Blessed by the Potato

Home Capital Group (HCG) is a company with some troubles that is being shorted by some colourful and entertaining (and IMHO likely correct) characters. But the implications of the story go beyond just a stock market tale.

Brief Recap:

Home Capital issues mortgages to borrowers, primarily in Ontario, with a focus on “homeowners who typically do not meet all the lending criteria of traditional financial institutions” (pick your euphemism as long as it’s not “subprime”), as well as traditional business that gets insured by CMHC. Around Sept. 2014 a whistleblower lets them know that several brokers were allegedly sending them fraudulent mortgages (independently, reports come out about people in the industry who help people forge documents). HCG’s CFO announced a retirement in November 2014.

In documents released yesterday, (H/T @TaureauResearch) Home Trust appears to notify CMHC about the issue at the end of October, 2014. CMHC seems amazingly chill about the fraud – no mention publicly or in the documents about cancelling the insurance, adjusting guidelines, or even reviewing anything. Hell, they say this: “CMHC thanked Home Trust for coming forward with the information and for being proactive in working together with CMHC to prevent fraud.” [page 90] The most that seems to happen is to schedule a review for over a year in the future (Jan 2016).

In May 2015, HCG releases its first quarter results, with no mention of the potential fraud issue, despite noticeably lower originations. The release just has a vague phrase about reviews. “The first quarter was characterized by a traditionally slow real estate market, exacerbated by very harsh winter conditions. The Company has remained cautious in light of continued macroeconomic conditions and continues to perform ongoing reviews of its business partners ensuring that quality is within the Company’s risk appetite.”

On July 10, 2015, they state that originations were down in the second quarter, and that they had terminated their relationships with certain mortgage brokers.

On July 29, 2015, they clarified – at the request of the OSC, they note – that in 2014 they were notified about “possible discrepancies in income verification information submitted by certain mortgage brokers. […] The investigation determined that falsification of income information had occurred but that there was no evidence of falsification of credit scores or property values.”

It’s not until after this that CMHC seems to get activated about the possible fraud (that they’re insuring!) On August 4th they ask if they’ve done any analysis about the exposure to the fraud, and on July 30 someone sends around the total exposure to Home Trust (again, redacted so hard to say for sure, but without an analysis of that issue), and that they’ll have a closer look then. On July 31, someone at CMHC appears to say that they can’t transmit information (on the brokers) from one lender to another (page 36, French, partially redacted), in response to an email asking if they have the list of 45 brokers from CMHC (page 37). Not until December 2015 does someone ask if anyone checked whether the brokers in question originated loans through other lenders.

Why Does This Matter?

The matter with HCG itself is just a symptom. It’s important for investors (and short sellers) of that company to understand those events are going on, and to consider what your opinion is of management that waits that long (with a poke from the OSC) to disclose an issue like that. But HCG is just a small player. Beyond that, it’s a sign of what’s happening in the housing market.

Yes, fraud exists in the market (and I’m not talking about HCG here: more generally). But more importantly, moral hazard exists, and there is a huge outcome bias at play. CMHC at first seems to care little about the issue: there are few arrears, so no biggie. But there are few arrears in a housing bubble anyway – no one defaults when their house appreciates 10-20%/yr. Everything seems great until the music stops. Similarly, many voices (including MPs) argue against tightening regulations and that Canada’s financial system is strong because arrears are low.

The message heard by players in the industry then is that there are no consequences for bad behaviour. If arrears pile up 5 years later, well then people may care but it will be too late. In the meantime, fraud is happening in the market (and I’m not alleging at HCG specifically), and there is no sense from the government or the banks that there’s anything wrong. They even call it “soft fraud” or fraud-for-shelter – bending the rules to get a house, which can’t be that bad as long as they pay the mortgage, right? (The one that they can’t technically afford if rates rise.)

