Investment Workshop 41: How Painful Will the Housing Crash Be?

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.

So the other day, I was having a Skype chat with a friend back home, and as I was regaling him with the life-changing experience that was the UK Chautauqua, I started to notice that he wasn’t really listening.

“Uh huh. Wow that’s great. Uh huh,” he would say distractedly. So I turned the tables and asked how he was doing.

Hoo boy. Bad move.

“I am SO stressed!”

“Oh no! What happened?” I asked, fearing some kind of medical issue.

As it turns out, people back home are getting financially squeezed within an inch of their lives. And it’s all housing’s fault. Work was heating up, to the point he was getting panic attacks on Sundays knowing he’d have to go back to work the next day. He had an investment property that was about to close, and he wasn’t sure how he was going to actually pay for the damned thing. And on top of that, the housing market in Canada had taken a dump on everyone with a roof over the heads.

That was when I realized it had been a while since I checked in with what was happening in Canada’s housing market, so I started looking into it. And what I missed was…not pretty.

What’s Been Happening?

Let’s recap a bit.

The Canadian housing market had been rampaging ahead for the last few years with apparently no sign of stopping, fuelling worry from international investors that Canada was barrelling towards it’s own 2008 moment and hubris from Canadians convinced that what happened to the “Stupid Americans” could never happen here.

Never mind that debt-to-income ratios had crossed the point when the American housing market blew up, and that the US Federal Reserve was starting to raise interest rates which would make everyone’s mortgage rates go up. Those concepts are too complicated for the average housing “investor” to understand, so they instead mumble something about “immigrants” and “Toronto’s a world-class city” and “housing always goes up” or whatever nonsense and then they go out and buy.

You know, typical home-boner behaviour.

Well, this year the government has been stepping in and tinkering with rules and regulations in an effort to protect home-boners from themselves. They introduced taxes on vacant homes. They started cracking down on investment properties evading capital gains taxes. They introduced punitive taxes on foreign buyers. They added rent control.

And all that seems to have inadvertently caused the housing crash they were trying to avoid. Whoops.

Sales volume has been sliding since spring, and now prices have plunged as well. In Toronto, for example, the average single family home has dropped from $1.2M in value to just below $1M. That a 20% drop since May! That means that on average, every family owning a single family home in Toronto just saw $200k of their equity disappear.

Now I’m starting to see where the stress is coming from.

And guess what? It’s about to get worse.

Oh Good, More Rules

There’s a new regulation going into effect this year called B-20. And as with most government policies, it is mind-meltingly boring. Here’s a link to the draft legislation in case you have a few hours on your hand and you want to die of boredom.

Basically, the changes coming in go like this:

  • Borrowers now have to qualify for their mortgage at +2% above the posted mortgage rate
  • This requirement now applies for people renewing their mortgage as well as new borrowers
  • Banks will now be required to adhere to strict loan-to-value (LTV) ratios which are recalculated dynamically at each renewal

Now, from what I can tell most of the media is focusing on bullet point #1 and #2. Having to qualify at a higher rate than the posted mortgage rate means borrowers will have less money to work with, which will cause the housing market to drop even more. Banks are estimating the effect will be somewhere between an additional 10% to 20% drop.

But I think the much more sinister motive behind this legislation is bullet point #3.

Why?

Well here’s the thing. Housing crashes manifest in two different ways.

  1. The Homeowners get fucked. Their housing values fall but their mortgage balances don’t, so they get stressed and miserable working like dogs to pay off their massive mortgage for 25 years, and at the end they end up with a house that’s worth less than what they paid for. This is a “normal” housing crash.
  2. The banks get fucked. This is much much worse, and is what happened in 2008/2009. The housing crash causes banks to lose so much money that they start collapsing, which then ripples into the stock market. And when it ripples into the stock market, people start losing jobs, which then causes more people to default on their mortgages, which causes more banks to collapse, etc.

So we now have a housing crash in Canada (arguably caused by the government). And the big question is, will this crash be the first type, or the second type?

And that’s where these regulations come in. You see, in Canada we don’t have the 25-30 year mortgage terms that the Americans have. Our mortgages amortize over 25 years (meaning that’s how long it takes to pay it off), but they renew every 5 years, meaning we have to go to a bank and refinance periodically.

And now making the LTV requirement recalculated dynamically means the borrower could be in for a world of hurt come renewal time.

Think about it. If home prices were going up, this rule does nothing. You would automatically qualify for the same loan amount you got your initial loan for, since the value of the home didn’t change (or went up). But if the value of your home went down, something interesting happens.

