Thursday, March 25, 2010

The Great Reckoning (... what'd I do?)

In April of 2009, Statistics Canada conducted a survey on financial capability.

The survey found that more than 1/3 of Canadians said they were either struggling or unable to keep up with their finances.

And you can bet your bottom dollar, dear blog reader, that a good portion of the other 2/3's (the ones that said they were not struggling to keep up with their finances) are probably in the blissfully ignorant camp.

Self-assessment scales need to be taken with a grain of salt. Most of us will report that we are good drivers. Not all of us are.

As I have said time and time before, the story of Canadian Real Estate is going to be the story of interest rates. And those rates are going to be going up. The only question is... how high are they going to go?

Over the past week I have tried show that the current economic 'recovery' is all based on massive amounts of government stimulus. That western governments were within hours of a complete meltdown of the world's financial system and - in a desperate attempt to prevent a nuclear meltdown - the braintrusts of our national finances responded with knee-jerk reactions to halt a complete financial collapse.

Now they are struggling with the repercussions of those moves.

Worse... key members of that braintrust now admit that they made key mistakes that lead us to this precipice in the first place.

This is important since the 'emergency measures' taken in September/October 2008 were based on the those very flawed strategies, strategies which were once again drawn upon and taken to the extreme in the heat of potential disaster.

In Canada our own 'braintrust' made several catasrophic moves that are going to wreak havoc on our country in the years ahead.

When the 2007 real estate crash swept across the United States, Canadians smugly looked down at their noses at our American cousins and exalted in the superiority of our Canadian banking system.

But as we would come to learn, our Canadian banks barely escaped their own meltdown in 2008.

All five Canadian banks are levered at an average of 31:1. According to a report by Sprott Asset Management this implies that, if the Canadian banks’ tangible assets were to drop by 3%, their tangible common equity would effectively be wiped out.

When the recession started to appear in Canada, and real estate values began dropping here; government moved quickly to intercede.

If asset prices could be protected, it was rationalized, our nation could weather the recession and minimize the fallout.

To achieve this 'asset protection', Canadian Banks received $65 billion in liquidity injections from the Insured Mortgage Purchase Program. This is the official way of saying the Canadian Government, through CMHC, purchased insured mortgages from Canadian banks to provide additional liquidity on the asset side of their balance sheets.

The Bank of Canada then our Canadian Banks with an additional $45 billion in temporary liquidity facilities and there was also assistance from the Canada Pension Plan through the purchase of $4 billion in mortgages prior to the IMPP program for a total government expenditure of $114 billion.

But real estate values in Canada were plunging nothwithstanding. Que the next phase of the 'asset protection' strategy.

The CMHC was ordered by the Federal Government to approve as many high risk borrowers as possible to prop up the housing market (with entry level buyers) and keep credit flowing.

  • In 2008 some 42% of all high risk applications were approved, a 33% increase over 2007.
  • Between the beginning of 2007 and 2009 Canadian Banks increased their total mortgage credit outstanding listed on their books by only 0.01% -- possibly the smallest amount of change in post WWII history.
This bit of financial magic to securitized all these mortgages by the CMHC is the only reason credit continues to flow to our real estate industry.

And it worked. Canadians jumped on the cheap, easy money and continued with a debt orgy that started in 2001.
  • The Canadian mortgage securitizaton market has grown from $100 billion in 2006 to $295 billion by mid-June 2009.
  • CHMC plans to expand securitization of debt to $370 billion by the end of 2009 as per the conservative government request.
  • CMHC indicates in its plan that it will insure $813 billion via a combination of mortgage insurance and mortgage-backed securities (MBS) by the end of 2009.
  • According to CHMC figures from 2008 and 2007 it is clear that CMHC has drastically exceeded their planned figures. It is expected that $812 billion is more than likely to be a minimum target.
  • At these rates of progression the Government of Canada will in effect be insuring well over $500 billion in securitized mortgages and lines of credit by the end of 2010. The Canadian Government will also have issued over $600 billion in outstanding mortgage insurance.
Make no mistake, the moves that the Canadian Federal Government took in 2008 forestalled the US financial meltdown from spreading to Canada.

By preventing the collapse of our real estate market; our financial system did not follow the path of our American cousins.

But at what cost?

Last Thursday we outlined the gigantic hole that Canadian households have plunged themselves into.

Debt held by Canadians is at an all-time high. Especially mortgage debt.

The policy of emergency interest rates and the moves to 'support' the Canadian banks can only succeed it there is a dramatic increase in the economic fortunes of the world economy.

But as I have outlined before, in order for the world economy to properly restructure we must still undergo a tremendous amount of deleveraging.

This will be a drag on any economic rebound for years to come.

Meanwhile, when the central banks start tightening monetary policy to mop up excess liquidity and stave off inflationary expectations and when capital markets start pushing back against massive government deficit funding and corporate debt rollovers, interest rates will have nowhere to go but up.

And, with it, will go mortgage servicing costs.

This process will not fully play out for 15 - 20 years, which means we will see very high interest rates for most of that period.

Since 2001 Canadians have been like the kids in the movie Ferris Bueller's Day Off. We have skipped class and finacially partied, having a grand old time.

At the end of that classic movie, Cameron Fry is left to deal with the ultimate reckoning from the reckless adventures of our heroes.

And while the movie glosses over that reckoning for Fry, that won't be the case for the 1/3 of Canadians say they are either struggling or unable to keep up with their finances when interest rates are at the lowest point in our nation's history.

Will Canada become a nation of Cameron Fry's?

When interest rates shoot up, Canadians are going to be caught in a debt vice of historic proportions. If 1/3 of Canadians are either struggling or unable to keep up with their finances now, what's it going to be like when the posted 5 year bank rate sits at 15%?

I distinctly remember a family friend, in the early 1970s, declaring that "the government will never allow mortgage rates to go over 10% because it would inflict too much financial harm on the people!"

By the end of the decade that family friend (as well as my parents) had to renew their home mortgages at 19% and 22% respectively.

How many are rationalizing in a similar delusional way today?

How many will be wiped out trying to service debt at interest rates at half of those 1980s levels?

How many will be uttering that infamous line... "what'd I do?"

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  1. Great series of posts. Funny, Ferris always seemed like a douche bag to me.

  2. Requiem for a day off? That's freakin brilliant!

  3. Great series, I enjoyed it all and agree 100%.

  4. Thank you for spelling it out in such clear comprehensive manner!