There are things that could have been done. Instead of being reactionary, there could have been more proactive actions at CMHC (which to be fair may have happened but not been captured in the FoI release, or been redacted). They could have flagged the brokers in question and checked for any past or future loans with other lenders – and sources suggest that the brokers that HCG stopped doing business with are still in the business, sending loans to other lenders. They could have put the loans back on the lender and cancelled the insurance without waiting to see if there was a claim. And nowhere did I see any mention of whether Genworth was in the loop on the goings-on.

Insured mortgages require the least amount of capital on the balance sheet. Simply putting them back proactively (perhaps with an investigation and some work on improving underwriting processes), even without a fine, would have an impact as the company would have to use capital to hold on to those mortgages, potentially slowing their growth or forcing them to go to the market to raise money. That would have been a small step, but one that would have sent a message that fraud is not cool.

But the bigger issue is that it was reactionary: there’s no evidence in the released documents of CMHC doing anything to prevent these brokers from continuing to write taxpayer-insured mortgages, or even quantifying the exposure until July 2015. It’s not until the matter becomes public and there’s the risk of backlash and people like Ben Rabidoux asking questions that anyone seems to bother to even quantify the potential risk, let alone do anything.

People like to state – with very little supporting evidence – that Canada’s financial system is safe, stable, conservative, etc., etc. But this example seems to show that nothing is actually checked in depth, and rules are only lightly enforced until something breaks into the media and public consciousness.

Yes, today arrears are low and the banks aren’t failing. The point of making a good system with oversight and strong regulations that are actually enforced is to keep it that way.

If you had asked me in 2011 or so, I would have gone on at length about how critical CMHC (and Genworth) mortgage insurance was to fueling the housing bubble in Toronto and Vancouver. Heck, you didn’t even have to ask me, I would have told you anyway. Having to save up a downpayment helps to make the system more robust, and acts as a brake when house prices start to rocket higher as people can’t save fast enough and get priced out. Mortgage insurance circumvents that, and lots of people were buying with minimal downpayments, thus it had to have been a big causal factor in the bubble.

In 2012 some reforms were announced, including that mortgage insurance would be capped at $1M house value. It was no 10% downpayment minimum like I was hoping for, but I thought that would help cool the market by providing an upper limit to the insanity (at that point the average Vancouver detached house had already crossed $1M, and the average Toronto one was a bit shy, but many neighbourhoods were over).

For a brief while you could see the strange behaviour as lots of houses that may have fetched prices ranging anywhere from $800k to $1.1M were all compressed into a narrow band near $990k. I thought a few more months of that and a few people with downpayments would push a bunch over $1M, and those without downpayments would have to exit the market, and the correction would start. I was so wrong. Before you could even take MLS screenshots and write a blog post on the strangeness, prices started rocketing higher again, and $1M was no kind of barrier at all.

And then the truly puzzling stats started coming in: Canada’s two most bubbliest cities had the highest downpayments. Roughly two-thirds of buyers across the country were tapping CMHC, but it was Toronto and Vancouver that were pulling the average downpayment up.

The bank of mom & dad was by and large saving the day. CMHC insurance became but a minor factor in Toronto and Vancouver’s housing bubble.

This is troubling because it meant that things had gotten away from the government’s ability to control via CMHC reform unless they went nuclear (i.e. 10-15% downpayments, not this wimpy sliding scale tweaking stuff — more on this below). It’s also troubling because many a First National Bank of Mom and Dad gets its financing from HELOCs, and that’s very pro-cyclical — it’s easy to get a HELOC while prices are rising (and indeed, you can fool yourself into thinking you have to and that it’s good for your kid to do so), but that source gets turned off when the bubble bursts, making corrections worse. It also masks the vulnerabilities in the system, making it look like we have a bunch of borrowers taking out ~20% of their equity and some buying new with ~20% down when really it’s more like a bunch with paid-off houses and a bunch with nothing (the total equity may be the same in both cases, but the latter group is much more likely to blow up).

