This House Kills the Middle Class

TheHighestBidder-14
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.

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!

Canada’s Bad Week (Or The Best Recession Ever)

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Perennial pessimists like myself have been waiting for something to go wrong with the Canadian economy for some time. But years have passed and the economy continues to defy logic. Despite abundant consumer debt and a housing bubble of record proportions, and an economy dependent on volatile material and natural resource markets, disaster has forever loomed but never struck. And while the TSX hasn’t always been the strongest performer, the Canadian stock market has proven to be quite resilient over the past few years.

TSX performance YTD, July 24, 2015. Yahoo Finance
TSX performance YTD, July 24, 2015. Yahoo Finance

That may be coming to an end however. The TSX has had five negative days in a row, following a sudden cut in Canada’s key interest rate. This is the second unexpected cut this year, dropping the lending rate from 1% to 0.5%. Energy prices remain quite low, off 50% from their high last year, and severely stunting Alberta’s economic engine. The Bank of Canada (BoC) was reportedly taken by surprise by the negative GDP numbers for April, marking four consecutive months of GDP contraction and edging us closer to an “official” recession of two consecutive negative quarters. Just this week the BoC predicted a $1 Billion deficit, challenging the Federal Government’s expectation that they would have a $1.4 Billion surplus.

Joe Oliver flees reports after refusing to take questions
Joe Oliver flees reports after refusing to take questions
The price of West Texas Crude, over the past 18 months. From NASDAQ
The price of West Texas Crude, over the past 18 months. From NASDAQ

The optimism that surrounds Canada’s economic future is an unspoken assumption that a reviving US economy floats all boats, just maybe not this time. As the United States economy continues to improve, the Federal Reserve continues to remain optimistic about raising the lending rate, a sign of burgeoning economic strength. Canada is going the other direction, and for now it seems, the two economies are diverging.

Things could still turn around; the Canadian economy has shown surprising resilience so far, and our falling dollar could very well help super charge the Ontario manufacturing engine, or the price of oil could begin a steep rise (it has in the past) and restart the Alberta economy. But the challenges faced are fairly enormous. 

But if I’m concerned about one thing, it seems to be the general Canadian obliviousness to the problems we are facing. The National Post called this the “Best Recession Ever”, because of how little has changed despite the worsening GDP. The BoC’s June Financial Service Review highlighted that the biggest threats to the Canadian market would be “some event” that would make it difficult for Canadians to service their ballooning debt, but that such an event was “very unlikely”. That was despite the collapsing oil price and the sudden need for two interest rate cuts.

 Optimism can easily become denial as “experts” twist themselves into knots attempting to explain how risks are really benefits, danger is really safety and hurricanes are only storms in teacups. And while business news thrives off of both controversy and hyperbole, there is also a vested interest in making things seem like they are under control. The news should be exciting, but never give the impression that the experts don’t know what is going on. Thus, everything is explainable and only in hindsight do we acknowledge just how out of control it seemed to be. Whether this is the case for Canada right now is hard to say. But the risks associated with Canada have been large for some time, and they have been ignored, dismissed or marginalized regularly by experts within the media. Being a smart investor means facing those risks honestly and acting accordingly.

Cities Are Hurting Your Retirement

The Economist endorses the Walker Report!

Well not really, but they have joined my cause on the problems we face with regards to urbanism and increasing urban density. It’s not everyday that you can say that the economist endorses your position (even if they don’t know it) but in early April my constant nagging about the insane price of housing became a feature for the weekly.

Most Expensive Cities In The World To Live In

How it felt when I saw The Economist article on wasted space in cities.
How it felt when I saw The Economist article on wasted space in cities.

If you haven’t been keeping up, I essentially have three big issues with homes in Canada:

  1. House prices are too high, especially in cities, which is driving a debt problem for many Canadians.
  2. Inflation in the housing market is likely creating a bubble, and considerable risk is building into the Canadian housing market as people over extend themselves.
  3. This problem is compounded by the need for city living. Increasingly people’s jobs depend on living in one of Canada’s big cities, where restrictions on development are aggrivating the situation.

Canada’s housing market is therefore a confusing and expensive mess. The risk is high but the need for housing is great and this fuels a great deal of arguments over how great the problem in Canadian housing really is.

The Economist’s take on this matter is an interesting one. It’s not just Canada that has an urban housing problem. Name a major urban centre and you are likely to see the same problem repeated. From Tokyo to London to New York and back to Vancouver urbanites everywhere are dealing with escalating home prices.Rising Property Prices

But the problem goes beyond merely being frustrated by increasing realty costs. Housing is a significant aspect to any economy. Building homes makes a lot of jobs, but affordable housing encourages a growing economy. As home prices eat up income there is simply less money to go around. It hurts domestic growth, slows trade and reduces standards of living.

