Blessed by the Potato

Went grocery shopping, with largely two things on my list: real food, and candy. At the intersection of the two: cocoa krispies, but they look to have discontinued them! Which is dastardly, because they were on sale this week!

Wired had a good article on magnetic navigation in sea turtles. Neat, because I was just talking about this in my lecture last week! Hope the undergrads find this. I love this quote: “A skeptic could reasonably believe that the latitudinal cue is magnetic, but that determining east-west position depends on magic,” Another recent article also discusses the radical-pair mechanism. I’ve long lamented the poor quality of journalism, especially science reporting, in these times of ours, but I have to say that I’ve been reasonably impressed with a few articles from Wired recently, in particular because they actually include the citations to the papers they’re talking about, so I’ve subscribed to their RSS feed.

The Berkshire Hathaway annual results are out, including Warren Buffet’s famous annual letter to shareholders. Worth a read even if you’re not a shareholder. Of course, many blog posts out there to help you digest the wisdom, including Larry MacDonald, Canadian Capitalist, and Michael James.

Barry Rithotlz points out that banks are writing credit default swaps on debt that doesn’t exist… if you figure out how to view the full story on the WSJ, let me know, I only got the first few lines as a preview, and there wasn’t even a link with the option to buy the article, so to me it just looks like a broken website (way to go, newspapers, you show the internet how conveying information is done!).

I got a response from my MP after my UBB letters: basically just a form response that the Liberals oppose UBB, and that they’ve received a lot of letters on the topic! Other than that, I haven’t noticed any news on the matter, so now I think we just wait and see what comes out of the CRTC.

A bunch of other bloggers got copies of various tax programs to give away (come on Intuit, it’s not a personal finance blog, but I do taxes too!). Oddly enough many of them only opened their contest up to their email subscribers. I guess people who use RSS to follow every. single. post. just aren’t worthy.

With even the permabulls like the real estate boards calling for the housing market to at the very least flatten out, it’s important to market your home’s selling features. A snazzy virtual tour may help, but might I suggest a space wall?

Toronto Realty Blog considers moving up. The post highlights a few things that I see as being horribly sick and wrong with the current Toronto market (well, it doesn’t intentionally highlight them, but they stand out to me):

• “Five years is far above the average time that a condo-owner will spend in one unit in downtown Toronto…” Transaction costs are high: so far, price appreciation has dwarfed them, but in a flat market, moving very often means more people should lean towards renting rather than buying. If people are feeling squeezed out (or bored, or whatever other reason they have for moving so frequently), then they do need to start to consider the risks of buying at the top, as they can’t just wait out a downturn in the unlikely event that it happens (even if that’s what they tell me). Five years sounds like a very short amount of time to buy a place for to me, so for that to be above the average sounds crazy.
• “As I look around the living room, I see a bookshelf with so many books stacked on top of the unit itself that I’ve begun a small pile on the floor […] and I can’t tell you how many things (skiis, snowboard, golf clubs, hockey equipment, baseball gear, winter tires) I keep in seasonal storage in my mother’s basement. Not only have I outgrown my space, but I can afford far more now as well.” The condos that are going up (even in Markham) are freaking tiny. I have trouble seeing how a single person fits in some of them, let alone a couple. That is partly due to amenities: no need to set aside room for a treadmill if your building has a gym, and space for more than two guests can be taken care of by the party room and movie theatre. But I have to wonder how much of the demand for these tiny units is driven by people buying from plans, and when the buyers will finally stop trying to get a place, any place, and start demanding livable space.
• “Let’s assume that I own my condo in cash, and I have no mortgage.[…] For whatever reason, I would rather keep my money in my condo th[a]n throw darts at the board known as the stock market […] so my all-in cost of living is only $545 per month.” Once again, the fallacy that owning your shelter somehow makes it free, or nearly so, without taking into account the opportunity cost, that is, the return one could get by investing that money elsewhere. Even a GIC-like rate added to the other costs listed would put that monthly total north of $1600 — more than what a 1-bedroom rents for. And along with it, the notion that somehow the stock market is risky but Toronto condos are not. Eventually, fundamentals will matter.

