily dwarf credit cards or in store financing. This suits banks and the BoC not simply because houses are considered more stable, but because banks have very little at risk in the financial relationship.

To illustrate why banks have so little at risk, you only need to look at a typical mortgage arrangement. Say you buy a $1 million home with a 20% down payment, the bank would lend you $800,000 for the rest of the purchase. But assume for a second that housing prices then suddenly collapse, wiping out 20% of home values, how much have you lost? Well its a great deal more than 20%. Because the bank has the senior claim on the debt, the 20% of equity wiped out translates into a 100% loss for you, the buyer. The bank on the other hand still has an $800,000 investment in your home that must be paid back.

Bank vs you

By itself this isn’t a problem, but financial stability and comfort is built around having a set of diversified resources to fall back on. In 2008, in the United States, home owners in the poorest 20% of the population saw not just their home prices collapse, but also all of their financial resources. On average if you were part of the bottom 20% you only had $1 in other assets for every $4 in home equity. By comparison the richest 20% had $4 in other assets for every $1 in home equity. The richest Americans weren’t just better off because they had more money, but because they had a diversified pool of assets that could spread the risk around. Since the stock market bounced back so quickly while much of the housing market lagged the result was a widening of wealth inequality following 2008.

Housing impact
The impact of 2008 on household net worth by quintile. From House of Debt by Atif Mian and Amir Sufi

In Toronto the situation is a little different. Exorbitant house prices means lots of people have the bulk of their assets tied up in home equity. Funding the enormous debt of a house may preclude investing outside the home or building up retirement reserves in RRSPs and TFSAs. A change in interest rates, or a general correction in the housing market would have the effect of both wiping out savings while simultaneously raising the burden that debt places on families.

The issue of debt is one that the  government and the BoC take seriously, yet despite the potential impact of high debt levels on Canadians and the looming threat it poses to the economy the mood has remained largely indifferent. The BoC, under the governorship of Stephen Poloz, has said that it isn’t worried too much about Canada’s housing market. This isn’t because there isn’t a huge risk that it could implode, but because even if it does it is unlikely to start a run on the banks. By comparison the view of Stephen Poloz on the debt levels of Canadians is that its your problem. A curious stance given that the BoC’s position has been to try and stimulate the economy with low borrowing rates.

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There will probably never be as full throated a reason for my job than the burden the Toronto housing market places on Canadians. From experience we know that concentrating wealth inside a home contributes to economic fragility, potentially robbing home owners of longer term goals and squeezing out smart financial options. But far more important now is that city councillors and home owners come to realize that the housing market is more prison than home, shackling the city to ever more tenuous tax sources and weakening the finances of the middle class. Until then, smart financial planning alongside home ownership is still in the best interests of Canadian families.

Are Economists Incompetent or Just Unhelpful?

 

 

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When economists get things wrong their missteps are practically jaw dropping. Despite making themselves the presumed source of useful information about economies, interest rates and economic management, often it seems that the economists are learning with the rest of us, testing ideas under the guise of sage and knowledgable advice. Their bias is almost always positive and the choices they make can be confounding.

As an example, let us consider the case of the Bank of Canada (BoC).

If there are perennial optimists in this world they must be employed at the BoC, for no one else has ever stared more danger in the face and assumed that everything will be fine.

For those not in the know, the BoC publishes a regular document called the Financial System Review, a bi-annual breakdown of the largest threats that could undo the Canadian economy and destabilize our financial system. Because they are the biggest problems we tend to live with them over a long time and thanks to the Financial System Review we can see how these dangers are presumed to ebb and flow over time.

For instance, two years ago the four biggest dangers according to the BoC were:

  1. A sharp correction in house prices
  2. A sharp increase in long-term interest rates.
  3. Stress emanating from China and other Emerging Markets
  4. Financial stress from the euro area.

Helpfully the BoC doesn’t just list these problems but also provides the presumed severity and likelihood of them coming to pass and places them in a useful chart.

Here is what that chart looked like in June of 2014:

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The worst risk? A Canadian housing price correction. The likelihood of that happening? very low. Meanwhile stress from the Euro area and China rate higher in terms of possibility but lower in terms of impact.

By the end of 2014 the chart looked like this:

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Unchanged.

