Blessed by the Potato

Shoppers Drug Mart has decided to strike back at the Ontario government’s plan to rejig how pharmacies are paid by cutting hours in many London-area stores. London was probably chosen since Deb Matthews is both a local area MPP and the Ontario Health Minister, rather than because of its long history as a test market. This is a classy move.

Shoppers has been the darling of many a Canadian investor’s eye: they’ve been growing like crazy the last few years, and pay a dividend to boot. However, even before this, I wasn’t too keen on the SDM story. I used to love Shoppers as a consumer. They were open late or 24 hours, they had, like, everything, and it was all reasonably-priced. Then a few years ago they started jacking the prices up; just last week I went in to get some half-priced Easter candy, picked up some OTC drugs too, and came home… I was checking what I bought, and even though I paid the price I usually pay, I found the packages were half the size of what I got from Pharma Plus last time — they’re now charging twice as much as Pharma Plus! Since this wasn’t just candy but expensive medicine, I took it back, and went to Pharma Plus instead. Yes, their Optimum program is one of the better loyalty programs out there, and yes their stores are bigger and better and stocked to the gills with everything and (until now) open later… but I don’t think I’ll be going back unless there’s a blockbuster sale sometime. This is, of course, years after we stopped going to Shoppers for actual prescription drugs because their dispensing fees were ridiculous — again, double what many other drug stores charge (and what my drug plan covers!).

Plus a lot of that juicy growth has been in expanding the square footage of their older, smaller stores. There aren’t many of those left, and with almost half as many SDMs in Canada as there are Tim Horton’s, I can’t see a whole lot of growth left for ex nilhio locations. So that pretty much leaves their high-margin beauty and cosmetics business as the only place left to continue growing. I think that actually will work out fairly well for them, but it’s not the rock-solid recession-proof pharmacy business that investors are being sold on.

I should say that I do have a bid sitting open for SC, but at $35.50 I don’t expect to get filled since the panic over the drug plan rules seems to be fading. At its current price ($38) I think it’s probably a decent enough buy for the low-growth long-term story, but I’m not convinced it’ll shoot the lights out of the broader market index, so I might as well buy that.

Peter Watts was found guilty for obstructing an officer. All he did was get out of his car during a search and ask what the problem was. For that he was beaten, maced, and to add insult to injury, sent back to Canada in December without his winter jacket. As if all that wasn’t punishment enough, a court has now also convicted him for obstructing an officer — a crime that can apply to such heinous acts as questioning an officer, or not complying with an order quickly enough (and here noncompliance can include asking “why?” when an officer orders you to the freezing pavement in December).

There was some half-joking talk here of boycotting some travel to the US because of how crazy the border had become. Now the next time we have a conference in the states, I think it will be a serious consideration.

American border guard: get your heads out of your asses.

There weren’t too many surprises in this federal budget, which coming from these clowns is a surprise in itself.

There was a provision for some money to create some attractive post-doctoral positions across Canada. At $70k each, these are decent grants (roughly double the typical post-doc salary)… but with only 140 country-wide, this isn’t going to hit very many people (i.e.: I probably won’t get one).

Of course, the large text giveth, and the small text taketh away. The budget also removed a loophole for some post-docs to get paid tax-free: scholarship income is now only tax-free for “real” students. I don’t know of any at Western that were getting paid this way, but presumably it happens.

The government, in a bit of a surprise move today moved to tighten mortgage lending rules to help reign in the housing bubble here (which, for political reasons they can’t actually admit exists). I don’t mean that rules of this sort coming into play were a complete surprise, indeed there has been much speculation and hope that some sort of tightening would be employed in the budget. Just that it was a surprise to come today when the federal budget is less than a month away. To me that’s an actions-speak-louder-than words type thing, that these rules couldn’t wait until the spring frenzy.

Anyhow, on to the new rules:

The weakest in my opinion is the new rule that refinancing can only take one down to 90% equity. It’s to help prevent people using their homes’ rising valuations as ATMs, but I have trouble seeing how it might actually prevent a bubble — just maybe lessen the pop since it makes it a little harder for existing homeowners to put themselves underwater alongside new homebuyers.

The way the banks and the CMHC will calculate your debt service ratios (i.e.: how much house you can afford) will change slightly, so that now you must be able to afford payments at the 5-year fixed rate instead of the 3-year one. Since the 5-year rate is currently a few hundred basis points higher than the variable-rate, it will help protect people from themselves, and ensure that a small jump in rates won’t cause people to have to leave their homes. Supposedly, many people in this rate environment are taking 5-year mortgages anyway, but I have to suspect that this is going to screen out at least a few first-time buyers whose real estate agents have sold them on a price point based on the “monthly carry” at 3% or some ridiculous temporary interest rate. Personally, I’d like to see this as an even more conservative rule: i.e., ensuring people could afford their houses if rates shot up to beyond the current 5-year rate — perhaps an arbitrary 8 or 10% rate, or perhaps the high water mark for the last decade (though that can also lead us towards fooling ourselves in long periods of declining rates).