[And to add, the other answer is “foreign money” which may be a bigger component of the market than I thought, but still doesn’t change the answer as to whether you should buy or rent — as we’re now seeing]

So that brings us to today, with some new rules from the Finance Minister. What’s interesting here is that a lot of the previous rule-tightening moves for CHMC didn’t apply to insurance that the banks took out on mortgages with over 20% down.

Aside: Why would they do that? So that they can securitize the loans. From the data I can find, roughly a third of all mortgages issued in Canada end up insured and securitized.

Now, loans used for portfolio insurance must meet the same criteria, plus the new criteria, particularly the closing the 5-year filter on qualifying rates.

Aside: a while ago the rules were changed to try to be more conservative so borrowers had to qualify at a higher rate — based on posted rates — than what they were to pay, to ensure that buyers had the financial flexibility to take on higher interest rates. However, if you went for a 5-year term you didn’t have to go through this check and could just use your contracted rate. This pushed many people into getting 5-year fixed terms (vs. variable-rate mortgages), and created incentive for the banks to make their 5-year fixed discounted rates their most intense point of competition.

So now there’s going to be an effective $1M cap on securitized mortgages (it’s possible to securitize and sell mortgages without insuring them but that largely doesn’t happen because Bad Things Happened and the market for that kind of product is dead — lookup ABCP). It will likely also spell the end of longer-than-25-year amortizations (which could still be had for people with more than 20% down).

That means any bank making a loan in Toronto or Vancouver where so many places go for over $1M is going to have to keep that jumbo loan on their books. No more moral hazard from passing it off in a securitization.

We’ll see how these changes affect the market in the coming months and years. Maybe this less-obvious change will have big effects. Maybe the market is already rolling over so it won’t matter. Maybe the meme is broken.

For the qualifying rates, the difference can be somewhat meaningful for those who are stretching to the limit. If you make $100,000/yr and can borrow up to a GDS of 39%, that means your maximum monthly payment for the mortgage and a few other costs (tax, heat) is $39,000/yr ($3,250/mo). If you take off say $400/mo for heat and property tax, that leaves you with a maximum mortgage payment of $2,850 on that income. With the 5-year filter you can use the actual rock-bottom rate of 2.5% to qualify, letting you borrow about $630k. At the qualifying rate of 4.6%, that takes you down to $510k — a fair bit less room to reach.

There are few ways the banks can respond to this. They can reign in lending (clearly the intended approach). They can say fuck it and put the pedal to the metal and just keep all the loans on their books. For the qualifying rate, that comes from the “posted” rates the banks put up. It’s not likely that they will lower the posted rates to circumvent the stress tests (those higher rates help them rake in interest rate differential fees when people break their mortgages and it’s low-hanging fruit to get people to renew at higher-than-market rates if they don’t shop around), but that is an option. Of course in that case the government can just specify a qualifying rate.

Also today Preet released his interview with Ben Rabidoux which is a good listen that touches on many of these issues (though it was recorded months ago).

An important topic they discuss is the rise of private mortgages (aka shadow banking). Now, an incredibly, impossibly stupid thing has been allowed to happen: people are expected to put no-condition offers on places in bidding wars in our hot housing markets. So every now and then (though surprisingly less often than I would have thought) someone can’t actually get prime financing like they planned, so they get a private mortgage to cover the gap. Or someone will get into trouble, and tap the private mortgage market.

Every time the government tries to tweak prime banking and CMHC just a little bit it does not work to cool the market, because the changes are too marginal. Instead they push a few more people into borrowing from mom & dad or private lenders, and normalize that whole system and alternate ways of qualifying. This approach is doing less to cool the market than it is to build the shadow banking infrastructure. That’s part of why¹ I think we shouldn’t keep trying a series of small nudges to CMHC and lending criteria, and letting the system build resistance to regulation. We’ve got to rip the band-aid off and punch the speculators in the nose.

1. The other part being that I am actually Ra’s al Ghul and believe that the bubble can’t be saved so we should just get on with purging the city.