Let’s pretend someone bought a house for $1M with 20% down. So their house is worth $1M, they paid $200k, and they owe $800k. Now let’s say that the house goes down in value by 20%, like what’s currently happening in Toronto. Now their house is worth $800k instead of $1M. Now let’s see what happens when they try to renew their mortgage.

The dynamic LTV calculation would kick in, and for a normal mortgage, the LTV ratio is 80%. So taking the new, lower value of their home and recalculating the LTV, that means the maximum they qualify for is now $640k. But their mortgage balance is $800k.

So that means in order to stay in that house, the homeowner will be forced to come up with $160k of their own money and hand it over to the bank. If he has to cash out his pension, or go to his in-laws with his hat in his hand, or give his boss daily blow jobs, he has to do it or he loses the house. So not only has the homeowner already lost his entire downpayment in this scenario, they have to pay $160k on top of that. Double screwed.

The alternative is to go into a high-ratio mortgage covered by mortgage insurance, but then they have to pay for additional mortgage insurance premiums which would get added on top of the massive mortgage they already have.

And if they can’t do that, then the bank can foreclose on the house, sell it at a loss, then sue the ex-homeowner for the difference, because we don’t have zero-recourse loans here in the Frozen North.

In all scenarios, you may have noticed, the bank doesn’t lose money, but the homeowner gets screwed.

So while B-20 is being marketed as a way to protect borrowers from borrowing too much, I think it’s far more sinister. It’s a ploy by the banks, who see big housing losses coming, to make sure that the one taking those losses isn’t the banks. It’s the homeowners. Double-screw the homeowners, and save the banks.

Winners/Losers

So who are the winners/losers in this new B-20 regulation being introduced?

Loser: The Homeowner

Hoo boy. The Homeowner gets screwed big time. In fact, the typical response when I talk to a homeowner about market corrections is “If it happens, I just won’t sell.” And before, that made sense. Sit on the house for 25 years and hopefully it will recover by then. But now, this no longer works. If your home value crashes, you can’t just sit on it and keep paying the mortgage. Because the next time the homeowner renews, the bank will now demand he pay for those losses now. You can no longer avoid losses via inaction.

Winner: The Banks

Don’t get me wrong. I’m not harping on these regulations and saying it’s a bad thing. I think it’s a brilliant strategic move. In a housing crash, homeowners always lose. You can’t prevent that. But what causes a housing crash to turn into a big rolling fireball of disaster is when the damage spreads out into the financial institutions. Then the stock market crashes and even people who didn’t own a home start getting hurt as job losses spread throughout the economy. The banks saw what happened in 2008 and they’re moving to protect themselves by throwing the homeowners under the bus. That’s what I’d do if I were them.

Winner: Index Investors

Throughout this year while the rest of the world’s stock markets have rallied ahead, Toronto’s market has remained stubbornly flat, despite Canada’s GDP being the fastest growing in the G7 countries, and part of the reason for this is the expectation that our housing market’s about to fall over and the TSX will do with the Dow did in 2008. But we can see here that the banks are moving to make sure the only one who will lose money is the homeowner. So as the housing crash continues and we see banks not fall over, we may see the TSX finally catch up to the rest of the world’s stock markets. By protecting themselves, the banks are protecting the TSX, and by protecting the TSX, they’re protecting the Index investors.

Conclusion

So there you have it. To question of “How’s Canada’s Housing Market Doing?” can be summed up thusly.

  • Houses are melting
  • Homeowners are losing money and are feeling increasingly stressed out and miserable
  • New regulations coming into effect will make this stress much much worse

And on that note, we shall now proceed with this week’s buys.

Canadian Portfolio

We begin, as always, by adding our cash into the portfolio and taking a snapshot of where we stand.

Asset Ticker Unit Price Units Market Value Allocation Target Allocation
Canadian Bonds VAB $25.32 143 $3,620.76 37.86% 40%
Canadian Index VCN $30.68 59 $1,810.12 18.93% 20%
US Index VUN $43.25 42 $1,816.50 18.99% 20%
EAFE Index XEF $28.93 50 $1,446.50 15.12% 16%
Emerging Markets XEC $26.46 14 $370.44 3.87% 4%
Cash $1.00 500.1 $500.10 5.23% 0%
Total $9,564.42