Interestingly the view from the BoC was that there was no perceivable difference in the risks to the Canadian market. Despite a Russian invasion of the Ukraine, the sudden collapse in the price of oil and the continued growth of Canadian debt, the primary threats to Canada’s economy remained unmoved.

So what changed by the time we got to mid 2015?

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The June 2105 FSR helpfully let Canadians know that, presumably, threats to Canada’s economy had actually decreased, at least with regards to problems from the euro area. This is curious because at that particular moment Greece was engaged in a game of brinkmanship with Germany, the IMF and the European Bank. Though Greece would go on to technically default and then get another bailout only further kicking the can down the road, the view from the BoC was that things were better.

Interestingly the price of oil had also continued to decline in that period, and the BoC had been forced to make a surprise rate cut at the beginning of the year. Debt levels were still piling up, and there was a worrying uptick in the use of non-regulated private lenders to help get mortgages.

None of that, according to the analysts at the Bank of Canada, apparently mattered. At least not enough to move the needle.

The December 2015 FSR is now out, and if we are to take a retrospective on the year we might point to a few significant events. To begin, the economy was doing so poorly in the summer that the BoC did a second rate cut, which was followed by further news that the country had technically entered a recession (but nobody cared). Europe’s migrant crisis reached a tipping point, costing money and the risking the stability of the EU. Germany’s largest auto maker is under investigation for a serious breach in ethics and falsifying test results. China’s stock market began falling in July, and the Chinese government was forced to cut interest rates 5 times in the past year. The United States did their first rate hike, a paltry 25 bps, but even that has helped spur a big jump in the value of the US dollar. Meanwhile the Canadian dollar fell by nearly 20% by the end of 2015.

And the Bank of Canada says:

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Things are better? Or not as severe?

In two years of producing these charts, despite continued worsening of the financial pictures for Canada, China, the EU and even the United States, the BoC’s view is still pretty rosy. What would it take to change any of this?

Whether they are right or not isn’t at issue. It’s the future and it is unknowable. What is at issue is how we perceive risk and how ideas about risk are communicated by the people and institutions who we trust to provide that guidance. This information is meaningless if we can’t understand its parameters and confusing if a worsening situation seems to change nothing about underlying risk.

As you read this I expect the Chinese and global markets to be performing better this morning on reassuring news about Chinese GDP. But I would ask you, has the risk dissipated or is it still there, just buried under positive news and investor relief? It’s a good question and exactly the kind that could use an honest answer from an economist.

 

Pay No Attention to the Bubble Behind the Curtain

Housing Bubble
From The Financial Post Magazine, Sept 15, 2015: “Canada’s Ever Growing Housing Bubble”

In the Wizard of Oz we were told that to enter the Emerald City, everyone had to wear green tinted glasses to “protect their eyes” from the “brightness and glory” when in fact it was the method by which the city itself was made to appear green. The first great illusion of the Wizard in the book. Canadian housing feels much like this. The worse the situation gets the more we are assured that the “brightness and glory” of the housing market is unassailable or simply not an issue, and we are invited to don our own emerald glasses.

Toronto LifeThe latest installment challenging that gilded view of housing and mortgages come from the November Toronto Life. Titled “Mortgage Slaves” it is a depressing look into the world of shadow banking and sub-prime mortgages here in Toronto, which far from popular belief is a lively and growing business. Private lenders and shadow lending can turn the reasonable prospect of paying a mortgage into a spiralling mess of debt. The family they interview took a moderate second mortgage for renovations, and promptly found themselves in financial trouble. Seeking help they refinanced several times with private lenders, moving their borrowing rate up from a reasonable rate of interest to 12%. Ten years on and they owed more money than they had paid for their house and were poised to have their home sold from under them.

FSR MFC LendingPossibly the most frightening thing is that Canadians borrow $10 billion a year for their down payments, meaning that the whole point of down payments is undone. And it is here that we see how problems arise. Housing has gone from being one of the most conservative practices to one of the most aggressive. Down payments are small, you still only need 5% to get a mortgage. The secondary banking business is growing, precisely in the area we don’t want with less credit worthy families. Housing prices are ballooning at rates far in excess of what would be deemed sustainable. The CMHC, the people insuring many of the mortgages and who will be on the hook for significant defaults, also believes that the housing market is vulnerable to a correction.

