Wednesday, April 3, 2013

A time bomb in the Canadian financials?

In my recent post about the Vancouver property market (see Is the secular bull market in Vancouver RE over?), I speculated out loud that a couple with 200K in annual income and 20% down payment could afford a house in the $1.0-1.2 million range, when Vancouver westside houses that aren't falling apart are trading at $2 million and up. These calculations suggested that the clearing price, in the absence of foreign buyers, would be substantially lower from current levels.

I have since had various discussions with mortgage brokers and realtors that indicated that my $1.0-1.2 million estimate is too low. It was suggested to me that a couple with 200K in annual income and 20% down could afford a $2.0 million home.

At first I couldn't figure out how this could happen. Using a standard mortgage calculator, assuming a 3% mortgage rate for mortgage with a 25 year amortization, I got a monthly payment of $7571, or roughly 91K a year. How could a couple with 200K pre-tax income manage with those kinds of numbers? How would they eat? Even assuming a 2% mortgage rate, I got mortgage payment of 81K a year - still a bit of a stretch for our hypothetical couple with 200K pretax income.

HELOCs to the rescue
After chatting with a couple of realtors, they revealed to me the answer: These people aren't financing their purchases with mortgages. They are financing their entire debt load with Home Equity Lines of Credits (HELOCs), which offer the "flexibility" of being secured, floating rate, interest-only loans!

With an interest only loan, a couple with 200K pretax income and a $1.6 million mortgage HELOC has payments of only $56K a year - which is well within the guideline of 40% of pretax income for housing related costs. Of course, the homeowner has the "flexibility" of paying more than the minimum interest payment each month in order to reduce principal. This financing "innovation" not only gets around the federal government's rules around mortgages, but creates a entire new profit opportunity for lenders.

Also consider the attractiveness of the HELOC business for the lender. These are secured, floating rate demand loans. Current HELOC rates are about 3.5%. Given their near-zero cost of funding, it's a great business (until it isn't). Now lever up those spreads up a "conservative" 20 to 1, imagine the profit potential!

It's a can't lose proposition, right?

For lenders, the HELOC business offers some degree of protection because the lines are secured (depends on your loan-to-asset ratio and how "real" your asset estimates are), floating rate (offloads interest rate risk to the borrower) and because of the demand loan nature of the credit line (just don't shout fire in a crowded theatre). Should the Canadian RE market tank, what happens to these "lucrative" lines of businesses and the "geniuses" who allowed the lending institution to plunge headlong into HELOCs?

An accident waiting to happen
I don't need to go on and on about moral hazard, but Canadians have been taking too much and too long a victory lap about the stability of their financial system. It's little things like the HELOC business in this country that scare me and suggests that there is a time bomb waiting to go off in the Canadian financial system.

For investors, think about the following: Should the Canadian financial system suffer a major hiccup because of a collapse in property prices, what happens to all that money that was chasing dividend yielding stocks, as the common shares of the major banks form a significant portion of the "blue chip" dividend yield universe?

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Anonymous said...

HELOCs are insured by Canadian crown corporation CMHC. Risk of loss for lenders is minimal.

If you want to find weakness, look at the monoline segment of lenders instead.

rp1 said...

Insurance of HELOCs ended Spring 2011. It was just one of many outrageous policies.

Anonymous said...

Actually I think CMHC stopped insuring HELOC on April 18, 2011

Anonymous said...

Wait. You mean both mortgages AND HELOCs are guaranteed by the taxpayer?

What could possibly go wrong.

Royal Arse said...

Several charts here on the characterists of household debt in Canada. BoC did debt study in 2012 which revealed the demographics and distribution of HELOC usage. It is scary.

GF said...


Anonymous said...

I thought the last round of mortgage rule tightening eliminated the insurance on HELOCs but I could be wrong.

Anonymous said...

Lenders can get HELOCs insured. It's all in the structure.

Gov't says no insurance on "non-amortizing" lines.

Do we all agree that's a very ambiguous definition?

How do you define non-amortizing on a loan that can be paid and re-advanced on a monthly basis?

No lender is foolish enough to lend uninsured.

Anonymous said...

Canandian lenders have $400+ billion HELOCs floating around.

Does anyone seriously believe this level of loans would be advanced without insurance?

Anonymous said...

rules surrounding HELOCs - before everyone gets too excited...

Calculating a HELOC

As per the Office of the Superintendent of Financial Institutions (OSFI), a HELOC can access up to 65 per cent of the value of your home. However, when pooled together with a mortgage, the total combined debt must not exceed a loan-to-value ratio of 80 per cent.

To see how this works, let us consider an example:

The value of your home is $100,000
You have 20 per cent equity in the home ($20,000)
The maximum home loan combination (mortgage and HELOC) you would be approved for is $80,000 (80 per cent loan-to-value)
However, the home equity line of credit portion would be capped at $65,000 (65 per cent loan-to-value)
The remaining $15,000 must be in the form of a mortgage loan

The minimum payment for the line of credit portion is merely the interest.

Anonymous said...

Here's how a lender might get a HELOC insured:

1. Borrower gets a regular mortgage at 80% loan to value
2. Lender concurrently insures the mortgage, securitizes it within a few days of execution.
3. After a month borrower converts part of the mortgage to a HELOC.

The only thing that could stop this from happening is lender objection.

Not so hard right?

Tonia said...

This is cool!