We then calculate how far off from target we are…

Asset Ticker Target Allocation Unit Price Current Market Value Target Market Value Current Units Target Units Difference
Canadian Bonds VAB 40% $25.32 $3,620.76 $3,825.77 143 151.1 8.1
Canadian Index VCN 20% $30.68 $1,810.12 $1,912.88 59 62.3 3.3
US Index VUN 20% $43.25 $1,816.50 $1,912.88 42 44.2 2.2
EAFE Index XEF 16% $28.93 $1,446.50 $1,530.31 50 52.9 2.9
Emerging Markets XEC 4% $26.46 $370.44 $382.58 14 14.5 0.5
Cash 0% $1.00 $500.10 $0.00 500.1 0.0 -500.1

And finally we decide on our unit orders being careful not to go into margin…

Asset Ticker Unit Price Action Fractional Units Units Proceeds
Canadian Bonds VAB $25.32 BUY 8.1 8 $202.56
Canadian Index VCN $30.68 BUY 3.3 3 $92.04
US Index VUN $43.25 BUY 2.2 2 $86.50
EAFE Index XEF $28.93 BUY 2.9 3 $86.79
Emerging Markets XEC $26.46 BUY 0.5 1 $26.46
Total $494.35

American Portfolio

And on the American side, we again start by adding in our cash and taking a snapshot of our current portfolio…

Asset Ticker Unit Price Units Market Value Allocation Target Allocation
Bonds BND $82.41 46 $3,790.86 38.21% 40%
US Index VTI $126.22 22 $2,776.84 27.99% 30%
International Index VEU $51.68 55 $2,842.40 28.65% 30%
Cash $1.00 510.55 $510.55 5.15% 0%
Total $9,920.65

We calculate how far off from target we are…

Asset Ticker Target Allocation Unit Price Current Market Value Target Market Value Current Units Target Units Difference
Bonds BND 40% $82.41 $3,790.86 $3,968.26 46 48.2 2.2
US Index VTI 30% $126.22 $2,776.84 $2,976.20 22 23.6 1.6
International Index VEU 30% $51.68 $2,842.40 $2,976.20 55 57.6 2.6
Cash 0% $1.00 $510.55 $0.00 510.55 0.0 -510.6

And finally, we decide on our purchase orders being careful not to go into margin…

Asset Ticker Unit Price Action Fractional Units Units Proceeds
Bonds BND $82.41 BUY 2.2 3 $247.23
US Index VTI $126.22 BUY 1.6 1 $126.22
International Index VEU $51.68 BUY 2.6 2 $103.36
Total $476.81

And with that, we’re done. Thanks everyone!

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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.

31 thoughts on “Investment Workshop 41: How Painful Will the Housing Crash Be?”

  1. Totally with you but it’s a bit misleading to say that home owners lost 200k in equity. The average is probably not a good measure as it is heavily influenced by outliers….. I’d probably use the median in this case.

    If you bought a balanced fund around the same time, you’d probably be down the same amount of you take the median.

    Long time reader, first time poster. I admire you two and are true sources of inspiration. At this point, we’ll be fully FI by 40 with minimal RE exposure.

  2. Excellent explanation of the B-20 rule that is coming into effect, I never knew the depth of the repercussions to the owner if the housing market collapses with this new rule. That would be pretty unnerving to anybody who has bought recently, knowing that when they renew their mortgage in the next few years that they might actually have to cough up a load of cash just to keep their house.

    Here in Vancouver, sadly the government intervention hasn’t achieved a great deal. Prices have stagnated somewhat, but they’re still stupidly high. Somethings got to give though, here’s to hoping rule B-20 is the straw that breaks the camels back.

    1. Sadly, the BC Liberals decided that subprime down payment loans were a good business for gov’t to be in. One can only hope the NDP disagrees…

    2. It’s always weird watching government interventions into the housing market. On the one hand, you want them to work, but on the other hand, if they do work it’s like “OMG WHAT JUST HAPPENED EVERYONE LOST MONEY.”

  3. That’s crazy, I didn’t know Canadians have to reinstate every 5 years. It’s certainly going to hurt the home owners during a downturn, even a correction.

    I work for a mortgage fund and we even have 40-year loans in the US!

    I believe there should be a good balance between government regulations and the market. It’s just unbelievable what happened in 2008, crazy DTI and no equity for the borrowers.

    1. I know, it’s a Canadian paradox. We’re convinced we’re smarter than Americans, yet we behave just as irresponsibly, and our protections in the mortgage industry are actually worse.