Home prices adjusted for inflationThe response from political parties during the last election isn’t just underwhelming to these problems, it was counter productive. Harper had promised to raise the maximum you could borrow from your RRSP for the First Time Home Buyers Plan. Trudeau’s plan was arguably worse, allowing you to dip more than once into your RRSP. The best plan was from the NDP to cut taxes to build more rental units.

The IMF, the Bank of Canada, the CMHC and The Economist all believe that our housing market is over valued. The response from banks, private lenders and politicians is to shrug and tell us not to worry. There is complicity from home owners and realtors, who are enjoying seeing the rising home valuations and the flurry of activity that it brings. Economists don’t worry because despite the high level of debt, Canadians don’t owe all that debt at once but over decades. So what’s the concern?

Economist HousingBut it should not take a MENSA level intellect to determine that nothing good can come from growth in the continued drop in quality of the banking system or in the quality of debt on issue. Politicians and citizens have to face a reality that high house prices are only good too a point, and that taming the housing market will pay greater dividends than the eventual fall disinterested parties are predicting. But most importantly, young Canadians should know that buying a house at any cost does not define financial success. But it could spell financial failure.

A Financial Advisor’s Thoughts on the Election

2015 election

Politics is personal and we are not in the game of telling you who to vote for, nor are we endorsing one party over another. These are our thoughts about three issues we find relevant to what we do on your behalf and how we look at the market.

Despite however sophisticated we may think we are, elections are still a confusing mess of promises, accusations and distractions. And making sense of what has been promised is quite difficult. Take for example the Liberals promise for an additional $20 billion in transit infrastructure spending over the next decade. That sounds great and will no doubt be welcome, but that works out to $2 billion a year nation wide (it is not being proposed to be allocated that way, but for simplicity purposes this will do). The cost of the controversial Toronto subway expansion is likely to exceed the $3.56 billion currently budgeted. Given the huge cost of transit infrastructure I’m at a loss to know how much difference $2 billion a year make across the country. Its a big sum, but I don’t know what it’s worth and I’d wager neither do you.

For this reason elections regularly fall victim to the desire of political parties and the media for an easier story to tell. And disappointingly this election spent far too much time talking about the niqab, an issue that, despite how you may feel, has only affected two people since the 2011 ban was first introduced.

There are a lot of issues in this election, but some that could have a meaningful impact on your investments and retirement savings, and I thought I’d share some thoughts on them.

TFSAs

Tax Free Savings Accounts have been a popular new tool for investing since they were introduced in 2009. Originally allowing for a $5000 per year contribution, then raised to $5500 and finally to $10,000 per year in 2015, the Liberals and the NDP have both vowed to roll back the increased contribution room to the more modest $5500 arguing that the room only benefits the wealthy. I have previously written that I think this is a bad argument and that TFSAs are a valuable tool for saving regardless of income. Obviously the Conservatives have promised to keep the contribution levels where they currently are, and notably there has been no discussion yet as to how a roll back would affect existing contributions and future contribution room, nor how the CRA would track this year.

Pension & Income Splitting

Pension splitting has been reaffirmed as a necessary and vital tool for retirees by all the parties. Conservatives, Liberals and the NDP have sought to reassure Canada’s most reliable voting block seniors that pension splitting will remain a part of their income options. In a telling move that illustrates how cynical perhaps our politics are and who will reliably turn up to vote, pension splitting will stay, but the NDP and Liberals would like to see income splitting go.

Income splitting, if I’m being honest, makes a lot of sense to me. Designed to help families with a large income earner and where one parent stays at home to raise children, it balances taxes paid where a two income family would pay less even though their combined incomes are equal to one large earner. The tax benefit is only open to families with children under 18 and capped at $2000, so it isn’t a necessarily huge tax write-off.

Interestingly, the argument against income splitting isn’t a great one. According to the Liberals (and backed up by independent think tanks) the tax credit is really only available to about 15% of Canadian households, and so by that logic alone has been described as a $2 billion tax break for the rich. My math suggests otherwise.

According to the 2011 census, there are just over 13 million private households in Canada. Couples with children account for more than 3 million of those households (3,524,915) or around 28%. That means (and I’ll admit I may have this wrong) eligible families for income splitting account for more than half of all households with children. So the idea that it isn’t a useful or widely available tax credit may not be as accurate as portrayed given who it is targeting.