The culprit is not a big bogeyman like the banks (though they are benefiting from this situation) but ourselves. In an effort to improve aesthetic standards of living by restricting changes to our surroundings we have unwittingly hurt our economic standard of living. Almost every city today is burdened with development guidelines and urban bylaws that restrict density and height. These rules run into the hundreds of pages and fill volumes in most city halls around the globe. It’s made cities like Bombay one of the most expensive in the world in a country that is one of the poorest. It restricts taxes and hinders economic and city improvements.

And cities need taxes. We tend to be critical of enormous budgetary outlays for cities, but whether it’s a new subway line in Toronto or a super-sewage pipe in Mexico City, cities depend on the taxes that are generated primarily through dense urbanization. This week the free newspaper Metro published an article showing which wards in the city of Toronto contribute the greatest amount in taxes. Unsurprisingly the “downtown” wards contributed the bulk of city revenue. Wards out in Scarborough had some of the lowest, a difference in the hundreds of millions of dollars for city revenue. Some are quick to point out that the “lie” about spoiled downtowners, but the reality is that density improves economic performance and reduces the burden of taxes while improving its efficiency.

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The Economist argues that we waste space in cities, and that comes with a high cost. According to their article the US economy is 13.4% smaller than it could have been in 2009, a total of $2 trillion. Because cities that offer high incomes (like San Francisco) become too expensive people endup working in lower productivity sectors, while making it difficult to live for those that choose to reside in those cities. In the case of Canada this potentially fueling an enormous and dangerous housing bubble while undermining our economic growth. But this is a problem of our own doing. Through our own efforts we have masterminded a situation that threatens our own economic well being. The question that remains is whether we can be clever enough to undo it before it hurts us all.

As for The Economist I will assume they should be calling me anytime to start writing for them regularly….

That phone call should be coming any minute now...
That phone call should be coming any minute now…

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.

Concerned About The Market and Recent Volatility? Contact Us!

Throwing Cold Water On Investor Optimism (Not That We Needed Too)

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From The Geneva Report

Yesterday the 16th Geneva Report was released bearing bad news for everybody that was hoping for good news. The report, which highlighted that debt across the planet had continued to increase  and speed up despite the market crash of 2008, is sobering and seemed to cast in stone that which we already knew; that the global recovery is slow going and still looks very anemic.

The report is detailed and well over a hundred pages and only came out yesterday, so don’t be surprised if all the news reports you read about it really only cover the first two chapters and the executive summary. What is interesting about the report is how little of it we didn’t know. Much of what the report covers (and in great detail at that) is that the Eurozone is still weak, that the Federal Reserve has lots of debt on its balance sheets, but that it has helped turn the US

A look at the Fed's Balance Sheet from the Geneva Report
A look at the Fed’s Balance Sheet from the Geneva Report

economy around, that governments have been borrowing more while companies and individuals borrow less, and that economic growth in the Emerging Markets has been accompanied by considerable borrowing. All of this we knew.

What stands out to me in this report are two things that I believe should matter to Canadian investors. First is the trouble with low interest rates. Governments are being forced to keep interest rates low, and they are doing that because raising rates usually means less economic growth. But as growth rates have been weak, nobody wants to raise rates. This leads to a Catch-22 where governments are having to take direct measures to curb borrowing because rates are low, because they can’t raise rates to curb borrowing.

This has already happened in Canada, where the Bank of Canada’s low lending rate has helped keep housing prices high, mortgage rates down and debt levels soaring. To combat this the government has attempted to change the minimal borrowing requirements for homes, but it hasn’t done much to curb the growing concern that there is a housing bubble.

The second is the idea of “Economic Miracles” which tend to be wildly overblown and inevitably lead to the same economic mess of overly enthusiastic investors dumping increasingly dangerous amounts of money into economies that don’t deserve it just to watch the whole thing come crashing down. Economic miracles include everything from Tulip Bulbs and South Sea Bubbles to the “Spanish Miracle” and “Asian Tigers”, all of which ended badly.

The rise of the BRIC nations and the recent focus on the Frontier Markets should invite some of the same scrutiny, as overly-eager investors begin trying to fuel growth in Emerging Markets through lending and direct investment, even in the face of some concerning realities. It’s telling that the Financial Times reported both the Geneva Report on the same day that the London Stock Exchange was looking to pursue more African company listings, even as corruption and corporate governance come into serious question.

All of this should not dissuade investors from the markets, but it should be seen as a reminder about the benefits of diversification and it’s importance in a portfolio. It is often tempting to let bad news ruin an investment plan, but as is so often the case emotional investing is bad investing.

I’ve added an investment piece from CI Investments which has been floating around for years. It pairs the level of the Dow Jones Industrial Average  with whatever bad news was dominating the market that year. It’s a good way to look at how doom and gloom rarely had much to do with how the market ultimately performed. Have a look by kicking the link! I don’t want to Invest Flyer

 

***I’ve just seen that the Globe and Mail has reported on the Geneva Report with the tweet “Are we on the verge of another financial crisis” which is not really what the report outlines.