Burn Your Mortgage

August 12th, 2017 by Potato

So this is going to be a review of Burn Your Mortgage, and TLDR, it’s mostly going to be me ranting and nitpicking so if you don’t want to get into that, just know that most of it is fine but there are some particular issues. This image sums it up:

Figure from page 9 of Burn Your Mortgage. The caption reads: Canadian real estate prices have been trending upward over the past 25 years. That’s more than we can say about the stock market over this same time. A commentary is superimposed showing that the stock market return goes off the scale of the real estate one before the halfway point in the data displayed, proving the caption wrong.

Before getting to the book itself, some quick background on the tale. Sean is famous for buying a place, living in the basement, renting out the rest, and working super-hard to pay off the mortgage before he turned 31. The Sean Cooper Story boils down to: guy makes $150-200k/yr, lives cheaply in a basement apartment, saves up $500k over 7 years. Yawn. Oh wait, he didn’t just save and invest that money: he bought a house and then burned the mortgage. Now that’s a marketable story!

The biggest problem with Cooper’s story is that it happened at all. In the book and several articles, Sean has said that the reason he was so motivated to burn his mortgage was because of his mother and how she struggled to pay off the mortgage. He had a nearly irrational fear and distaste for debt.

So what should a debt-averse single person who is frugal and content living in a basement apartment do? Rent, of course! No, wait, I meant buy a house you don’t need! Then you can rent out the top floor while you live in the basement apartment, adding risk, losing your principal residence exemption, stressing about the mortgage and pouring everything into paying it off. I have referred to this as Cooper’s Folly.

Indeed, back when Sean first set off on the journey I pointed out that renting out the top floor of his house wasn’t as good a deal as he made it out to be — he was effectively paying something in the neighbourhood of $800-900/mo to live in a basement apartment based on the numbers he was publishing, which is what basement apartments cost anyway. In hindsight, the Toronto real estate market has been on fire, but because he didn’t stay crazy levered, he actually would have been wealthier if he had just rented a basement apartment, saved himself some stress and worry over debt and space heaters, and invested in a diversified portfolio (thanks to the markets also having a great 5-year run — over 12% annualized for an aggressive e-series portfolio vs ~9%/yr for Toronto real estate).

Anyway, this is just the background to the book: Sean bought a house, rented most of it out, lived frugally, worked an insane amount, and paid off the mortgage in 3 years (or, because the downpayment was also significant, the alternative title might be “local man works three jobs, lives in basement, saves $500k over 7 years.”).

The first chapter relates that story, and talks generally about buying a house, while barely even analyzing whether anyone should be buying a house or if renting might be better in their situation. Where it does touch on the topic, it does an egregiously bad job of it, so if you happen to know something about how to compare the options it comes across as extremely biased towards buying. The figure above says volumes about the dismissive tone towards renting and investing. He takes a dig at bears (throwing shade at Garth Turner in particular), but then sets up a strawman version of the rent-and-invest thesis to then make a show of toppling. Sean ignores interest in the rent-vs-buy comparison (implying it’s insignificant), then on the same page says that mortgage interest is a compelling reason to pay down your mortgage (implying it’s an important factor). Within a few pages he talks about the power of leverage as a reason to buy over renting (indeed, 2 of his 8 pros to buying relate to leverage)… then excoriates the reader to not use leverage and burn the mortgage.

MegaMaid from Spaceballs. She’s gone from suck to blow!

After that, the rest of the first section is generic advice on frugality, with a lot of lists… Most of it is fine, but parts of it read weirdly. To take one particular example, he suggests that you could save $500/yr on gas by planning your trips better and driving more efficiently. I spent $400 total on gas last year. Yes, I don’t drive much and have a pretty efficient car, but even with a normal car getting 10 L/100 km, that would take about 4500 km/yr of “extra trips” to get that kind of savings — it really just isn’t realistic. Similarly, who spends $1000/yr on taxis (actually, more than that, if they can save $1000/yr by cutting back or splitting with friends)? A lot of what he talks about in the frugality tips are outside his expertise and it shows.

Weirdly enough, there’s only ~4 pages on work ethic and time management. This really could have been almost the whole book, as the side hustle thing is a huge part of how Sean did what he did and is within his circle of competence to talk about. In some of his better times, Sean made more in a month (on top of his regular job!) than I made in a year as a grad student.

