Blessed by the Potato

I posted yesterday about some bullish (or not-bullish but not-bearish) arguments on housing and why I think they’re overlooking important factors. Michael James hosted an interesting discussion on his blog where he called me his favourite writer (well, not quite). Larry MacDonald left a comment there about an upcoming article he’s writing for the Globe. I hate to preemptively publish, and want to read it and give it a chance before formulating a response, but unfortunately tonight is the only time I’m going to have this week to write.

Larry’s comment was that “interest rates don’t go up in isolation, as he [referring to Ben Rabidoux, but could equally apply to me] appears to assume. Looking at business cycle dynamics over history, interest rates and household income tend to rise together.”

This is another case of something that is true but not helpful. Yes, the economy will likely be doing better when interest rates do finally go back up (next year, or next decade), and that likely will bring wage growth. But that doesn’t obviate the risk of buying an over-priced house now: the impact of rising rates and that of rising wages and employment are vastly different:

• Rates can rise very quickly, increasing payment obligations equally quickly, whereas even robust wage growth takes time to compound enough to influence affordability metrics.
• The impact of modestly higher rates on affordability/mortgage payments is in all likelihood going to be much greater than the impact of the associated wage growth.

Let’s work through a concrete example: say that you’re an approximately average Toronto couple. Together, you pull in $100k/year, and recently bought a house at $575k, taking on a $460k mortgage fixed for 5 years at 3%. Your monthly payment of $2180 is a touch over 26% of your gross pay: with heat and taxes it’s still (barely) below 32%, so this place is officially affordable!

About halfway through your mortgage term, this ridiculous not-quite-a-recession we’ve found ourselves mired in ends. Job growth picks up, and inflation rages at 10%/year. The Bank of Canada (and the bond market) is forced to respond to this double-digit inflation threat, but in this dream scenario mortgage rates merely go back up to 6%.

You don’t pay much attention because your mortgage isn’t up for renewal until 2018, and by that time surely wage growth will take away the sting. Well, following the first two and a half years of pay freezes at work, things indeed started looking up: with consecutive raises of 10% you’re now grossing $128k, and you’ve paid your mortgage down to a mere $393k.

Then you get the bad news: your monthly payment is now $2800, still representing a touch over 26% of your gross pay. If property taxes and heating costs have also increased 28% due to inflation, then your place is still borderline affordable at 32% of your income. But you were one of the lucky ones: what if your wage growth had merely paced interest rates? Using 2.5 years at 6% wage growth would mean your mortgage alone was 29% of your income — with taxes and heat your GDS would be over 34%. Your house would have to fall in value by 14% (in nominal terms) in order for a buyer in the new environment to buy it with the same affordability metrics as you enjoyed back in 2013.

What if you were one of the unfortunate few whose mortgage renewed the very year the economy picked up and rates increased? You’d have been afforded no time for the inflation you heard so much about to increase your wages… so your mortgage payment alone would top 33% of your pay, and the affordability pressure would attempt to push house prices 23% lower.

So what I’m saying is that the effect of small changes in interest rates on affordability is very likely to be much greater than the offsetting effect of wage growth. Interest rate increases raise the cost of buying a house immediately, but wage growth takes time — and we’re unlikely to see the BoC or the bond market allow wage inflation to rage for a few years before getting around to lifting rates off the zero bound.

Perspicacity is one of my favourite words. The dictionary definition mentions understanding and discernment, and I think of it as more specifically referring to the ability to discern what is and is not important from conflicting data. Part of what helped rocket it to near the top of my favourite word list is that it was the defining trait for NASA astronaut selection during the space race:

The quality most needed by a scientist serving as an astronaut might be summed up by the single word ‘perspicacity.’ The task requires an exceptionally astute and imaginative observer but also one whose observations are accurate and impartial. He must, from among the thousands of items he might observe, quickly pick out those that are significant, spot the anomalies and investigate them. He must discriminate fine detail and subtle differences in unfamiliar situations, synthesize observations to gain insight into a general pattern, and select and devise key observations to test working hypotheses.

There have been many articles on the state of the housing market — more every day — but for today I will pick on Larry MacDonald. In part because his dig (or his headline editor’s) at bears for making “unsubstantiated claims” was highly unfair: housing bears are some of the most data-driven people I know. (Though speaking of editors, he may have just drawn the short straw in taking sides for a manufactured debate). And in part because his articles (like many bullish ones) seem to lack perspicacity.