  4. Your commentary on the Canadian housing market (at the very least Vancouver and Toronto) is on point. I live in Vancouver and people are delirious to the point of hallucination with house fever here. This might be the bucket of cold water they all needed. Painful, for those who entered the market at the wrong time, but less painful than a type 2 crash.

    Also, this reminds me of that scene from The Big Short:

    Casey: What am I supposed to do? Write a piece called “We’re all fucked”?
    Charlie Geller: Yes! That’s a perfect title!

    You’re not afraid to write the “We’re all fucked” articles, and I love that.

  5. I’m just catching up on your Cdn and US portfolio. Am I understanding that each WEEK you are buying $500/Cdn and $500 USD of ETF funds? When did you start these portfolios? Are they non-registered? Do you arrange a direct transfer of funds into these accounts? Do you manage these accounts online with your buys?

  6. Wow, this could be really interesting to watch from the U.S. side of things. I think the U.S. housing market is starting to top out. You see that in major markets like NYC and San Francisco. Boston is still frothy, but starting to top out a bit.

    1. I’d love to hear our American reader’s perspective. How much does this sound familiar to you and do you think the stuff our government’s trying is going to prevent a 2008-style collapse?

  7. Let’s use facts now – average etf investor in Canada is pretty much flat YoY due to fx. The housing market is still up 5% YoY.

    1. Hey, all I’m saying is that the lenders are scrambling for the lifeboats and making sure they’re not the ones that take losses. So interpret that as you will.

  8. I’ve been reading Garth Turner’s blog for a while, and thus have a weird interest in the slow-moving trainwreck that is the Canadian housing market.

    I do think that having a truly fixed rate mortgage as an option would protect owners quite a bit. We have variable rate mortgages here that are an option for some (hopefully savvy) owners but having EVERYONE on a variable makes a crash somewhat inevitable, as rates have nowhere to go but up.

      1. We have longer terms I have seen 8 and 10 year, but horrible rates. Royal has a 7 year fixed for 3.5, but the norm is a 5 year term.

  9. “So we now have a housing crash in Canada”

    Er, no. Toronto is not Canada. Canada has a whole bunch of housing markets influenced by national and local factors.

    Many markets haven’t experienced big gains over the past couple of years while TO values skyrocketed. Halifax prices were up 2% yoy. Central Montreal up 9.1%. Saskatoon down 5.7%.

    Vancouver reacted to the foreign buyer’s tax last year with a drop and then a recovery. Saskatchewan’s housing market has been falling for a couple of years and is a buyer’s market. Victoria remains a seller’s market.

    Also, your interpretation of draft guideline B-20 is incorrect as follows:

    “Borrowers now have to qualify for their mortgage at +2% above the posted mortgage rate”
    TRUE FOR NEW MORTGAGES AND REFINANCING. NOT TRUE IF YOU RENEW WITH THE SAME LENDER.

    This requirement now applies for people renewing their mortgage as well as new borrowers.
    NOT TRUE IF YOU RENEW WITH THE SAME LENDER.

    Banks will now be required to adhere to strict loan-to-value (LTV) ratios which are recalculated dynamically at each renewal
    NOT TRUE IF YOU RENEW WITH THE SAME LENDER.

    As announced in a revised version of the draft Guideline B-20, the proposed change with regards to the +2% on contractual mortgage rate would only apply to new mortgage loans (if you want to buy a house), mortgage refinancing or if you decide to renew your mortgage with a different financial institution. It would not apply if you wanted to renew your mortgage with your current financial institution. Your friends are likely going to be fine. There will be fewer transfers of mortgages or refinancing by those with less equity.

    You are also incorrect in your analysis of housing market crashes imo. Crashes in the market do not happen one of the two ways you identify. Homeowners in Canada have not been paying a mortgage for 25 years only to find out they have a property worth less than they bought it for. This can happen to new homeowners if the market declines, but those holding seven years or more will not likely be in this position based on the stats. Certainly not after 25 years.

    Just like the stock market, housing rises and falls in value but over time statistically it increases at various rates in various markets in Canada. In some smaller towns which lose a major industry values might decline longer term.

    You really should spend more time reading the guidelines and stats and less time following Garth. He has been wrong about housing for a lot of years as much as he has been of assistance to you with investing. You are writing about something you, imo, don’t thoroughly understand. Your investing series for stocks is much less open to critique imo because you have real life experience and it shows.