Let’s not understate this: he’s a very hard-working guy. He worked 80+ hr weeks for years at a time — not just a few months holding the world together while his wife was sick or ahead of a major deadline. And he kept that grind up without burning out.

Part of why I didn’t like the book is because of the massive missed opportunity there — I kept expecting to hear how I could also burn my hypothetical mortgage by hustling to earn more than my day job income, and how to fit all those hours in a day and avoid burning out. But the formula for success remains a secret. There is a side hustle appendix at the end, but it’s almost an insult, full of vacuous tips like “Childcare: Look after other people’s kids.” Yes, that is seriously the entire tip. He also suggests donating plasma for money, but there are only two clinics in Canada that do that (Moncton and Saskatoon), and Canadian Blood Services does not and will not pay for donations (though Wayfare is only alive because of the work of ~200 blood/plasma donors, so please do that one anyway). The rest of the list serves similarly as a brainstorming session with no regard to practicality — and clearly isn’t the way that he did it.

Anyway, from the generic middle we come to the FOMO section:

“Although foreign buyers help prop up the economy, many locals are finding themselves being priced out of the market. It’s probably wise, if you’re in the financial position to do so, to buy now while you can still afford to.”

Yep. He also suggests turning to the bank of Mom & Dad, so they can tap a HELOC on their house to help you buy one. Or buy with a friend (“great way to build equity and get your foot in the door” — BTW there will not be a giveaway as I threw up on my copy).

Only late in the chapter, after fanning the FOMO, does he include a note of temperance: “Buying a home is a good long-term investment — most of the time. But it doesn’t always make good sense. (With a book title like Burn Your Mortgage, I bet you weren’t expecting me to say that.) In fact, you may jeopardize your financial freedom if you buy a home before you’re ready and end up selling it within a year, say.” I for one, could have done with a lot more temperance.

The book pays a fair bit of lip service to buying what you can afford and staying within your budget, so it seems like a huge gaping hole that it’s not until much later that he does actually provide a rule-of-thumb on what affordable means. Though that gets immediately undercut because after introducing the figure for affordable, he says to spend more in a pricey market (no justification on how that’s still affordable, or why you couldn’t spend more of your income in a less hot market).

There’s actually a lot of detailed information after that on buying a house, features of a mortgage, and getting wills and insurance, and there’s a lot of promise here… except the FOMO stuff makes it hard to recommend. Not just on getting in before being priced out, but things that are very Toronto/Vancouver red-hot market centric like going in with a “clean” offer, or a bully offer for good measure.

Here’s where I want to take a bit of a side-bar discussion: this is a dumb thing to do. If you actually need financing to close, then you have to including a financing condition, because if for whatever reason you can’t get a loan (which could be due to an unforeseeable event like changes to mortgage regulations or a weak appraisal), you can’t close and are liable for damages that can be costly without that condition as an out.

Realtors put a positive spin on this and call it a “clean” offer, but you might as well call it a “naked” one (and that gets into another sidebar about the incentive to make a deal happen vs. protect a client). Now, in a flaming hot real estate market (such as Toronto has seen up until recently), those are the lengths buyers have been driven to. So if you want to give advice to people that helps them “win” a bidding war and get a house, you have to be pragmatic with the prevailing conditions and suggest they put in a naked offer. And that’s one approach and I get that and it’s fine — but it should also come with the appropriate warning label, and at the very least acknowledge that most readers in the country are not facing such dire competition and can proceed with more sense.

The other approach is to try to give people unpopular advice to protect them, in which case you can acknowledge that the stupid thing is happening, and tell people not to do it. It’s a small risk, sure: most deals close and the buyer finds a way to finance; most pre-construction purchases end with the market flat or higher and a buyer is able to get a mortgage and close. But in a book that also suggests buying life insurance for young healthy people, this is a comparable risk and deserves similar discussion. As a bestseller, it could have helped turn the tide on foolishness. Besides, in markets where you “have” to go in with a naked offer and completely expose yourself to the risks of not being able to close, the price-to-rent might favour renting anyway.

Conclusion

Burn Your Mortgage is mostly harmless. The lead-in ignores the alternatives and serious risks involved in buying, it has a strong pro-buying bias throughout, and there are better sources to go to for frugality hacks, budgeting advice, and side hustle tips. But if you’re going to buy a house anyway, the middle section does have a fair bit of handy information on what’s involved in the purchase and financing process. To be fair I’ve focused on nit-picking the other sections, so the truly helpful middle chunk is not reviewed in detail.