We had the one where he tried to set up an esoteric monetary policy criteria as being necessary for a housing correction, though left unsaid was the market’s vulnerability should such an inversion in the yield curve arise, or how changes to mortgage insurance might have the same effect. The affordability index is a perennial favourite, though it is highly interest-rate dependent. In short, lots of focus and analysis on the measures and factors that are — IMHO — not as fundamental.

The most egregious is also the most recent: “Is Canada talking itself into a housing crisis?” He tries to take a paper by Shiller — Professor Robert “Irrational Exuberance” Shiller! — to make the case for there not being a bubble in Canada, and that all the negative media stories may cause a downturn when the fundamentals are ushering in a soft landing.

In that piece, he picks bits out of the stories to come to strangely opposite conclusions. You can find the Shiller paper online, explaining that buyer expectations help set house prices — and that the media may have helped change those expectations as the market turned in the US around 2006. But that’s negative press precipitating a downturn in an over-valued market that’s primed for it, quite a different matter from Canada “talking itself into a housing crash.” Indeed, in that same article Larry cites a CBC interview with Shiller from September, summarizing Dr. Shiller’s points as “Canada should be spared.” Yet for many others, Dr. Shiller’s take-home message from that interview was “I worry that what is happening in Canada is kind of a slow-motion version of what happened in the U.S.”. He’s not at all saying that housing prices won’t correct or somehow be spared — the suggestion is that such a process won’t take the banks and the rest of the world economy down with it.

Dr. Shiller argued — in advance — that the fundamentals were out of line and that a correction was due in the US. He has not been as vociferous about Canada, but has several times said that Canada in general, and Vancouver in particular, are worrisome. Hell, even when trying to be bullish the bit about the RBC affordability index can’t support the insane singularity that is Vancouver. The paper Larry cites is about perception and media reports affecting the timing of the correction, not causing it. If anything, it’s just as much about how expectations helped fuel the bubble in the first place.

The real world is a messy place, and markets particularly so, with a great deal of data to parse, much of it conflicting. Hell, differing perspectives and valuation schemes are what make a market. So one must proceed with a degree of perspicacity: seeing what is significant, understanding what conflicting data imply, and acting with all due caution.

Came home tonight to find my desktop had died :(

No response from pressing the power button: no beeps, no fans, no lights. I can’t remember what the output on the motherboard power connector is supposed to be, but there are 2 pins at 5V which sounds about right, leading me to think that the power supply may be ok but the motherboard is dead.

It’s a real piss-off and bad timing on a number of fronts: I had just done a whole bunch of catching-up on bookkeeping and what-not over Christmas… and haven’t backed up since. I cracked a tooth 2 weeks ago, which is going to cost about $500 out-of-pocket to fix (over $1000 if insurance won’t kick in for it), and my cat racked up hundreds of dollars in vet bills in the late fall, so I just don’t need another major expense like this right now. Work has been crazy busy this lately, and will continue to be for the next two — I just don’t have time to deal with this right now. Plus, it’s frickin cold out, which means it’s static-y and just not the best time to go building a new system.

Anyway, I have some options:

• I can try to find a motherboard that will take a Phenom (now a ~4 year old processor) and see if I can rebuild it replacing only the motherboard. It’ll likely cost around $100 for the MB (if I can find one). There’s a chance other components were taken down with the MB, leading to either paying a lot to rebuild a computer with 4-year-old parts, or a waste of money on the MB. Even if the MB is the only part I need to replace, I might still have to spend a lot of time on a full reinstall if Windows ends up not liking the replacement.
• I can build a new computer trying to keep as many likely good parts as possible: new MB, processor, and RAM, but old video card, power supply, case, drives. I think this is a decent compromise between cost and likelihood of success. I’d almost certainly have to reinstall Windows from scratch (maybe finally time to move on from XP), which is another timesink.
• I can just buy a whole new system, likely pre-built in that case: getting all the parts and assembling it may not be cost effective — it has been in the past, to be sure, but I just priced out a Dell XPS for ~$800, and I don’t know if I can do much better than that piecemeal without waiting for Black Friday or Boxing Day to come around again. The downside (aside from the cost) is that they don’t seem to offer Windows 7 any more, and I’m too old to deal with this Windows 8 start screen app nonsense. Plus, as much as I love my Dell laptop, I find their desktops always end up developing rattles.
• I can set up my current fairly decent laptop to run the nice monitors and effectively turn it into a desktop. That strands all my data (and I just updated quicken and got all my tax spreadsheets together… without external backups!) and while my 2-year-old laptop is almost as powerful as my 4-year-old desktop, it just seems too weird to me to be on a laptop all the time. Plus it would deprive the cat of her favourite heated napping place. But, it’s free.