First up, the 5th edition of the Canadian Real Estate Blog Carnival is up on Landlord Rescue.

In the news today, the government tweaked mortgage lending rules slightly, reducing the maximum insured amortization to 30 years, maximum refinance LTV to 85%, and removed government insurance for HELOCs.

The various financial forums are still discussing the HELOC issue — I’m not sure myself how many HELOCs were actually insured, so it’s probably a minor issue. Refinances should likewise be a small piece of the pie. So that leaves the reduction in amortization. On the one hand, this is something that will influence almost every first-time buyer, as huge swaths of that section of the population have been opting for the maximum amortization to grab as much RE as they could. I myself would have preferred an increase to the minimum down-payment at the same time, but we’ll take what we can get. What’s the impact? Very briefly, if someone had a maximum mortgage budget of $1000, then:

At 35 years, they could get a $260k mortgage at 3%, or $198k at 5%. With the new 30 year maximum amortization, that same $1000 monthly budget gets $237k at 3%, and $187k at 5%. The effect is interest-rate dependent, but it means that for someone at the very edge of affordability, their maximum house price just went down something like 5-9%. Not a huge effect, but hopefully something to get the ball rolling.

Partly for the laugh, Wayfare gave me a book of mortgage payment tables for Potatomas. For those of you not familiar with these tables, they date from a time before spreadsheets and online java calculators, when if you wanted to know what the monthly payment on a mortgage of a certain amortization at a certain interest rate would come out to, you had to run the calculation by hand. To help, tables were drawn up with the figures pre-calculated so one could just look up the value rather than calculating it. It was published in 1981, and has tables for 9% interest through 30% interest, in 25 bp increments. Interest rates below 9% were so unfathomable that they didn’t bother to print them in the book.

I’m not sure what the lesson there is: whether these current low interest rates are indeed so far below the historical norm that people should be prepared for higher rates in years to come, or the opposite: that times change, and now 9% is unfathomably high, and I shouldn’t keep trying to warn people about rates that aren’t likely to be seen again.

Anyhow, I wanted to explore a little bit the idea of risk and the housing bubble. This is based a bit upon some percolation of recurring themes here, and a bit upon some things people are saying on the internet (because no one in real life wants to talk to me about housing anymore).

First we really have to try to understand risk. Everyone has at least a little bit of gut feel for what risk is, and how some things are riskier than others. But everything has some form of risk to it: even GICs risk not keeping up with inflation, or in large concentrations, outliving your money. Volatility is sometimes used as a proxy for risk, in part because it’s easier to measure. But volatility doesn’t tell the whole story of risk, not by a long shot. If I’m talking about risk being the potential for permanent loss, for turning your life inside-out and just ruining your whole day, then volatility isn’t really a good measure of that at all.

If you look at a graph of the Toronto housing market over a number of years, it’s this incredibly smooth line moving up from the late 90’s to the late 00’s, and even beyond that there’s this smoothed bump in the 80’s and a little wiggle at the end in ’08/’09. So in terms of volatility, housing doesn’t look risky at all. Yet to my mind, it really is. One part of that is how the lack of volatility works against it when there is a crash. Go back to the last crash in ’89. If you were unlucky enough to buy at the top there, you’d see the value of your home decline some 30%, and stay down for years. It would take well over a decade to get back to break-even.

“But,” the people say, “why would I sell then?” And that’s a very strange question, because those same people often don’t have the same pragmatic zen attitude towards stock market corrections. With housing, you can be forced to sell when you’re underwater, for the usual reasons: job loss, move, family circumstances change, etc. When the stock market crashes though, you don’t have to sell your stocks (except for margin calls), unless you’re already retired. Heck, you can even rebalance and buy more.