Footnote:

And just as this post was being put up, this from the Star: “Others, who bought unconditionally, have discovered they can’t get the financing to meet their purchase obligation. In some cases, the bank appraisal has come in at a value below what a purchaser agreed to pay, leaving the buyer scrambling to make up the difference.”

Rent and Invest the Difference. Or Not.

August 4th, 2017 by Potato

In some markets there’s a difference in the cash flow between buying and renting. Particularly in Toronto and Vancouver, it can cost a lot less each month to rent a house than to buy the same place (this is why there’s commentary about these cities being in a bubble). You can (should!) save up that difference and invest it, and come out much better as a renter than a buyer.

I’ve been banging that drum for a while. I made a rent-vs-buy calculator to help you estimate how much better off you might be.

But a very important point is that you don’t have to save the difference. It’s not just about how much money you have at the end (though that’s important), but the options you have along the way. You can spend the savings on increased lifestyle if you want — living in a bigger/better house than you could otherwise afford, travelling more, eating out more, whatever it is that you want to trade money for to improve your life. Or have Plan A be save and invest the difference.

When the shit hits the fan, you can use the difference as an important safety buffer on your budget. You may “build equity” with each mortgage payment, but you can’t eat equity, and in the meantime you have to keep paying your mortgage.

So when Wayfare was in the hospital and then continued being sick so we’re down to basically one income, we were (and still are) able to stay in our house. Firstly, because we had an emergency fund. Secondly, because we have awesome parents who can help pick up Blueberry so I could keep that one job (and who gave us the confidence that there was another backstop behind our emergency fund if needed). But also because, as expensive as Toronto rents are, we’re actually able to (almost) afford to live here on (almost) one salary.

Let’s do a quick comparison (not our personal numbers, but taken from real GTA listings of similar houses on the same street, and the ratios would be the same):

  Owned house Rented house
Mortgage/Rent $2933 $2200
Insurance $100 $40
Property tax $550 0
Maintenance* $700 0
Total $4283 ($3583) $2240

(All else equal, see notes, * – maintenance can be deferred/ignored temporarily in a crisis, but not long-term).

When cut down to a single salary of ~$4,350/mo after-tax and CPP/EI ($70k/yr pre-tax), a family in the rental house still has $2,110/mo to spend on food, transportation, utilities, phones, summer camp, and other necessities, so the emergency fund doesn’t get drained too fast with one person out of work. It’s likely a tighter budget than they had before, but they can manage for a fairly long time if needed.

In the owning situation, there’s only $767 left over — not nearly enough to get by on, and then only if they ignore maintenance. The house is eating through the emergency fund, and with nothing being set aside for maintenance they’re one poorly timed major repair away from catastrophe. Unlike the renters, the owners have to worry about a possible forced move on top of the immediate medical crisis.

Having a few years of that kind of cash flow difference with two incomes (and saving the difference) also meant that the renters also go into their medical crisis with a good-sized emergency fund saved up, and instead of being used up in the purchase, the sizeable downpayment is spinning off dividends to help with cash flow. So even if they fell short or lost both jobs, they could manage for a while.

This is why the rent-vs-buy debate matters. In exchange for a little less security of tenancy, the renters gain a massive increase in resiliency and flexibility.

Notes: This is the edge of affordability for a 2-income household where each head makes $70k/yr pre-tax (and on a side note, I had to go north of the 407 to find a matched pair of 3-bdrms to fit that kind of budget, but the price:rent holds in North York). The maintenance amount is a rough estimate and can be deferred/ignored in a crisis for a while. This simple cashflow analysis ignores factors like investment returns/opportunity costs, transaction fees, etc., that would be captured in a full rent-vs-buy calculator. While not our specific numbers, the ratio of the owning cashflow to renting cashflow requirements is still very close to the choice we faced when we moved here.

On Rent Control

April 6th, 2017 by Potato

An important principle in our society when it comes to rentals is striking a balance between a landlord’s ability to make money and a tenant’s security of tenancy. A tenant will call whatever place they are renting home, and deserves to have some reasonable modicum of security that they will get to continue to call that place home.

They should not be kicked out because they got a non-destructive pet, because of their skin colour or religion, or that of their significant other (or the very fact that they may have started dating since the place was first rented). A tenant shouldn’t get kicked out because it would just be more convenient for the landlord to flip the place if it was vacant, or because the tenant didn’t welcome the landlord’s sexual advances – we as a society have said that the laws are going to protect against that.

