Blessed by the Potato

There has been a real barrage of articles about the housing bubble in the MSM lately. Perhaps because January is both a slow news period and a slow real estate period, so it’s a good time to get it all out, or perhaps because the topping process has begun, and the awareness of the problem has started to spread from gloomy spreadsheet addicts like myself to society at large. Based on some very non-scientific mining of Google’s news search, mentions of a housing bubble started to increase about a year before the top in the US, and really were flying wild when the prices finally turned the corner. Here, stories about a Canadian housing bubble roughly doubled last year, to about 500 hits in 2011. There have been over 200 hits already in 2012 — just one month!

Alongside the stories that warn of the danger are ones that try to explain it all away, including two recent ones by Larry MacDonald (who I respect) and Mark Weisleder (who, well, let’s just say he makes these kinds of mistakes a lot). Together, they make a few basic points:

• House prices have been stable.
• Immigration.
• Interest rates are low, and even if/when they do rise, they will be accompanied by job growth.
• Recourse mortgages.
• Low foreclosures.
• High valuation metrics… but, like, so what?
• Bears only call for a bust due to recency bias, because we just saw a housing bust in the US.

So, to the point-by-point rebuttal machine!

Though some are shared, Mark’s arguments are obviously much weaker than Larry’s. Only he would make the point that housing has been stable and the GTA is nice, so it’s an attractive buy. Of course the converse implies that if housing does start to turn, it will turn badly because that point in favour of buying goes away, and instead becomes a point in favour of selling.

Similarly for his immigration argument: we do get a steady influx of immigrants to Canada (and the GTA in particular). Beyond just immigrants, babies will still be born, teenagers will still turn into twenty-somethings, and people will still move out of their parents’ basements. That was as true in 1992 as it is today. For that matter, it was as true in 1989 as it was in 1992. These things are all true, have been true for a long time, and mean absolutely nothing when it comes time to deciding whether now is a good time to buy a house in Toronto. It means your house won’t be completely worthless, but doesn’t mean a painful 10-35% correction isn’t in the works — as witnessed first-hand by buyers in Toronto, 1989.

The point about low interest rates is also not particularly strong. Even with the recent deals on fixed 5 and 10-year rates, you will be exposed to future rates for a long time when buying a house. After all, the typical mortgage is 25 or 30 years long. It is much better to buy at higher rates and a lower price than to scramble to buy at high prices and low rates. Think of the possible outcomes: if rates move lower, you get a gift and can pay off your mortgage faster. If rates move higher, you face a hardship. If rates are as low as they’ve ever been, the odds are this is as good as it will get, with likely hardship to follow.

Now Larry makes a point about higher rates being accompanied by higher employment, which should offset the price declines that higher financing costs would bring. But to that I simply say: invert it. Prices were up 10% in Toronto last year, and apparently the economy is still just limping along, warranting low rates. So how big of a driver is employment vs interest rates for house prices? To me, that indicates that while there may be a bit of tempering if employment and wages gain along with increases in rates, those are not going to have a large enough effect to counter the decrease in prices that will come from the higher rates. Rates trump jobs when it comes to our housing market.

Recourse mortgages is a common reason thrown around to explain why Canada may be different than the US. It’s an interesting one, too. Sure, if the bank can come after you for your other assets you’re going to be less likely to strategically default and walk away from the house. That’s going to slow the positive feedback cycle, but there’s very good evidence that it’s not realistically that big of a factor. To point out the real-world evidence, again, just look at Toronto, 1989: mortgages were recourse then, too. Didn’t stop the bust. Many US states also had recourse mortgages (including Nevada, one of the few states to escape the housing meltdown — oh, no, my mistake, it’s one of the hardest-hit).

Let’s consider that point in a little more detail. Why doesn’t the recourse action save the housing market? At the core level, the simple answer is because it doesn’t fix anything in the fundamentals: the only way for price-to-rent and price-to-income to come back into line is for price to fall or rents and incomes to rise. So having recourse mortgages may stem the tide and positive feedback cycle of strategic defaults and foreclosures, but doesn’t bring any new buyers to the market. But even then, how much of the tide does it stem?