Housing

Economist Canadian DebtAs you know, I hate Canadian housing, (but love talking about it). It’s a known disaster waiting to happen that consistently defies odds and makes everybody nervous. But while it’s where Canadians have accumulated the greatest amount of debt it hasn’t really been an election issue. The importance of reducing the cost of housing hasn’t really been recognized either. There are efforts from all parties to create more affordable housing, but that isn’t the same thing.

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To this end both the Conservatives and the Liberals have brought some terrible ideas to the forefront. Conservatives have made their once temporary home renovation tax credit permanent, although they’ve cut it’s value in half to $5000 from the original $10,000 and have pledged to increase the maximum you can borrow from the Home Buyers Plan. The Liberals are offering to allow you to dip into the First Time Home Buyers plan more than once. Neither of these plans are great. The housing market is too hot and encouraging the use of RRSPs (you know, your private retirement savings) to encourage more homeownership highlights the complicity of Canada’s government in the soaring debt levels of Canadian families.

Home Ownership

In the end we may long for a political party that advised caution against further home ownership in a country where it is already at record highs, and one of the highest in the developed world. Just a reminder, the view of the government is that while high debt is a natural byproduct of low rates, too much debt will still be your fault.

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We aren’t trying to influence your vote, but we think it is important to understand that underneath the bluster and mudslinging are policies which can directly impact the financial well-being of Canada, and Canadians like you. So please remember, on October 19th, vote!

The Three Most Dangerous Things This Morning

This week three big issues are defining the financial landscape

Greece Isn’t Done Yet!

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Despite a no vote in Greece over the weekend, the EU still believes it is within the collected interest within the Eurozone to stop Greece from imploding. Strong resistence seems to be coming from Greece on this issue as the Greek Prime Minister, Alexis Tsipras, swanned into Brussels with Cheshire cat grin and nothing in hand to negotiate with. Greece has five days to work out a plan with its creditors before being declared in default. While the Greek situation seems to be playing out at a glacial pace, the fact is that these tactics can only go on for so long, and eventually (presumably by the end of the week) a point of no return will be passed and negotiations will be moot. The stakes are high as a Greek default, while not insurmountable by European leaders, risks creating problems in other member states. That contagion is at the heart of German reluctance to cut Greece any slack and it is the real concern that is adding volatility to the market. Markets would like to see a sensible conclusion to the Greek problem since it will reassure everyone that the larger plan for Europe is still in place. A chaotic Greek exit from the euro could simply make matters worse.

China: Start Panicking and Throw Things!

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Ghost CitiesFor years people have scratched their heads at the curious case of China. China’s economy is huge and somewhat a mystery. Like most big economies, the government makes predictions about the future of economic growth. Unlike most big economies those predictions are always right and never need any revision. In addition to China’s always correct economic growth numbers, China has embarked on massive infrastructure projects. So massive that they’ve built entire cities where no one lives. This combination of big spending and highly suspect numbers has made many people wonder whether there is a looming problem within China that has yet to rear its head.

That problem may have arrived this month. The Chinese stock market has lost close to 40% over the last month and the government has had to step in to try and stop the collapse. So far that hasn’t worked. Prices in China have surged over the last few years as many smaller investors have not just placed money in the market, but borrowed to do it as well. While there were rules to stop “leveraged market mania” within the Chinese market, like all rules they were both weakened over time and people have found ways around them (you can read more about that in this May report: Credit Suisse Report on Chinese Leverage).

China has a market bubble and it’s in the process of deflating. Just this spring 20 million people opened stock accounts, while whole towns have given up farming so that they can play the markets. The Chinese government isn’t oblivious to this problem, and has taken extreme action to try an prop up the market, but whether that will work has yet to be seen. Meanwhile concerns that the market is collapsing is driving many investors to sell, exacerbating the situation.

Canada in Recession? What’s a Recession?

bocCanada’s economic situation is…unclear. At least, that’s the best case scenario. The regular reports from the Bank of Canada, The Financial Systems Review, which details risks within the Canadian market and has regularly highlighted that the indebtedness of Canadians poses the single greatest risk to the economy. If the economy were to change in any way that made servicing those debts impossible the effect would be serious. Since the December report, the Bank of Canada had made an unexpected rate cut to help prop up the economy which was being affected by the falling price of oil. The June FSR (which you can read HERE) stated the same thing, but hoped that an improving American economy would also float Canada’s economic boat. But shortly after publishing several things went wrong. It was revealed that the Canadian economy had contracted four months in a row, with the last month coming as a complete surprise to the BoC. Today, news got worse that Canada has had a record trade deficit, and combined with other bad news gives weight to the likelihood that Canada is already in recession. While this will add pressure for a rate cut, the real message here is that the Canadian market is far more dangerous and volatile than many investors think. That’s something that Canadians reviewing their portfolios should be highly aware of as they consider their retirement nest eggs.

