How Could Canada's Bursting Real Estate Bubble Affect All Canadians?

Recently, Bloomberg published a news item on Canada's banking system and its relationship with the country's real estate market.  While I'm not prone to quote from the mainstream media since it is my preference to post directly from the source material, in this case, the source material is not available to the general public since it was obtained by Bloomberg under the freedom-of-information law.

In a document obtained by Bloomberg, Valasios Melessanakis, manager of policy development at the Office of the Superintendent of Financial Institutions (OSFI) wrote that Canada's past history of bank failures related to real estate lending and sharp drops in housing prices could happen again.  Mr. Melessanakis writes that:

"Canada is not immune.  Just because nothing happened in Canada in 2008 (a U.S.-centred crisis), does not mean that Canada is not vulnerable to a housing correction now....The market may break because the fundamentals are not sound (i.e. an overvaluation of homes)...".

For those of you that are not aware, OSFI is "...the regulator and supervisor of federally regulated deposit-taking institutions, insurance companies and federally regulated private pension plans."  It is a federal agency that supervises and regulates 431 banks and insurers as well as 1396 federally registered private pension plans with total assets of $4.245 trillion as of March 31, 2011.  OFSI has recently been empowered as the overseer of the Canada Mortgage and Housing Corp. (CMHC) and has proposed new rules that will make mortgages a safer investment for banks.  The most stringent new recommendation coming from OSFI is that mortgagers must re-qualify for their mortgages every time they renew or refinance as shown in this quote from OSFI's most recent draft proposal:

"The LTV ratio (loan-to-value) should be re-calculated at renewal, each refinancing, and whenever deemed prudent, given changes to a borrower’s risk profile or delinquency status, using an appropriate valuation/appraisal methodology."

This issue could become critical if the current high real estate prices drop or if interest rates rise.  Should real estate valuations drop and many home owners find that their tiny bit of "skin in the game" (i.e. equity) is gone and they are underwater, the situation could flood the market with for sale properties, pushing prices down very painfully.

As well, OSFI is suggesting the following:

"With respect to the borrower’s down payment for both insured and uninsured mortgages, FRFIs should make reasonable efforts to determine if it is sourced from the borrower’s own resources or savings. Where part or all of the down payment is gifted to a borrower, it should be accompanied by a letter from those providing the gift ensuring no recourse. Incentive and rebate payments (i.e., “cash back”) should not be considered part of the down payment."

This is going to impact some of Canada's banks since at least some of them have a record of offering a "cash back" program for consumers availing themselves of mortgages.

Back to Mr. Melessanakis.  He also notes that home equity lines of credit have 

"...contributed significantly to growing overall household debt...This is not sustainable...".

How is this going to impact most Canadians, particularly those that have been prudent by either saving their money or paying down their mortgage?  The OSFI is very concerned about the health of Canada's banking system if the housing market follows that of the United States.  While many of Canada's banks are well capitalized compared to their international counterparts, those of us who have taken the time and made the eye-glazing-over attempt to read through the opacity that passes for a bank annual report know that much is hidden from public view.  The examples of the failures of both the Northland Bank (NBC) and the Canadian Commercial Bank (CCB) from the mid-1980's should give Canadians pause to ponder the repercussions of a bank failure, particularly a major bank failure.

As an aside, I have first hand experience with a bank collapse.  I was "fortunate" enough to be a customer of both banks when they failed in 1985.  I can quite clearly recall the closing of the Northland Bank over the weekend and actually making it up to the executive floor on the first business day after they closed their doors, asking to speak to the President of the bank.  I didn't get a chance for obvious reasons!