To answer that question, we have to get an idea of how many strategic defaults there might be vs. bankruptcies. If you can’t pay the mortgage, if you’re severely underwater, and if you have very few other assets, there is really no difference between a strategic default and a bankruptcy — and we still have bankruptcy here. You give the house back to the bank and you start over with nothing. Many people — far too many — have bought in recent years with nothing down and are house poor: aside from their house (with just a thin slice of equity in that), they have very few savings and investments. So to them, there’s no difference between a strategic default and full bankruptcy. If someone has a lot of other assets, then they may have considered a strategic default, but how many of those people are there who also have so little home equity that they’d be willing to trash their credit and walk away, if only it weren’t for that damned recourse mortgage? I’d bet not terribly many. Not enough to matter anyway.

So recourse mortgages aren’t going to stop a housing bust, and are certainly no reason to go out and buy now (if anything, it should give you pause as a buyer).

Hmm, low foreclosure rate. Let’s see, prices in Toronto were up about 10% year-over-year last year. Why are there any foreclosures? Even a 5%-down buyer could sell the place, repay their mortgage, and cover all the sundry transaction fees, taxes, and penalties if they ran into financial trouble in this market. They just had to stay solvent for a year. No, foreclosures are a lagging indicator: only when the housing market is already flat or going down and people are getting into financial trouble does the rate go up, because all other options have been taken away.

Both Mark and Larry touch on valuation metrics. Part of Larry’s point is valid: they don’t tell us about when the correction will come. I’ve been bearish for years precisely because the metrics have been out of line for years. But that said, severe over-valuations like this rarely correct neatly, with a long period of modest negative real returns — “crashes” or “corrections” are the norm. Mark’s point… does Mark have a point? If you don’t like averages, fine, use medians. But don’t compare the nominal number with one method to the nominal number from another: what was the median Toronto income to the median Toronto house price historically, and what is it now? You can’t try to hand-wave the fundamental imbalance away like that Mark, I’m too perspicacious for that.

Finally, to Larry’s point about recency bias: I disagree. I think the recency bias is not clouding the vision of the bears, but rather the bulls like Mark. The last crash in Toronto real estate was 1989, when many current first-time buyers were kids, or gametes. All they’ve known for recent history has been rapidly increasing prices with no risk.

Asides: Mark has a few other points that aren’t even remotely relevant, but I figured I’d rake him over the coals a little more.

His final bullet point about debt ratios shows how clueless he is about what these population measures are showing: for a given person, a debt-to-income ratio of 150% is nothing. Hey, a 25-year-old making $50,000/year who just bought a $400,000 house with nothing down except the closing costs would have an 800% ratio, and people still wouldn’t look at him funny. That person should be able to handle the payments and has lots of time. But what about a retired 70-year-old who has a pension of $40,000 and is $60,000 in debt? That’s only 150%, yet is clearly a much worse situation than the young guy at 800%. So the important thing with these population measures to see how they change over time. The Bank of Canada isn’t worried about one particular Joe having 150% debt-to-income, it’s worried that for a long time that ratio stood at 100% and over the last few years has climbed to 150%. I wonder how Mark would interpret a stat like the average family has 2.3 kids? He must be one of the ones envisioning whole neighbourhoods hiding kids with only a third of a body in the basement.

The closing message about the US not allowing the economy to fall apart in an election year is face-palm worthy. 2008 was an election year, Mark. The reality is that the US government, for all its nuclear missiles and predator drones, is helpless to stop a housing collapse. Ours will be even more impotent since we’ve already burned up the government mortgage guarantee, low rates, RRSP raiding, and extended amortization options.

“I have yet to meet a father who didn’t see little feet emerging and immediately feel the need to run out and throw himself at an insurance salesman.” — Garth Turner

Wayfare and I just had a very short discussion about our life insurance needs. I off-handedly remarked some time ago that one of the factors that maybe should go into the typical rent-vs-buy analysis is the reduced need for life insurance as a renter, but since I didn’t know what the cost was, it was hard to model (and I assumed, trivial).

Anyway, with a new spud under cultivation, I thought it was worth discussing seriously, and we very quickly agreed that we didn’t: she makes more than I do (though as of next week, “0” is an easy bar to hurdle), but both of us are capable of supporting a single-parent family on our own. If we both die, both our sets parents are well-off enough to take in a grandchild and not become destitute themselves (at least with our savings to help out).