Danger Creeps: Housing Bubbles and Crying Wolf

I can not find a better metaphor for Canada's housing market than this image from the movie UP! (Which is a film I highly recommend)
I can not find a better metaphor for Canada’s housing market than this image from the movie UP! (Which is a film I highly recommend)

If you’re looking for some good reading Google “Canadian Housing Bubble” and you could fill a library with the amount of material available. There isn’t a week that goes by without some new article somewhere screaming with alarm about Canada’s precarious and overvalued housing market. I’ve written many myself, but in conversation almost everyone admits that regardless of the danger nothing seems to abate the growth in home values.

From the Globe and Mail, published May 13, 2015
The history of the average five year mortgage in Canada going back to the mid 1960s. It’s hard to believe that Canadians once paid interest rates in excess of 20% to buy a home. Today rates are at an all time low and unlikely to rise anytime soon. From the Globe and Mail, published May 13, 2015

This defying of financial gravity gives ammunition to those that doubt there is any real risk at all. The combination of low interest rates, willing banks, rising prices and an aggressive housing market has given a veneer of stability to an otherwise risky situation. Combined with the “sky is falling” talk about the house prices and it is easy to understand why many simply accept, or outright dismiss, the growing chorus of concerns about house prices.

26621859Nissam Taleb’s book “The Black Swan” highlighted that negative Black Swan events tended to be fast, like 2008, while positive Black Swan events tended to be slow moving, like the progressive improvement in standards of living since the end of the Second World War. But it would be fair to say that creating a negative event requires a prolonged period of danger creep, a period where a known danger continues to grow but remains benign, fooling many to believe that there isn’t any real danger at all.

I would argue we are living in such a period now. The housing market is continuing to grow more precarious and many Canadians are finding that their own financial well being is connected to their home’s appreciating value. Between large mortgages and HELOCs, Canadians are deeply indebted and need their home prices to continue to inflate to offset the absurd level of borrowing that is going on.

As an example of how the “danger creeps” have a look at this article from last week’s Globe and Mail which highlights a young couple living in Mississauga with a burdensome debt and an unexpected pregnancy. They are classified as some of the “most indebted” of Canadians; house rich and cash poor. By their own estimates they are over budget every month and 100% of one of their incomes goes exclusively to pay the mortgage, stressful as that is they aren’t worried. It may seem irresponsible on their part to buy such a home, but they couldn’t do it if there weren’t many others complicit in making such a bad financial arrangement. Between lax rules from the government, a willing lending officer and well intentioned families that help out, it turns out that creating a financially fragile family takes a village.

A nation of debtors is a vulnerable one indeed. I’ve often said that financial strength comes through being able to withstand financial shocks, and this is exactly where Canadians are falling short. It’s the high debt load and minimal savings (and that these two issues are self-reinforcing) that make Canadians vulnerable. A change in the economic fortunes would force many Canadians to deleverage and in the process would inflict further damage to the economy and likely many homes onto the market.

Such an event is strictly in the “uncharted seas” sector of the economy. No one has a clear idea what it would take to shift the housing sector loose, or what would happen once it did. And that’s just the unknown stuff. With interest rates at an all time low it would also only take a small increase in the interest rate (say 2%) to bump up many people out of their once affordable mortgage and into unaffordable territory.

That’s the problem with slow growing danger, it has a glacial pace but when it arrives it is already too large to be dealt with easily. In one of my favorite movies, the Usual Suspects, Kevin Spacey utters the line “The greatest trick the devil ever pulled was convincing the world he didn’t exist”. That’s something we should all be wary of, the longer the housing market stays aloft the more convinced we become that not only is it not dangerous, but that there was never any danger at all.

It Doesn’t Matter if There Isn’t A Real Estate Bubble

Last week I published a piece on the dangers of the housing bubble in Canada. It caused a stir with a number of clients and followed many articles over the past two years about our concerns with the Canadian economy.