I’m heading into the busiest three weeks of the year for me. Caffeine levels are at max, and I’ll be trying to survive the stress and sleep deprivation until this project is done, so don’t expect a long post in the next while. Here are a few short updates though.

Renting in Toronto: I’m scoping out rental houses in Toronto to get a feel for where current rents are. For several years market rents have been quite stable and it’s been easy to conclude that the absurd price:rent ratios were not going to be fixed by rents increasing. Every now and then a rental would come out way above market, where clearly a landlord was trying to actually cover their costs on a recent purchase price instead of collecting market rates and hoping for appreciation. However, this fall I’m seeing that rents are actually up, with a huge spread in prices (and price:rent). For houses that would be ~$1.3M in a particular neighbourhood, I’m seeing rental rates from $2600 (about where prices from last year would be with inflation) through to $3600. And it’s not just “that one crazy listing” (though one listing did sit for over a month at that top end and is now down — not sure if it found a tenant or just got pulled), there are places at each point in the spectrum, which makes for price-to-rent ratios of anywhere from 460X to 375X — a pretty big spread.

Even at the high-end of that range, renting is still the better deal (because prices to buy are crazy), but it’s surprising to see nearly a thousand dollars a month in possible rent inflation in just a year’s time. Moreover, I’ve commented before that one of the nice aspects of renting over buying is that you get a lot more for your housing dollar — we could never afford to live here if we had to buy. Well, if rent rates are increasing that much, we might not be able to afford to live here even as renters. On the one hand that’s a scary thought, on the other, I don’t really think Toronto’s priced dual-professional families out of even the burbs forever. I’ll have to keep a closer eye on the market to see if it’s just an anomaly of a few crazy people putting their listings up at once without knowing the market rent, or if it’s truly gotten that much more expensive.

In discussions with a reader on the rent-vs-buy choice (which I’ll turn into a post later), I had to bring up the point that buying is in many ways easier (distinct from better) when you’re looking for a detached house. While there are detached houses available, and while it’s the better move financially to rent, there are 20 or 30 for sale listings for every house for rent. It can take months of looking to find one that ticks all the boxes for you, and part of what makes that a challenge is that as a renter you’re almost exclusively looking for as-is properties (or close enough to as-is — it’s possible to put some work in to a place to make it your own space with a long lease or even to negotiate repairs and upgrades with a landlord, but you’re not going to do anything major), whereas when buying you always have the option of getting any old place and gutting it.

I also volunteered to re-write the rent-vs-buy calculator page as part of the Reddit /r/PersonalFinanceCanada wiki effort. I’ve written so much over the years on real estate and the rent-vs-buy choice and the math involved, but I really don’t have a good “start here” resource, and the last time I tried to write one it got way too long and ranty (and when I tried to make a “start here, how-to” page for investing, it turned into a book). Again, busy now, but look forward to something like that later in the fall — and if there’s already a good guide that would serve the average Redditor off the street, let us know and you’ll save me the trouble.

Because Money: I’ve been a guest several times on the Because Money internet show (in fact, the guest with the most appearances on the show). This year I’ll be joining the team as a producer — basically clicking on things while the hosts and guests chat, and every now and then throwing graphs up on the screen because I’m a nerd. We’ll also have MYD doing the hard work of off-line producing, which will make Because Money a downloadable audio podcast and not just a YouTube sensation. For season 3 Chris Enns will fill the seat of Ensign Redshirt/Male co-host #3, and we were really clear in our enunciation of the words of warding to try to ensure that the same curse does not befall him.

Course: This busy period was not unexpected, and that’s why there was nothing in the release schedule for the course in September. However, things started getting busy earlier in August than I had expected (plus I actually took an actual vacation instead of using that time off work to work on the course), so most of the modules I had promised for August are not up yet. Sorry about that, I’ll try to get them all done in the October update (none of the August videos are shot, but most of the articles are at least partway finished).

