Peter, Paul and Mark

When I was a little boy, and growing up in a rural farming town, I often heard some of the locals say that they were going to ” borrow from Peter to pay Paul”. Some of the farmers around were even more vicious, and they were going to ” rob Peter to pay Paul”. I couldn’t for the life of me figure out why anyone would name their child Peter – you were certainly ensuring they would be borrowed from or even worse – robbed their entire life.

As I got a little older though, I realized that it was only a metaphor, and the farmers in the area weren’t going around terrorizing anyone name Peter and taking all of his cash. Apparently borrowing, or robbing from Peter to pay Paul worked for generations. People to this day still try this tactic on a regular basis. Apparently Peter has some very favourable terms, and a very low APR, as everyone is always borrowing from him.

Unfortunately for most Canadians, they have yet to realize that their house is named Peter, and their lifestyle is named Paul. Canadians as a group have been borrowing from Peter ( house ) to pay Paul ( lifestyle ). Now, this arrangement has worked quite well for the better part of a decade and a half. Every couple of years you hit up your local mortgage broker ( maybe he is named Peter too ) , and you borrow some equity to pay off the sins of a lavish life. While Canadian as a whole have perfected the tactic, they certainly aren’t the first. Back in the early 2000’s the US homeowner practically wrote the book on this tactic – borrowing insane amounts of money and overleveraging their homes to pay for a lifestyle that they couldn’t afford elsewise.

Like all good things though, it came to an abrupt end in 2007 when the sub-prime mortgage crisis came about. While there is always a raging debate on what caused the global financial crisis, housing was at the forefront, and the main driver of the collapse. Housing collapsed because prices were simply too high. Whenever you see any asset class get a hockey stick like chart – it is not sustainable. All of a sudden people couldn’t afford to buy homes, interest rates were going up, and people had to refinance the refinance to be able to afford to refinance.

So long as the price of the asset you own keeps rising, then all is fine. Canadian know this all too well. Housing was on a tear. However, at some point in the market cycle prices start to level out, and then all of a sudden they start to….gasp….go down. In the US housing collapse the problem was very very simple. The US had a program called an interest only option ARM. Now, for those of you too young to remember, the product worked like this:

You had a teaser rate for say the first 12 months of Prime -2.50%. Your payments were based on this teaser rate. You could also select an interest only option on this payment. So if your interest only payment during the teaser rate period was 4.00% on a $400,000.00 home ( $16,000.00 a year in interest ), but you could only afford $10,000.00 a year in payments, you could make your $10,000.00 in interest payments, and the bank would simply add the $6,000.00 to your balance. So you started the next year with a balance of $406,000.00, and on and on it went. In a rising housing value environment this worked. However, all good things must come to an end at some point.

Now, at this point you are thinking ” Well, good thing Canada doesn’t have an interest only option ARM”. But think again. Anyone on a static payment variable is basically on an interest only option ARM product. They aren’t paying any principle, and now a lot of them aren’t even covering interest, so the interest is reverse amortizing onto the mortgage balance, and the amortizations are extending out farther and farther, in some cases going over 100 years.

So far the US and Canada housing trajectory is looking the same: 1. Cheap rates led to housing going up. Check. Everyone piles in to investor properties they can’t afford, but no worries – we will assign or sell the property before possession. Check. Prices start to go down and people start to get tight on cash, so the number of active listings start to go up. Check. For the record, Canada is at this stage of the housing problem. Listings are starting to pile up, and Toronto is now at a 30% to 35% sales to new listings ratio. This is well below a balanced market, and well into buyers market territory. Fucking Toronto for god sake!!. The city we were told would always be different.

Okay, so this is where our friend Mark enters the chat. In the subprime housing collapse as properties started to go up for sale, and people were getting pinched – property values started to drop. All of a sudden the bankers got a little scared and started to clamp down on new lending. This made for even less prospective buyers and inventory started to pile up. The laws of supply and demand tell us that prices have to drop further if there is a lot of supply. At the same time the bankers were restricting new credit, the bank regulators decided to look deep at loans on the books. Regulators decided they should start to ‘mark to market’ the assets against the loans.

Mark to market is a very simple process where you take the value of the asset on the banks books, and mark it to the current market price. For example, if you bought a home for $400,000.00, and had a mortgage for $350,000.00 you would be at an LTV of 87.50%. However, if the market value of the house fell to say $330,000.00 you would now have an LTV of 106.06% LTV. If the bank is only allowed to lend to 100% LTV, they now have a problem. All of a sudden they have to allocate extra funds towards your loan for reserve losses. This is a very simple example, but you can get the idea. So, as property prices drop, the LTV of the loans on the banks books grows. Eventually it gets to a point where the bank calls the mortgage in, and you either have to come up with the cash, or sell the property. Now, if you were a person on an interest only option ARM product, you probably weren’t the person with tens of thousands of dollars just kicking around in the old sock drawer to pay down your mortgage demand…….so, you list the house, further exacerbating the number of listings. Prices drop again because of all the new listings, banks have to mark to market every 90 days, so the values are now even more out of whack, and round and round we go.

Will the same thing that happened in the US happen in Canada? Maybe. OFSI is the bank regulator, and they seem to change their mind regularly on what they allow and don’t allow. Remember when OFSI was all hot and horny about banks not having 30 year amortizations? What the fuck happened then? How the hell can the Big 6 banks carry amortizations on mortgages of 100 years? Well, like I always said, OFSI doesn’t protect the consumer – they protect the banks. OFSI knows damn well if the banks had to call all the mortgage that are either over 100% LTV, or over 35 year amortizations they would cause a massive problem – so OFSI lets it slide, hoping rates come down, and all gets right in the world. Well, news flash – rates ain’t coming down.

They say that history never repeats itself – but it certainly rhymes. Right now Canada is tracking the US housing problem tik for tik. Did the governments of the world learn lessons from the US housing collapse? Maybe. Will governments allow banks to play fast and loose with rules to avoid a potential housing meltdown? Maybe. While a lot of Canadians are really learning what robbing Peter to pay Paul is all about right now, many are vastly unaware of the parallels of the housing conditions and what it could mean for their future.

If Canadian banks are made to ‘ mark to market’ it could start the great unwind of Canadian housing prosperity. I am not here to say that it happens, only that it could happen. Although, it is not all doom and gloom. When the US experienced the Great Financial Recession (GFR) of 2007 to 2009, it whipped people into better financial shape. The US going into the GFR was the world’s most over levered consumer, and now they are somewhere around 4 or 5 depending on which business article you are reading. (In case you are wondering, Canada now has the most over levered consumer in the world.) Oh look another parallel. The pain of that recession really made people budget, borrow less, and be a little more cautious. Every cloud has a silver lining I suppose.

The problem with asset collapses is that you never know what straw will break the camels back. It is usually something you don’t anticipate that does it. In the US it was simply a function of success. It got to the point where properties didn’t have to go down, but because of the reverse amortizing of the interest only option ARM, they simply had to stop going up.

I don’t know what it will be that causes the Canadian Camel to have its back broken. It could be Peter, It might be Paul, but never count Mark out .