The stock market by comparison is far more volatile, on any timescale. There have been 3 separate crashes in the Toronto stock market since the 1989 Toronto housing market crash. And the severity can also be frighteningly worse, about 50% top-to-bottom in the last crash. But, the recoveries are far snappier: not even counting dividends, someone unlucky enough to invest at the very peak of the market in 1989 was made whole by what looks* to be 1993; someone concerned with getting back to the 2000 peak found it in 5 years. Though we haven’t quite gotten back to the peak of mid-2008, in just 2.5 years we’re down less than 10%, and I’m pretty sure another 2.5 will find us back up there (and that’s not including dividends). Yeah, stocks are more volatile, but that works both ways, which means those crashes are both more frequent but also transitory. And you don’t have to buy in one chunk and get unlucky and find yourself at the peak (like with a house) — you can buy in year after year, so the real-life situation isn’t even this dire (as one would hope, since your investments are supposed to make you money). With diversification and rebalancing, you can do even better than the straight index.

But there’s still the fairly legitimate idea that stocks are risky: they can go to zero. Nortel went to zero, and that event seems to be burned into the Canadian mindset. “Can you point me to the house that went to zero?” Well, individual stocks are risky, but portfolios much less so. Even in one of the worst stock market declines in recent memory, a diversified portfolio was only down by about half, and much less if you had bonds too, and even then only for a short period of time. Think not so much of the house that went to zero, but the roof, or waterheater, or deck that became worthless. They’re just components of the overall investment, which as a whole is not as risky as the sum of its parts.

Leverage and familiarity of course play into the real and perceived risks: because of the high leverage employed these days (5% down baby), I’m deathly afraid of the potential for real estate to ruin your whole life. Because it’s strange and foreign, people in general are afraid of equities: the concept of distributed ownership in hundreds of companies is alien, and not in the daily experience of most people (or even in their educational readings), but everyone knows about houses (in fact, I’m writing this rant while sitting in one). However, the lack of volatility, and the last crash taking place when my cohort was still in elementary school can lead to some false complacency on the matter.

I’ve mentioned before that if real estate is overvalued by 30%, and if the typical family spends about 30% of their income on housing, then if they buy in too close to that peak, that leads to about 10% less money in the budget — about what people save for retirement. Even though it’s not so expensive that you can’t afford to put a roof over your head (that would probably bring an end to the bubble), it’s pricey enough to impact your financial health for essentially the rest of your life, which is why I waste so many electrons on this. It’s legitimately important, and it can be controlled.

I don’t know how to get people comfortable with stocks though, because it’s a fair point that if you don’t save and invest the difference when renting, the benefit isn’t really there (though even just saving in a savings account may be attractive if housing is overpriced enough relative to rent). On the one hand, equities are the riskiest, most volatile class of investments. Indeed, Mandelbrot suggests they may be even riskier than we first imagine. On the other hand, they’re not all that risky when diversified and held for very long periods of time (and as youngish folks, we have very long periods of time on our hands). Combined with the fact that it’s cheaper to rent right now, renting and investing the difference really looks to be the less risky path. Though the English language has the expression “safe as houses”, it’s not true all the time, and blind faith in real estate is in my mind, one of the most risky notions facing young Torontonians and Vancouverites.

* – Sorry, I just have a (not particularly great) graph for data that old.

It’s been a hell of a few weeks. Thesis progress has been exceptionally slow. Diet has been downright terrible for similar reasons. The snow is ridiculous here: something like 4′ has fallen since Sunday. The height of the snow on the lawn isn’t quite that high, as it’s settled and compacted, but I’m calling it 4′ as I measured 3′ of snow after the first day and a half of solid snowfall, and had to clear another foot or so after shovelling that away. And now to top it all off I’m sick. I think I’ll cry if I end up writing better while hopped up on cold medicine.

After the first 24 hours of snowfall, and halfway through the third round of shovelling:

Then, against all reason and goodness in the universe, it continued to snow all through the following day:

And while the worst of it is over, it’s not completely over yet. It’s going to snow at least a little (up to a few inches) for each of the next 5 days, according to the forecast.

First up in the links, the 4th edition of the Canadian Real Estate Blog Carnival. As an update to my post in that, Wayfare tells me that the landlord has reimbursed us for most of the materials cost of the work we did (I believe everything we had receipts for).

Nova Scotia proposes mandatory organ donation. I tend to agree that the default should be “donor”, but it’s an ethical minefield for a number of reasons.

Another person (Prem Watsa this time) starting to question how far Chinese demand can take commodity prices.