Questrade: They can’t leave well enough alone over there, and have tweaked their UI again. It’s a fairly minor change so I’m not going to rush to update the errata for the book.

Hard to miss the news out of BC this week as a surprise tax on foreign purchasers of Vancouver-area real estate was launched, along with new data showing that foreign money in BC real estate is actually quite substantial.

It’s hard to say what this will mean in the near-term: will foreign money find a loophole and keep pouring in? Will Vancouver crash while the firehose of hot money shifts to Toronto and Victoria? Will 15% prove to be no kind of barrier considering that prices have gone parabolic this last year, and how desperate some of the hot money is to leave? Indeed, that last point had been made often enough before this news on the high prices and risk of a crash in Vancouver — “so what if it crashed even 75%, walking away with $500k clean is better than losing all $2M” people would argue.

No Grandfathering

The tax takes effect next week — a good move so we don’t see a spike in sales looking to beat the change, as we have with long-anticipated CMHC changes in the past. However, one strange aspect is that there’s no grandfathering in: deals that were already in the works that close after Aug 2 will have the tax applied.

For some people, that’s going to be exceptionally painful: not all foreign purchasers are wealthy oligarchs skirting capital controls. A newly recruited UBC assistant professor coming up from the US who happened to buy a place at the wrong time is going to have a huge cash call at closing soon, or will have to forfeit their deposit to walk away from the deal if their lawyer can’t argue force majeure.

Normally when a tax such as this is put into place there’s a grandfathering provision, where people who had already made deals under the old rules get taxed according to the old rules. Whether this lack of grandfathering is a bug or oversight from the rushed nature of this tax or a deliberate feature is another question.

How could it be a feature, you ask? Well, this tax is not so much about raising revenue or equalizing opportunities in the market so much as it is a psychological message. I even saw (though I didn’t keep the article to link) a BC official say that if this tax succeeds in its mission it won’t collect a single dollar — it’s intended to run foreign money out of Vancouver, not just tax it. And it does this in a flashy, surprising, attention-grabbing way. By sucker-punching a few deals in progress it will sacrifice a few innocent bystanders and create huge resentment and awareness amongst foreign buyers (and their local realtors) that BC is not a place to be making deals you can’t afford to have go sour. It will help address that sticky notion that Canada is a safe place to park (or in the parlance, launder) money, with stable, reasonable government that is gun shy on meaningful interventions.

Indeed, if there’s any good to come out of this, it will be the anecdotes from this (and from the Urbancorp mess in Toronto) reminding buyers that there is significant risk to “investing” in real estate, especially with long-duration pre-construction contracts at massive multiples of rent where anything can happen between when you sign and when you take delivery. Hopefully this pain will resonate for a generation, like Nortel did for reminding equity investors in Canada that risk exists. Your grandchildren will start saying that “real estate can only go up” and the neighbour will over-hear and shout over the fence “the BC tax on foreigners! Fly, you fools!”

And yes, there’s also the “they should’ve” arguments that draw away from the impending martyrdom — no “regular” person should be buying pre-construction, that’s a playground that by all rights should be restricted to accredited investors who can afford the risks and delays (of which a 15% surprise tax is actually not the worst thing that could have happened). And junior UBC profs and other people coming in to actually live in the city should have waited until they got their permanent residency status before buying (and rented even then, given the price-to-rent insanity in the city). But that’s cold comfort to people who face a large, surprise tax because of a lack of a simple grandfathering clause (and a tax that’s a cash call at that — no word yet that they will be able to roll this into a mortgage).

A Clear Message

What Next for the Bubble?

At the same time as the tax was in the news, CMHC finally woke up and labelled BC as having “problematic conditions.”