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But on Wednesday I was at an industry lunch with another group of advisors talking about the Canadian housing market and was met with a curious objection over whether there was any real danger at all. Another advisor happily pointed out to me that while the indebtedness of Canadians may be high, it is still affordable, and we should be mindful of the famous investors you have been hoisted by their own doom saying petards.

While it’s true that many doom saying predictions don’t come to pass and we should be careful before signing on to one particular points of view, arguing that lots of debt is affordable and therefore no threat is similar to a drug addict arguing everything is under control because they still hold down a job. The job is irrelevant to the problem, although it’s absence is likely to make matters worse.

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This is why it is somewhat irrelevant to worry about the Canadian housing market. Whether you believe there will be a soft landing, a hard landing or no landing at all, what Canadians have is a debt problem. Only it’s not a problem because it’s affordable. Also it’s a problem.

If that last sentence is confusing, don’t worry. It sounds worse coming from the Bank of Canada, who in their December Financial Systems Review pointed out that debt levels continue to climb but the relative affordability of the debt remains consistent. And while an economic shock to the system could make much of that debt unserviceable, for now that seems unlikely. They concluded this section of the report identifying the risk to Canadians as “elevated”.

This is non-committal nonsense. In economic terms there is a bomb in the room that needs to be diffused, has no timer but will go off at some indeterminate future point. The problem is that Canadians can’t seem to help by adding more debt to the pile. In January Canadians added another $80 billion of debt through mortgages, lines of credit and credit cards, a jump of 4.6%. Our private debt is now over $1.8 Trillion, larger than our GDP. Household saving’s rates are at a five year low, 3.6%. But in 1982 the savings rate was 19.9%. In other words we’ve had a dramatic shift away from savings and towards debt.

Savings rate

While 30% of Canadian households have no debt, almost every demographic is susceptible to the growing debt burden. Even seniors have a growing debt issue. Canada is now unique in the world for having debt levels in excess of the peak of the American debt bubble in 2008, and is currently only surpassed by Greece. Traditionally I am highly cautious about grand pronouncements about market doom and gloom, but in this instance I am of the opinion that ignoring Canada’s debt problem is willful blindness.

How to best handle this problem will have to be left to others. There is no simple solution that will not trigger the bomb, and the goal of any government is to slowly reduce the average debt burden without hurting the economy or deflating the bubble. For my part I tend to advise people to pay their debts down, shy away from things they cannot afford and encourage saving rather than debt spending to limit risk. When it comes to saving for the future there is no reason to make many people’s problems your problems.

Why It Matters If The Fed Raises Rates

628x471This summer might prove to be quite rocky for the American and global economies. The smart money is on the Federal Reserve raising its borrowing rate from a paltry 0.25% to something…marginally less paltry. But in a world where borrowing rates are already incredibly low even a modest increase has some investors shaking in their boots.

Why is this? And why do interest rates matter so much? And why should a small increase in the government borrowing rate matter so greatly? The answer has everything to do with that financial black hole 2008.

I asked NASA to use the Hubble telescope to take a photo of the 2008 financial crash. This is what it looks like from space.
I asked NASA to use the Hubble telescope to take a photo of the 2008 financial crash. This is what it looks like from space.

No matter how much time passes we still seem to orbit that particular mess. In this instance it is America’s relative success in returning economic strength that is the source of the woes. Following the crash their was a great deal of “slack” in the economy. Essentially factories that didn’t run, houses that sat empty and office space that was unused. The problem in a recession is convincing 1. Banks to lend to people to start or expand businesses, and 2. to convince people to borrow. During the great depression the double hit of banks raising lending rates and people being unable to borrow created a protracted problem, and it was the mission of the Federal Reserve in 2008 to not let that happen again.
US GDP Growth 2012-2015 source: tradingeconomics.com

To do that the American government stepped in, first with bailouts to pick up the bad debt (cleaning the slate so to speak) and then with a two pronged attack, by lowering the overnight lending rate (the rate that banks can borrow at) and then promising to buy bonds indefinitely, (called Quantitative Easing). The effect is to print mountains of money, but in ways that should hopefully stimulate banks and corporations to lend and spend on new projects. But such a program can’t go on for ever. Backing this enormous expansions of the treasury requires borrowing from other people (primarily China) and the very reasonable fear is that if this goes on too long either a new financial bubble will be created, or the dollar will become worthless (or both!).