A hilarious episode of BNN’s Market Call Tonight last night, as a real estate broker called in to rant about why rates can’t go up for 10-15 years. His logic is that a rate increase would cause a real estate crash, so it can’t happen. That reminds me of some other backward-thinking, such as the Globe article some time back that said Toronto rents were going to go through the roof in the next few years, because otherwise investors buying condos at today’s prices couldn’t make a profit. I find it hard to believe that some people are so wedded to the real estate only goes up meme that it becomes totally tautological as they use it as a justification for other calls… but there we have it.

Ellen Roseman reports on a case of a real estate agent abusing the buyer’s agreement.

I already had a quick note on the December TFSA strategy, but CC also has one for you.

David at Toronto Realty Blog points to an article about questionable spending at MPAC. He then comments on how wildly variant the MPAC assessments are relative to actual sale values in Toronto. I then point out that getting the absolute valuation of properties isn’t important to MPAC, since it’s only the relative valuation that matters (though perhaps it is fair to poke them for playing their tax-payer funded Wiis since they don’t do a great job there, either). The city doesn’t collect more tax when property values go up. Instead, the tax rate is adjusted so that their total revenue figure comes out: they basically take the total budget, divide it by the sum of all property values (assessments), and that gives them the tax rate for the year. The MPAC assessment is just for determining relative taxation. You can check that by looking up what the property tax rates were over the past few years. The tax rate actually went down from 2005-2006, and 2008-2009-2010. Under each of those boxes for the year is an example calculation, where you see that despite the changing tax rates and property values, the total tax grab goes up fairly consistently by about 2-3%/yr, which is I’d wager about what the typical Torontonian has experienced. When I am finally redeemed and property values do turn around… property taxes won’t. The mill rate will just be adjusted up to compensate for the lower assessed values so that the take remains the same.

Indeed, there’s a good reason for MPAC to consistently under-assess: there’s a cost of dealing with challenges. People who believe that the assessment should have some relation to the actual sale price will think that they’re getting a steal when the assessed value is below recent comparable sales, and not appeal the assessment when it comes in low. However, I don’t want to leave off with the impression that MPAC is doing all right — though they only need to get the relative valuations right, there are far too many stories out there about how they’re not doing even that much. And indeed, checking up on whether the relative assessments are correct would be easier if the absolute measures were at least close.

The Star’s Moneyville section had another real estate fluff piece on Friday, aiming yet again to reassure people that a housing correction won’t happen here. I was at first just going to let this one slide — after all, this is going to be my 4th post in a row on real estate, so sorry for those that are interested in other topics. It doesn’t really raise any new points (except for the incorrect one about no downpayment mortgages being “illegal” — they’re only illegal without insurance, but they’re all CMHC insured, so it’s a red herring), and it was quickly dismissed by people in the forums, over at Financial Insights, and even the big dog took a bite out of it over at Greater Fool. Where this takes a turn is that in the comments section of the Greater Fool blog post, Ian Lee comes in to try to clarify his points (see comments #75, 96, and 146). So now there’s some new points to counter. For the most part his arguments apply more to reasons why a housing downturn won’t spiral out of control and take the rest of the banking system out with it (AKA, the “US style” crash), rather than why housing won’t go down in the first place.

It’s a long conversation thread over there, with many people going back and forth, so I’ll just focus on a few keys points here.

Nothing he’s said so far has made me reconsider that buying a house now, in Toronto, would be anything but a terrible idea. Anyway, on to the specifics:

“But you are assuming that because you lose your job, you immediately list your house for sale AND reduce your asking price. A large number of mortgages issued today are issued to two income households which diversifies risk for both the bank and the borrower. Even if you decide to list your house, you list it at what the real estate agent recommends AND if you are clever, you will NOT disclose your unemployed status to the broker, which would reduce your negotiating power”

This all depends on whether two incomes are needed to keep the property, and my understanding is that in the expensive markets (Toronto, Vancouver) they are. If that’s the case, requiring two incomes to afford the house increases risk. When you have two wage earners the odds of either one suffering a job loss is higher than the odds of just one person suffering a job loss: basically, you’ve bought two tickets in the “unemployment lottery.” If only one income is needed to stay afloat, then yes, it adds redundancy… but that is not how it’s working in many cases these days. For many couples that second income is a mandatory component of the household’s income statement, a requirement to keep the household operating. That means systematic risk has been increased by this demographic shift.