As renters, we don’t have a mortgage to discharge or huge transaction costs for moving, so it would be reasonably easy (at least financially) for the survivor to move to a smaller, cheaper place. And the aforementioned savings would help with any burial expenses, additional childcare costs, or bereavement leave.

A few online calculators confirmed that our life insurance needs were basically zero (varying between a $150k policy and negative $80k depending on the calculator and assumptions used). I went ahead and got a few quotes for a $100k term-10 policy, and it’s not terribly expensive, but not trivial either: about $150/year for someone my age. This might all change once I see little feet with their widdle toes, but for now, hey, we don’t seem to need it.

UWO has decided to rebrand itself, going from the University of Western Ontario to Western University. And it’s not even April 1st yet. I don’t particularly like the new name; it’s not terrible, but I don’t see the need to change, and it kind of makes me think it’s in the wrong part of the country (shouldn’t “Western University” be in Alberta or something?). UWO had a fair bit of brand recognition under both UWO and Western which was working, so I don’t know why they’d throw away the UWO part. They mention in breaking down the new logo that they’re proud to be in London, and proud to be Canadian… but apparently not so proud to be in Ontario.

Kind of funny, because just a few weeks ago we were making fun of a newspaper article that referred to “Western University” — so perhaps not wrong, just early.

One weird thing is of course that web address — still at the old uwo.ca. I tried going to western.ca, and there’s nothing there. According to the whois, the domain is owned by a HR firm in BC. So the URL will likely be anachronistic now. [update: they did get westernu.ca] They say that the legal name is still the University of Western Ontario, and that’s what will appear on the diplomas.

Anyhow, one upside to leaving (sob, sob) is that I don’t have to go and redo all my powerpoint templates to suit their new branding.

There is a company out there with the majority of its operations in China. It has had an incredible, unbelievable run in its stock price, up 400% from the bottom in 2009. This run has been supported by impressive sales numbers, growing the top-line (revenue) by better than 50% per year for several years running, and the bottom line (net income) by better than 70%.

They are in a business that is apparently not very capital intensive: their PP&E is less than a third of one year’s earnings, yet their margins remain very strong. This company generates an impressive amount of free cash, with minimal capex requirements (the single largest use of cash, by far, is for “investments”, which commentary indicates are largely fungible bonds). They carry an incredible amount of cash: 10X inventories, and almost 3 year’s worth of capex, in cash, at any given time. Including investments, they have resources to cover their current inventory and full-year’s capex 19 times over. They could stop all shipments, not make a single sale ever again, and still continue paying the expenses associated with the R&D and general operations of the company for a full 10 years by using the liquid resources they have built up.

That, my friends, is a staggering amount of non-productive assets to keep on the balance sheet. Why is it not going into R&D, or capex, or aquisitions, or better yet, to dividends and buy-backs? If you knew all the intimate details about a business that was doubling every other year — because you are running it — why would you ever choose to hold cash — so much cash — instead of buying more of that business? So my spidey senses start tingling: are the assets listed in the financial statements really there?

Is this the next great Chinese stock fraud?

Now of course, you probably all know exactly which company I’m talking about. We all know the company is real. The books are very likely real. I’m not seriously suggesting otherwise. But I have to wonder if perhaps when you are looking at this company if one of the risk factors you write down on your analysis shouldn’t be “potentially the biggest stock fraud since Nortel, WorldCom, or Enron. Biggest ever.”

Disclosure: no position. And yes, I am a little jelly.

Krystal Yee weighs in on the eternal savings vs line of credit (LoC) emergency fund debate. I disagree with her on a number of points which is largely just personal preference, but importantly she’s needlessly fearmongering on a few points, and that needs to be cleared up.

To begin, I think of emergency preparedness as having multiple levels, each of which requires its own solution.

The first level is not financial at all: what if you get stuck in your house? A bad blizzard, a quarantine, earthquake, or zombies roving the neighbourhood. Whatever it is, money won’t help you. You need to have a few days’ supply of food and water (and um… q-tips). The government has a site that’s a good resource for basic planning. Remember, it doesn’t necessarily have to be a separate dedicated cache: if you normally keep bottled water in the house, then just make sure your inventory never goes below a few litres; likewise for shelf-stable, easy-to-prepare food.