    I’m not sure if TO will recover quickly or not – maybe it will go down more – it certainly has had a sharp ride up. I do agree there are some new homeowners who will be negative in equity for a period of time and others who are having their financing impacted. Same in any falling market. If the past is any indicator the market will go up again… and then down… but long-term up. Just like the stock market. The wild card is leverage. If rates rise significantly that would, imo, create greater hardship and the risks of leverage are real if you have to sell.

    1. it was amazing how poorly written this blog entry was. BLATANT misrepresentation or flat out lack of understanding. Lose credibility real fast that way….awful

  10. Because the next time the homeowner renews, the bank will now demand he pay for those losses now. You can no longer avoid losses via inaction

    ……….

    good grief. This is wrong

      1. You should carefully fact check what you write rather than relying on someone who has little credibility on this topic to provide you with answers. Go to the source ie. contact the OSFI – they respond to emails.

        A financial institution has a vested interest in renewing a mortgage where payments are being made. Foreclosing on negative equity is not fiscally prudent and under b-20 it is not required for renewals at the same institution.

        If b-20 is enacted as drafted, and it is currently a draft for consultation, it may be slightly more difficult for some to transfer their mortgage, but even today a transfer results in a new credit check and qualification screening.

        The real changes in b-20 are:

        Requiring a qualifying stress test for all uninsured mortgages (ie.more than 20% down);
        Requiring that Loan-to-Value (LTV) measurements remain dynamic and adjust for local market conditions where they are used as a risk control, such as for qualifying borrowers;
        Expressly prohibiting co-lending arrangements that are designed, or appear to be designed to circumvent regulatory requirements.

        The changes are not meant to create a situation where someone who is paying their mortgage cannot renew, and in my opinion they do not change this from the current situation in which mortgage renewals generally happen automatically if you have been making payments and don’t transfer to another institution.

  11. Houses are melting
    Homeowners are losing money and are feeling increasingly stressed out and miserable
    New regulations coming into effect will make this stress much much worse

    …………..

    did you take drama as an elective in high school?

    -melting? lol. Not at all. certain areas are correcting

    -i’m a home owner. Don’t feel stressed or miserable. Quite happy actually.

    -regulations will have minimal effect on me. May affect others moreso? sorry to hear about your friend. Overleveraged himself/herself?

    1. Good for you. I was referring to my idiot millennial homeowner brethren who bought at the peak, or overleveraged like crazy into multiple investment properties. They’re all stressed and miserable, and it’s about to get worse.

  12. I live in one of those crazy real estate markets in Canada (i.e. Vancouver). The general sense I get is that first time, local buyers are not actively shelling out $1M to $2M to buy a detached house. Those folks are likely purchasing more modest starter homes in the suburbs or condos, townhouses in the $400k to $800k range, because that is what the income and debt servicing ratios indicate as possible (assuming 20% – 25% down payment).

    The folks playing in the $1m – $3m game are either wealthy foreign buyers or existing home owners who have built up significant six digit+ equity from rising real estate over the years, and trading up or laterally (moving further to suburbs).

    This is an important distinction to make.

  13. Banks are not going to have renewers cough up hundreds of thousands of dollars. That’s preposterous and there is no precedent for it. Banks have zero interest in taking such an action as they will inevitably lose billions in interest dollars.

    Garth has been talking out of both sides of his mouth for years. He has banked millions in real estate while preaching about its doom for years.

    The Toronto market is correcting yet prices are STILL higher than last year.

    Toronto real estate is seasonal meaning it’s ludicrous to compare spring prices to summer prices. Summer is a slow season as is winter – prices drop and inventory rises every year. Spring and fall are where money is made.

    Real estate will be worth more in 25 years than it is today, and that’s always been true. In 25 years the GTA will house 2.9 million more people. More demand, more pressure, higher prices.

    As others have pointed out, the interpretation of the new legislation is a very bad misreading.

    Anyone that has bought a house and holds will be fine.

  14. No, you don’t understand. These regulations have already gone through and will take effect at the end of the year.

    Things are going to get painful for homeowners who bought at the top. Hope you’re not one of them.

  15. Bonds are good, I had some money in cash, a T-bill fund actually, and thought, WTF ? it pays nothing, and even if Bonds fluctuate, the distributions are about 1-2% and make up for it. I am close to 50% Bonds 1/2 long (30 yr) and 1/2 short (2-5 yr) both have merits, I just like to diversify.

    Housing is toast in Van and Toronto, and the spill off will erode all the other citys. I have a friend selling, but she wants to wait until next spring… OMG… cant get her to list now, but here in Victoria, we are at a peak, next spring could be a drastic different story.

    D.

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