“In fact, Canadian home ownership is at the highest level in our history at 67%. AND the mortgage delinquency ratio – which must be reported to Bank of Canada by the banks is less than 1% (compared to the USA where 1 in 4 homes are under water OR in foreclosure)”

I think his numbers are a bit dated — the spike has been tremendous in the last few years and is closing in on 70% now. Either way, that rate of home ownership is several points higher than it ever has been in our history, and the same thing played out in the states: people who perhaps had no business owning homes ended up buying them anyway, because it was trivial to get a mortgage.

Furthermore, you must realize that foreclosures lag prices. The fact that foreclosures are as high as they are in Canada is an extremely troubling point. In many major markets prices have been increasing at a very decent clip for several years now. Even with a zero downpayment, a borrower in trouble should be able to sell their house and come out whole after just 7-10% increase in prices, which is just a year or two of appreciation these days. So if anyone is getting foreclosed on, it’s either due to extremely bad lending (where the homeowner can’t even budget for repayments a year into the future), or because the foreclosure rate is very high in the non-bubbly areas, making the national average rate look “normal”. Remember, in the US the foreclosure rate was also quite low even while trouble was brewing.

“Concerning my comment that the US housing crisis was caused – NOT by market failure or by government failure – but by what I called “Congressional failure”, I can provide the approximately 60 slides of a paper that I presented at a conference called “Financial Armageddon” at Carleton University in 2009. EVERY slide I presented was publicly sourced from the Federal Reserve or the US Treasury or from Fanny or Freddie or HUD or the US Census Bureau or quotes from the Congressional Record of Barney Franks or Chris Dodds. These slides are remarkably illuminating and demonstrate my hypothesis that Congressional policy caused the housing bubble and then the housing collapse. […] In my Financial Armageddon paper, I provided empirical data to show a large influx of new first time buyers into real estate, that upset the equilibrium or balance between supply and demand, causing a bubble to form i.e. excess demand chasing limited supply. It was caused by the US Congress watering down the mortgage eligibility rules e.g. zero down payment, which encouraged large numbers of low income people to buy homes. Then when these low income people realized they could not afford the new home, they walked away (no recourse in the US), turning the bubble into reverse – into a collapse.”

I’m so puzzled by his views… Except for the non-recourse part (which as we’ve seen with recourse states is a small factor), how is this different than the scenario where CMHC allows for low/no downpayment, 35-year mortgages in Canada? We had a large influx of new buyers because of the rule changes. We shot our home ownership rate up 5% in 5 years in the midst of lowering interest rates. We had prices increase far beyond the historical norm for several consecutive years. How can you then conclude that our outcome is going to be so dramatically different than what the US experienced? [Yes, I will concede that it will not be as deep or as fast a correction, but house prices are going down, especially in TO and Van].

“I concluded that, going forward, we will experience what we experienced in the past with housing prices that overshoot. In the early 1980s, house prices went flat line for several years as they did again in the early 1990s.” [… he is then challenged by the fact that there was in fact a fairly substantial crash in Toronto in the early 1990’s …] “again, it depends on which real estate market you are using. Nationally, it was a wash – although yes, TO and VAN declined. No disrespect to anyone – but Toronto (3 million?) and Vancouver (2 million?) are not the totality of Canada’s 34 million residents.”

I’ll be the first to say that real estate is local, and that most of Canada will not be hurt too badly by what’s coming. But, those are huge local markets (their metro areas combined are 1/5th of Canada’s population). For me, I’m looking to move to Toronto, and chose to rent because the local market has gone insane. If you’re being interviewed for the Toronto Star, it’s very disingenuous to say that Canada’s [national average] housing will be ok, but snicker behind your hand at the suckers in Toronto and Vancouver who are going to get wiped out.

[Ok, yes, that’s a bit of hyperbole]