The last point is the one that I think is the most needed, and will do the most to stem speculation: people buying real estate other than as their primary residence, i.e., speculators, must put down at least 20%. So anyone that’s been investing in multiple condos in Toronto because you only need 5% to get your foot in the door will find that they have to have some money to buy. Unfortunately, it’s probably also the hardest to enforce — after all, if you search the blogs of the speculators, you’ll find they seem to skate around the other principal residence rules in efforts to make their flipping gains tax-free. I’m sure they’ll argue that they intend to live in each of their units, but had to buy the next three before selling the first… Depending on how this rule is implemented, it could start deflating the condo market quite quickly: if people who signed up for a dozen pre-construction units two years ago for completion this summer find they now have to have 20% down at the close, they may be in a terrible rush to sell. If existing contracts aren’t affected though, then it will still take some time for the hot air to work its way out of the system — which is probably how this will be implemented.

So, some quick (slightly inaccurate) numbers:

Let’s say you’re a couple with a gross income of $100k. 32% of that monthly is $2666/mo — that’s the guideline maximum for your mortgage payment, heating costs, and property tax. Let’s assume your heat and property tax are a fixed $300/mo, which leaves $2366/mo for the mortgage. With a 35-year amortization and a 3-year posted rate of 4%, you can afford a morgage of about $534k. At the 5-year posted rate of 5.4%, that maximum possible mortgage drops to $446k. A decline of ~17% in the maximum house you can buy. Depending on how many people were actually at the limits of their debt service ratios, that could undo the massive run-up that we had in 2009 as a result of the low interest rates.

There is a great deal of systematic risk associated with allowing people to buy homes with 0 or 5% down. It’s a part of the system that I really think needs to be changed, and that I hope does get changed soon if our government ever gets back to work (especially with the deficit, I hope they’re refunding their salaries for all this time off!).

The risk comes from a number of fronts. One is that it allows young, stupid people to buy homes. People who don’t have a track record of sticking to a budget, or of weathering a bad year, or even of being able to save very much at all are allowed to take on massive amounts of debt, which is in a way kind of crazy. Especially since the ability to buy with a small downpayment means that it often ends up that the downpayment is all the homebuyers have at first: no emergency fund in case something unexpected happens, and no equity in their home to borrow against. They start off stretched to the limits. Multiply it out across all the young recent homebuyers in our population, and a slight recession (where they are caught with their shorts down and need to sell due to job loss) can turn into a massive housing bust. I have to admit that I was actually surprised that the emergency interest rates were able to overcome this last year — I had given the Canadian housing market up for dead when it ground to a halt in the fall of ’08.

Add it all up: people with no proven history of being able to stick to a budget for a long period of time, no home equity to speak of, and no safety net, and it may not surprise you to hear that having no equity in your home is almost as strong a predictor of defaulting on your mortgage as having poor credit. Now, that’s for the post-crash US market, so it’s having no equity to begin with and then being upside-down that I’m talking about, but with only 5% and closing costs of ~10%, even a flat market can leave you upside-down if you’re forced to sell. Of course, “layered” risk factors are exponentially more risky: someone with poor credit (i.e.: someone who has been late or defaulted on a payment in the past) but managed to save up a 20% down payment and has it invested in the house has let’s say a ~1% chance to default in a bad housing market, and someone with good credit but no equity has a ~0.8% chance of defaulting, but someone with poor credit and no downpayment is way more likely to default, at say ~7%. This is where a lot of the attention goes in the discussions of the shoddy US lending practices and how Canada is “different”… but we’re writing a tonne more low-downpayment mortgages (though to people with decent credit), which is really only a difference of degrees vs subprime in terms of risks to the system. It’s not throwing gas on the fire in terms of adding accelerants, but it still burns.

And speaking of acting as an accelerant, have you ever heard someone complain in the last few years that “the market goes up faster than we can save!”? And what happens when someone complains that the housing market is going up faster than they can save? They stop saving and dive in with whatever they’ve got, even if they have to borrow the downpayment from mom and dad. It’s how speculative bubbles are made: prices start to rise, and people, being afraid they won’t be able to buy higher, buy in a panic. Which drives prices higher… When you have to have skin in the game, it can slow things down. If you have to save up 20%, it can mean that no matter how fast the market goes up, you still have to keep saving. You can’t bring demand forward from younger and younger people afraid of being priced out but who don’t have savings yet. And if you do get priced out then that helps act as a natural brake, because the demand is both removed when prices over-shoot (and people trying to save harder may spend less and put a damper on the local economy which may also help slow the market), and because it limits speculative frenzy. You don’t see a whole lot of people running down to pick up a half dozen condos on the first day of pre-sales when they have to put down 20%.

Of course, the most bizzarre proof that I have that low down-payment mortgages are dangerous is the existence of the CMHC itself. Banks are not allowed by law to hold a mortgage with less than 20% down — if they could, they might write many such mortgages. But doing so would put our whole banking system at risk if there’s a housing crash because there’s a good chance that even with a minor housing crash, with many homes having several years of mortgage payments under them, that the banks could not expect to recover more than 80% of the home’s original value. And banks failing due to aggressive mortgage writing could bring down commercial lending, and lead to panic and runs for deposits, and all the doomsday scenario stuff that we just went through in the US. So our banks aren’t allowed to hold those sorts of mortgages without insurance.

However, in a strange twist, a low-downpayment mortgage insured by CMHC is less risky to the bank than a conventional mortgage would be, since CMHC doesn’t just cover the difference between the actual downpayment and the insurance-free 20%, but rather the whole cost of the mortgage. The risky mortgage is basically off the bank’s balance sheet and put into a CMHC mortgage-backed security. Ah, yes, “securitization”. You’ve heard that word in the news a lot: a way of taking the risk away from the people making the decisions about writing a mortgage. Yes, that risk factor is alive and well up here in Canada, despite the recent lessons from the south.