And none of them mean a damn thing without rent control, because all the landlord has to do is jack the rent to a level no one can afford, and the tenant gets forced out (“economic eviction”). They don’t even have to show that that’s actually the new market rent or find a new tenant at the new price. They could jack the rent from $1000/mo to $100,000/mo, evict the tenant they don’t like (for any reason whatsoever), then rent it to the next tenant they do like at the original $1000/mo and nobody in power blinks an eye.

So in Ontario it’s a big deal that we don’t have rent control on properties built after October 1991. All those new condos built in the boom, many of which are serving as rental stock, are uncontrolled and there are essentially no protections for tenants. This is especially important in the midst of a housing bubble, as people feel there’s no option but to buy (no matter the price) if they don’t have the security to raise kids as tenants. We’ve been seeing that in the news recently in Toronto, with the Premiere picking it up this week when the rent doubled on a few people for an economic eviction.

Now, I think the existing pre-1991 rent control is a very good compromise between security and economics: the landlord can charge whatever the market will bear when the tenant leaves, and they get to put through increases in line with inflation (set by the government) while the tenant stays there. So the tenant gets protection, but not the unit. And to a large extent, the government rate is actually about what rent inflation is. I spent a decade in London, Ontario, and watching the rental market* there, market rent inflation if anything lagged the allowed increases. I know the approximate rent a few people were paying in downtown Toronto near UofT, and running those through the increases to today gets to within 5% of the current asking rent in those areas. Other than the last few years, rent inflation has been really low. And when costs legitimately spike (like when our apartment replaced the boiler or property taxes increased), the landlord can apply for an above-guideline increase, which goes before a third-party arbiter.

But, it doesn’t have to be that exact system: we could add enough rent control to prevent economic eviction, but allow double the rent increases for places built after 1991, or have regional inflation rates, or permit any increase to market rent, with the burden of proof on the landlord to apply to a board or ombudsman that that’s actually the new market rent and not a ploy for economic eviction.

Some people on Twitter and elsewhere have railed against rent control for buildings after 1991 – including Ben Rabidoux, who I usually agree with – as it would dis-incentivize building rentals. But I simply do not see it here.

First, there was hardly any building of rentals after the exemption was put in, and we’ve had almost three decades for that to do something. So evidence suggests it was not effective as an incentive, and taking it away isn’t going to change that.

Second, deciding whether to build a rental building depends on a number of factors: how much it costs to build and operate versus how much you can bring in in rent. The current market conditions and base case projections on inflation and financing costs are massively more important to that decision than rent control rules. Having free reign to increase rents only helps you in the scenario where rent inflation increases rapidly and where tenants do not turn over very often and where the government doesn’t recognize the inflation in the guideline increases. For more normal scenarios, the lack of rent control is a nice option (mostly to skirt eviction rules) but otherwise doesn’t really affect the economics of your building — doesn’t sound like the make-or-break incentive to me. Indeed, for most cities over most of the last few decades, the provincial guidelines (and occasional above-guideline requests and vacancy de-controls) have been plenty to keep your units at market levels. So yes, putting in rent control will be a dis-incentive, but a relatively minor one compared to the other costs of building and operating, and is nowhere near something that should out-weigh the social need for some measure of rent control (without which all other tenant protections are toothless).

And the fact is, cap rates are garbage right now. Rent control or not, we’re going to get hardly any serious purpose-built rentals in the GTA simply because people are willing to pay far more for a condo for consumption than a rational investor would for a rental (driving up land and construction costs). There are many other incentives to condo building (including that you get to crowd-source your funding and punt the risk to individual saps), and disincentives to purpose-built rentals (including the property tax regime). Despite the fact that at the moment there is no rent control on the books for future rental units, I’m amazed that there are any being planned in this environment, and I’m sure that there is a story about back-room dealing with the city to have made that happen anyway.

So I say bring on rent control for buildings after 1991: as it is for others, or a weaker compromise form if necessary, but something to provide more security of tenancy than the current economic eviction free-for-all.

* – note, there are no good data sources on market rents that I know of. Everyone complains about CMHC’s because it only tracks large apartment buildings, which tend to be older. Many rentals don’t show up on MLS so the realtors don’t have a good picture, either.

HCG TL;DR

March 17th, 2017 by 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.

Mortgage Insurance, Tightening, and Shadow Banking Infrastructure

October 4th, 2016 by Potato

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.