What effect will all this have on the bubble? Hard to say. Bubbles are driven by the madness of crowds. On the one hand there are reports of locals trying to back out of deals on the news of the tax — the existence of the tax has shattered their confidence in the meme that rich foreigners will continue to drive the price of property up to something on par with Monaco or New York. If confidence in “infinity” as the upper bound to GVA house prices has indeed been shattered, then that alone may help the market come back to earth regardless of what happens with HAM and whether the tax actually changes anything on that side of the equation. However, Vancouver in particular has been astoundingly immune to the forces of reality (WMAGNFARB), and eschatology is a scary and imprecise business. Plenty of bubbles have caught second and third winds (and the GVA is at least on its third wind now); some have “melted” while others were “like someone flicked off the lights.” Even that second type takes time to appreciate as it plays out in real time — RE does move very slow, and even what we call a “hard stop” in the history books is still several months of uncertainty in the present.

As for the GTA, it would not surprise me if enough people will believe that HAM will flood the 416 instead, driving the parabola for another year or so to apogee.

These things take time to sort out, and in the meantime my core message remains to rent and avoid the whole mess.

I was stuck on the subway for a long time today. A really long, sweaty, stinky time. My commute this morning took two hours door-to-door thanks to numerous PAAs (Passenger Assistance Alarms — they happen so often they’re just referred to in acronym form) on the line. It’s a hot July day, and though the train is air conditioned, much of that time was spent loitering at various platforms with the doors wide open, sucking in the hot platform air (superheated by the A/C exhaust). It’s days like this that really drive home how much Toronto was not built for the enjoyment of its citizens.

Nelson had a post with a title that seemed targeted right at me today, explaining how much lower the cost of living is in small towns (mostly driven by the lower cost of housing), which is a great opportunity for teachers and other professions who get paid about the same amount no matter where they go (indeed, there is a surplus of new teachers in the big cities, while his local school has unfilled positions).

Comparing living in a small town to living in Toronto or Vancouver has a lot of subjective factors to consider, from amenities and attractions to salaries, job prospects, and the network effect. Indeed, I used to live in the virtual paradise of London, Ontario, which featured a modest cost-of-living, all the day-to-day amenities one could want, jobs within walking distance of livable communities, good curling, and all within a short drive of Toronto for weekend visits and the odd bit of ephemeral culture that wasn’t native to London. However, my family and Wayfare’s family live in Toronto, so — network effect at play — when we spawned we came back upstream to do so here in the GTA. Plus we both have graduate degrees and work in specialized fields, and we both make more in the GTA than we would have in London… though in London we might not have needed to make so much, possibly leaving more time for leisure and Blueberry.

Aside from my own situation, I see still more and more people pour into the GTA, and many of them do not have any particularly specialized jobs, family ties to the area, or difficult two-body problems to solve. Indeed, many are young and single, lamenting the costs of home ownership, and I’m left wondering: “Why are you in this city? GTFO!”

At what point does it make sense to take a paycut to move to a smaller city? At what point does a higher salary in a big city offset the higher costs of living? Enter the GTFO calculator.

Here you can enter your salary in the big city and a smaller centre, as well as the salary hit your spouse might have to take to follow you into fire, into storm, into darkness, or into Hamilton. Then you can enter the different housing costs and assume all else is equal to see approximately how much better off you’d be with the GTFO move — and how long it would take for your dirty city money to make up for the bubblicious living costs. There’s even a fudge factor cell for renters, or people who want to factor in having to get a 2nd car or whatever.

It’s set up as a Google Sheet with a protected range over where the magic happens, so you can just type right into the input range to get your answer instantly (a trick I copied from Sandi). So, how much more do you have to make to balance out the higher housing prices of Canada’s more expensive cities? Find out for yourself now!

Forced insight: you may find that seemingly large paycuts are still worth it (in a financial sense at least) because of how very expensive Toronto/Vancouver houses are now. It takes a lot of years — likely more than you have — making an extra $10-30k to outpace an extra half a million in mortgage debt.

Note: there is a way to parallelize the Google Sheets, so if you see more than ~4 people trying to edit it at once, let me know and I’ll get off my lazy butt and do that.