Not sure what to do now. I’m also pissed off at the stupid thing: I liked that desktop, and I only built it like 4 years ago. It should last longer than that.

The debt-to-income ratio in Canada has been breaking new records for the past few years, and a little while ago surpassed the lofty level reached in the US before their housing bust. There have been a few slightly alarmist articles in the press about that, but even more that brush it off. The latest (and what made me decide to write this post) comes from Robb at B&E:

“The rising debt-to-income ratio makes for splashy headlines, but all it means is wages have been flat for a few years while cheap borrowing rates fueled a huge increase in low interest mortgage debt.”

Robb makes light of the record reading in debt-to-income, and I think I know why: it’s a difficult metric to wrap your head around, as evidenced by the fact that the rest of the post talks about matters on the single-household level. The debt-to-income measure is however a population measure, so it’s hard to interpret thinking about it as though it were any given household.

Indeed, with the measure at “only” 164%, it sounds downright low if you approach it with the right mindset. If you’re at the stage of your life where you purchased a house at a fairly prudent 4X your income and put 20% down, your debt-to-income from the mortgage alone would stand at 320%, so it’s hard to see why a national figure at half that is alarming.

To interpret it, you must first remember that it is a population measure. It includes those people earlier in their lives with massive mortgage debt loads as well as those who are near retirement, and should have peak earnings with minimal debt. Even then, saying that any one level has meaning is quite difficult, as you then have to parse the demographics, figure out how many old people you have and what their debt-to-income should be, how many young people, etc.

Fortunately, the second important thing to keep in mind with population measures like this is that changes over time are often more important than the absolute level. And that is what makes the recent readings in the debt-to-income measure alarming. Just 8 years ago (2005) the metric sat at 120%. That implies that Canadians have, on average, increased their debt loads by 37% in that time, or about 4% per year (relative to incomes, or in real terms).

On top of that, we have to consider how we would have expected the ratio to change over that time. One big factor is demographics: as the baby boomers near (and enter) retirement, we should expect a larger portion of our population to become debt-free — leading to an expectation that since 2005 that debt-to-income measure should have been trending down, not up. That means that we have some combination of seniors getting much closer to retirement with debt or even entering retirement with debt, and young people taking on disproportionately more debt, so much that it is swamping the demographic effect (mostly the latter).

Another influence over the past few years has been decreasing and record-low interest rates. People have suggested that it’s fine for people to be taking on more debt relative to measures like income because low rates have lowered the servicing burden. On the other hand, if people had been prudent, the low rates could have meant the same payments on the old debt would retire it even faster, another factor that might lead us to expect another incremental decrease in the population measure of debt-to-income. An increase instead means that we now have more debt that is even more interest-rate sensitive. Sure, it’s fine and dandy and easy to manage as long as interest rates stay low, but it implies an added risk to the population should rates increase in the future.

In the context of a housing bubble, this is even more meaningful. Much of the increased debt load has been mortgage debt, used to pay for houses that have increased in price. This is debt that will be long-lived, giving rates lots of opportunity to increase and make repayment difficult. If boomers are carrying debt into retirement, it may be due to a plan to hold onto more real estate — and the associated mortgage and HELOC — for the time being and downsize later, building more pressure for a future crash. The point of it all is that debt-to-income is a measure of risk.

Some have asked why another metric isn’t used, such as debt-to-assets, or reformulated, debt-to-equity. And the reason is that it doesn’t give the same warnings on risk. Yes, if you have assets to support your liabilities, you could in theory sell your assets to settle the debt. However, people in general don’t do that so debt must ultimately be repaid with income. It’s tougher to use debt-to-assets to identify risk (or changes in risk over time). In asset bubbles the debt remains after the assets correct, so you could be refinancing appreciating assets to use more debt to buy more assets, keeping the same amount of equity on the way up. Unfortunately once the asset stopped appreciating, the debt remains, and only after the fact would you see the debt-to-equity ratios move. By way of example, you could save up $25k on a $50k salary and buy a $250k house with 10% down, giving you a 90% reading on debt-to-assets and 450% debt-to-income reading — high on a population measure, but not outrageous for a single, young household. If the house appreciated to $350k, you could sell it and move up to a $1.25M house and still have 10% down, giving you the same 90% debt-to-assets measure. Yet now your debt-to-income is a whopping 2250% — it is clear that you will never pay that mortgage back on a $50k salary.