The NBC and CCB were relatively small, western-based banks with assets of $1.4 billion and $2.7 billion respectively; fortunately for taxpayers, this was only three-quarters of a percent of Canada's total banking assets.  As western-based banks, their investments were heavily concentrated in the western provinces in oil, gas and real estate loans.  The early 1980s were tough on the west; first there was the National Energy Program which was followed in quick order by a rather severe drop in the price of oil; the combination pretty much killed the oil industry.  Interest rates were at or just below their all-time peak with mortgages in excess of 16 percent.  Calgary's real estate market plunged; I can recall some houses plunging by more than one third in value over a two year period.  Many homeowners that had bought real estate during the heady days of the late 1970s and early 1980s found themselves owning more mortgage than house and, until the laws changed, a large number of these people simply sold their homes to "dollar dealers" who would buy your house for a buck, rent it out to unsuspecting tenants, collect the rent and never make a single mortgage payment until the bank finally foreclosed and turfed the temporary inhabitants.  This was the business environment that killed both the Northland and Canadian Commercial banks, the first Canadian banks to fail since the Home Bank failed in 1923.  Both the NBC and the CCB saw the quality of their loan portfolios follow Western Canada's economy into the toilet.  This situation could well be a predictive precursor of what could happen nationally.

How did this impact the banks' customers?  Mortgages were transferred to another major bank so those with loans saw little change.  The only thing that saved depositors' bacon was the backstop of the Canadian Deposit Insurance Corporation or CDIC which insured depositors funds up to $60,000.  CDIC is a government-backed insurance plan for bank deposits, allowing depositors to retrieve their funds if a given bank or trust should fail.   Interestingly, it took CDIC until the fall of 1991 to wind-up operations for the Northland Bank.  In my personal case, my deposits were settled within two months.  

Let's look a little more deeply at CDIC, Canada's bank deposit insurer of last resort.  Here is a chart from CDIC's most recent annual report for 2011:

Notice that CDIC has $2.208 billion in cash and investments and $1.1 billion in provisions for insurance losses.  They also have the ability to borrow an additional $17 billion from the Federal Government.  While all of this may seem like a lot, in fact, it would cover only a tiny fraction of the $604 billion that Canadians have on deposit at the 85 banks and other financial institutions that are members of CDIC.  For example, Canada's smallest "big five" bank in terms of deposits, the Canadian Imperial Bank of Commerce or CIBC, manages $116.6 billion on behalf of personal depositors and an additional $134.7 billion on behalf of businesses and governments (not all of which may be covered by CDIC).  You can see quite quickly that if one of Canada's larger banks failed, the CDIC would quite quickly require a massive taxpayer-funded bailout since their cash would quickly disappear.  

As an aside (and yet further proof of the concern out there), here is an interesting quote from the CDIC annual report expressing the same concerns as the OSFI:

"The largest risk to CDIC’s membership (i.e. banks and other financial institutions) remains the possibility of a significant and prolonged decline in Canadian real estate prices. Higher interest rates and mortgage servicing costs for borrowers could also translate into credit quality issues in CDIC’s membership."

CDIC also notes that there is an increased risk that their insurance powers will be inadequate to support its insurance risks should a financial institution fail.

Let's go back to the credit provisions and mortgage side of CIBC's portfolio.    Provisions for all types of consumer credit losses in 2011 were actually down $181 million from the previous year to $762 million.  While total domestic mortgages of all types reached $260 billion, up from $249 billion in the previous year, the loan loss ratio dropped to only 0.48 percent, down from 0.56 percent in 2010 and 0.70 percent in 2009 which, in light of the current real estate market euphoria, would seem to be heading in the wrong direction but it could just be me.

Looking at the much bigger mortgage picture, total Canadian mortgages tallied at approximately $1 trillion in 2010, half of which was insured by the Canada Mortgage and Housing Corporation or CMHC (also known as the Canadian taxpayer) as shown on this pie chart:

The Federal Government who, by law, must back CMHC's insured mortgage loans, has had to increase the limit of the total value of mortgages that the CMHC can insure from $350 billion in 2007 to $450 billion in 2008 and its current level of $600 billion, more than Canada's entire federal net debt.  Can we say "bubble"?

From all of this, you can quite quickly see how a decline in the value of Canada's housing markets could impact all of us, those who have been prudent and paid down the value of their mortgage as well as those who have actually managed to cobble together some savings.  If, as the OSFI fears, a major Canadian bank failed, CDIC might find themselves begging Ottawa to cover the deposits that they cannot.  Additionally, CMHC might find themselves prostrate at the knees of both Steve and Jim begging for more.  Either way, I think that we all know who pays in the end.