Today the Fed is trying to determine whether that time has come. And yet that answer seems far from clear. Investors are wary that the economy can survive without the crutch of cheap credit. Analysts and economists are nervous that raising rates will push the US dollar higher, making it less competitive globally. Meanwhile other countries are dropping interest rates. Germany issued a negative bond. Canada’s own key lending rates was cut earlier this year. People are rightly worried that a move to tighten lending is going in the exact opposite direction of global trends of deflation. If anything, some argue the US needs more credit.

The question of raising rates reveals just how little we really know about the financial seas that we are sailing. I often like to point to Japan, whose own economic problems are both vast and mysterious. Lots of research has gone into trying to both account for Japan’s economic malaise; it’s high debt, non-existent inflation, and how to resolve it. Currently the Japanese government is making a serious and prolonged attempt to change the country’s twenty year funk, but it is meeting both high resistance and has no guarantee of success.

Similarly we have some guesses about what might happen if the Fed raises its rates in the summer or fall. Most of the predictions are temporary instability, but generally the trend is good, raising rates usually correlates to a stronger and more profitable market.

But that’s the key word. Usually. Usually European countries aren’t issuing negative interest rates on their debt. Usually we aren’t in quite a pronounced deflationary cycle. Usually we aren’t buying billions of dollars of bonds every month. Usually.

The answer isn’t to ignore the bad predictions, or obsess over them. The best idea is to review your portfolio and make sure it’s anti-fragile. That means incorporating traditional investment techniques and keeping a steadfast watch over the markets through what are often considered the quiet months of the year.

Canada’s Problems Are More Severe Than You Realize

house-of-cardsOn December 10th, the Bank of Canada released it’s Financial System Review for 2014. It outlined numerous problems that continue to grow and potentially undermine the Canadian economy. Globally this report attracted a great deal of attention, not something the BoC is used too, but with a rising concern that the Canadian housing market is overvalued, an official document like the FSR gets noticed.

Screen Shot 2014-12-14 at 10.56.42 AMTo understand why Canada is growing in focus among financial analysts around the world you need to turn the clock back to 2008. While major banks and some countries went bankrupt, Canada and its banking system was relatively unscathed. And while the economy has suffered due to the general economic slowdown across the planet, the relative health of our financial system made us the envy of many.

Screen Shot 2014-12-16 at 10.39.42 AMBut the problems we’d sidestepped now seem to be hounding us. Low interest rates have helped spur our housing market to new highs, while Canadians in general have continued to amass debt at record levels. Attempts to slow the growth of both house prices and improve the standard of debt for borrowers by the government have only moved loan growth into subprime territory.

If all this sounds familiar, it’s because we’ve been talking about it for sometime, and sadly the BoC hasn’t been able to add much in the way of clarity to this story. While we all agree that house prices are overvalued, no one is sure quite how much. According to the report the range is between 10% to 30%. Just keep in mind that if you own a million dollar home and the market corrects, it would move the price from $900,000 to as low as $700,000. That can make a considerable dent to your home equity and its too big a swing to plan around.

Screen Shot 2014-12-16 at 10.39.06 AMOn top of this is the growth of the subprime sector in the market. Stiff competition between financial institutions and an already tapped out market has encouraged “certain federally regulated financial institutions” to increase “their activities in riskier segments of household lending.” This is true not just in houses but also in auto loans, where growth as been equally strong.

The Financial System Review also goes on to talk about problems growing in both cybersecurity and in ETFs (both subjects we have written about). It also talks about some of the positive outlooks for the economy, from improving economic conditions globally and support for continued economic activity. But its quite obvious that the problem Canadians are facing now is significant underlying risk in our housing and debt markets. These problems could manifest for any number of reasons (like a sudden drop in the price of oil, a significant slowdown in China, or a fresh set of problems from Europe), or they may lay dormant for months and years to come.

For Canadians the big issues should be getting over our sense of economic specialness. As I heard one economist put  it “Canadians feel that they will be sparred an economic calamity because they are Canadian.” This isn’t useful thinking for investors and as Canadians we are going to have separate our feelings about our home from the realities of the market, something that few of us are naturally good at. But long term investor success will depend on remaining diversified (I know, I link to that article a lot), and showing patience in the face of market panic.

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