The next level is for the likely but not severe “emergencies” or “lumpy” expenses you may face, and that’s IMHO best kept in cash (in your chequing/savings account, not literal paper cash). Whether it’s HR screwing up and delaying your pay by a month, getting hit with a car repair, needing to fly across the country for a funeral, or finding a sale on a big item you didn’t properly budget for, there’s a reasonably high likelihood you’ll need a few hundred to a few thousand or so dollars at the ready. But much beyond that and I think it’s more optimal to put the money to work rather than keep it around.

After that comes the less likely but larger expenses. This level, I argue, shouldn’t be kept in cash unless you are very conservative. A line of credit is a good option here, alongside the ability to sell investments and use that cash.

What are the trade-offs? If you don’t keep cash and are hit with an emergency that needs more than a few hundred/few thousand dollars to cope with, you’ll have to find a way to cover that. If you borrow from a LoC you’ll have to pay some interest, if you sell investments you may have transaction fees, you may be forced to sell low and buy higher later when you recover from the emergency, and you may have to temporarily give up some TFSA room. None of that sounds so onerous to me, especially when faced with a rare, expensive emergency.

So, what did I find so objectionable about Krystal’s post? A few points:

Her first point, she says “after your emergency money is gone, you will still be debt-free” which implies that after using a LoC to cover some emergency, you would be in debt if you didn’t keep a cash cushion. But if you approach it from an all else being equal perspective, you see that’s a ridiculous false dichotomy: if you had cash and spent it you’d realistically be no better or worse off than if you had invested the cash and then borrowed against the investments in an emergency. Yes, there is debt, but you’re not in net debt — with the click of a mouse you can sell your (bond) index funds and pay off the LoC if you so choose. And if you’re debt averse, you may be less likely to tap the LoC for avoidable “emergency” spending that might otherwise drain the cash account. In other words, the choice is not between cash and debt, the choice is between cash and investments with a debt option.

Her second point is entirely personal: sure, going into debt is stressful. I had to experience it myself when I went 4 months this summer without a paycheque, and sold off investments and tapped my LoC to make ends meet. But the fact I had debt on my LoC was a trivial, marginal increase to my stress caused by the overall situation. And because I had invested my money rather than keeping $6000 in cash lying around, I made several hundreds of dollars on that money over the years, which was more than a fair trade-off for that marginal stress.

She almost gets the point on the 3rd bullet: the bank controls the LoC. The big risk of the strategy is that the bank could pull your LoC at exactly the moment you need it most (e.g., if you lose your job, or during a liquidity crisis). One way to help ameliorate that is by securing the LoC against your house, if you have one and have enough equity (a HELOC). “If your line of credit is secured by your home equity, you have the added pressure of knowing that you will be putting your house is at risk.” [sic] No. Well, technically, yes. But realistically, no. No one in the history of Canadian banking has had the bank repossess their house over a few thousand dollars on a HELOC. The risk to your house is there from the emergency itself: if you don’t make your mortgage payments, or pay your property tax, or whatever. Not from actually using your HELOC to cover a few thousand for an emergency (the amount she says you should keep in cash instead).

To say it again more clearly, the risk of using a HELOC for your emergency fund is that the line gets taken away, not that the house gets taken away. It’s more risky than holding unproductive cash, but it’s a remote risk that’s not really worth getting worked up over.

So in the end, I think a better strategy is to keep a small (~1 mo) emergency fund, and then have the rest invested, with access to a LoC/HELOC if needed. The choice is not between a large cash emergency fund and nothing to fall back on at all — those investments are available if you need them. And of course, that’s one of the reasons I recommend filling the TFSA first over the RRSP, since you can withdraw from the TFSA if you do hit a bump in the road and need to cash out. Since it may take a few days for transactions to clear, the LoC can help you bridge that time, and also give yourself some time and breathing room to decide if you do need to liquidate, or just borrow and repay the LoC from future savings.

It all depends on your own risk tolerance of course: if you can’t sleep at night without a big metaphorical mattress stuffed with cash under you, then so be it. You’d most likely be better off investing most of that cash, but you do need to take your own psychology into account. Just don’t go out of your way to make up risks to frighten yourself with, the world is scary enough as it is.