Tuesday, April 29, 2008

The Canadian consumer is extremely healthy

Banks bank on ‘healthy' Canadian consumer,

TARA PERKINS AND LORI MCLEOD Globe and Mail April 29, 2008 at 9:26 PM EDT

“The Canadian consumer is extremely healthy right now,” Dave McKay, the new head of domestic banking at Royal Bank of Canada, said at a presentation for analysts in Toronto.

“The Canadian consumer is strong, they have not leveraged the equity in their homes nearly to the extent the U.S. has, so there is still opportunity there,” he said, noting the need to be prudent.

But “I do not lose any sleep at night about our home equity business whatsoever,” Mr. McKay said, noting that “you can't compare the Canadian and U.S. home equity market, they're just night and day.”

Yet another sign of a top?

This dude Dave has really drunk the Kool-aid or more likely, he is talking up his company. He is saying that people can even take out more money from this homes (since they didn't get as crazy as the Americans) and that he is sleeping well at night.

Does he not see the turn in the Canadian housing market? The other housing markets in the world that are falling? The commodity bubble that seems to be starting to implode again as the US dollar strengthens? Nope, he points to record employment and the fact that Canadian banks keep their mortgages on their books as reasons that things will not fall apart here.

I believe that the job market has turned in recent months and that things are really slowing down in Montreal and Toronto based on my limited contacts. I'm not hearing about layoffs yet, but this is to simply point out that if the housing and commodity markets head south, the job market will follow. Housing lead the job market in the US and I believe a similar thing is happening worldwide.

As for keeping mortgages on the books: I will need to research this, but my gut feeling is that the banks were giving money away in many cases. In a boom, banks make money by lending to anyone. In a crunch, they stop lending to almost everyone.

Even Mr RBC Bull points out an alarming point (for a bull):

There has been a shift toward lengthy mortgage terms of 40 years. Mr. McKay said it's something RBC has been warning customers about. Bank staff tell customers their interest and carrying costs will go up with lengthier mortgages, and make them aware of the pitfalls and costs, he said. Customers are responding by saying “I understand that,” but they want to free up their cash flow in the shorter-term, and plan to pay off their mortgage in fewer than 40 years by making lump sum payments, he said. “Customers have consistently told us that they plan on managing it,” he said. “Whether they can all do it or not is a good question.”

Of course customers plan on managing it. They assume that the good times will always be here and that they will always have a job, no need for any savings and they will make a lot more money in the future. Plus, their house will appreciate 20% per year....

Conclusion: I don't buy it. The Canadian consumer is doing OK for now because of the huge windfall from the commodity and housing bubbles and a soaring Canadian dollar (that has lowered core inflation). If those one-time factors are finished for at least the time being and the credit crunch really rears its ugly head, our Canadian consumer will be headed to the doctor.

Monday, April 21, 2008

Commodity Markets Updated

It appears that I was a little early in my bearish call on commodities. However, with the exception of oil and a few select commodities, most are still below their Feb/March highs. I covered most of my shorts at small losses in late March when it looked as if the Socgen and Bear Stearns lows would hold. I played gold pretty well thus far as I took profits on some big down days.

I still think that commodities (excluding gold) are headed lower this year and the TSX with it. The TSX is actually a big up day away from its all-time highs! (With the exception of HGD (an ultrashort gold ETF), I have no positions here but may take some in the future).

Bubbles can persist for a long time, and perhaps I am way too early on this one.

What will be the catalyst?

One thing that can hurt commodities in the short run is a strong US dollar. The US dollar has become universally despised. If it can put a short/intermediate term bottom here versus the Euro and rally to 1.50-1.52, it could put a top in oil, gold and other commodities, especially given the leverage and profits inherent in these positions. The Fed meeting next week looks like a 25 pt cut, and this could be the spark that the USD needs.

What are some of the clues that perhaps this commodity rally is not for real?

1) The Canadian dollar topped in November at 1.10. It is currently near par. It has not confirmed the 2008 commodity rally (bearish divergence). If commodity prices were to continue strong, shouldn't the Canadian dollar be stronger? Perhaps the loonie has been weak due to the aggressive rate cuts or perhaps it was simply too speculative a move back in November.

2) Record oil prices have only recently allowed oil stocks to hit new highs. Perhaps this is due to general stock market weakness or perhaps the stocks are leading the underlying commodity... The same is true in certain other areas (such as gold). I believe that the crude oil market is not a free market with a level playing field as it trades so strangely. However, if we get a true breakdown (as we did in Sept 2006) to sub $100, this would likely bring the rest of the commodities down as well. I don't buy the BRIC argument and I think that oil at these levels can not be explained by demand pressures.

Since it also looks as if the financial rally is ending, the 75% of the TSX in 3 groups (mining, oils and financials) could be vulnerable here. I don't think most Canadians realize how risky the TSX is right here.

I'm also looking for the BoC to cut 50 tommorrow.

Thursday, April 17, 2008

I was wrong: The Turn is Here

WOW!! The March data from CREA was off the charts horrible...

I was wrong when I wrote this on April 8:

" Canada's turn may be coming. Clearly, the turn in Canada is not here as of March 2008. However, this does not mean that the turn isn't coming."

snowy February numbers were not good, but they were not disastrous (a la Britain's March). I thought that March would show some deterioration over the Feb numbers, but not to this level. I wrote that line attempting to take the focus away from a myopic short term view and look to the future. Well, the future is here...

The average selling price of existing homes in March rose by only 4% YoY (down huge from 6.2% YoY in February and 11% for 2007). YoY sales number for March dropped almost 19%!!

That is a huge slowdown that has brought price increases down near to the CPI rate. This means that a house is showing almost no appreciation in real terms.

CREA had projected a national 2008 price increase of 5.5% and a slight decrease in sales to 512K (from 520K in 2007, a drop of 1.6%). Those numbers are fantasy now based on the Feb & March data.

Here is a summary of the CREA numbers (gathered from press release, articles):

2008 Proj 2008 Q1 Feb 08 Mar 08

Proj Act Act Act

Price 5.5% 5.5% 6.2% 4.0%
Sales -1.5% -13.0% -10.0% -18.7%

In the G&M today:

“Canada's six-year housing market boom is officially over. Aside from a few choice prairie locales, sales are melting faster than this year's snowpack,” Douglas Porter, deputy chief economist at BMO Nesbitt Burns, said in a research note.

New listings (inventory) were up huge as well. March sales fell by 40% in Calgary, 34% in Edmonton and 22% in Toronto

In the G&M, it points out that Porter and TD continue to expect "moderate home-price gains" for the year. Do they really believe this or are they speaking for their bosses who hope to avoid a US style crash? Ted Carmichael of JPMorgan talks about price declines in the next 12 to 18 months in the National Post. JPM has a smaller presence in Canada, so maybe he is more free to speak his mind?

The turn is here. The chain of events that I put out last week may need revision, but I'll wait until we get further confirmation with the April numbers, as it is dangerous to rely too much on one data point.

I am not 100% sure about this (I will need to research further) but it appears that the British and Canadian housing markets are turning faster than the US market did in 2005/06. Moderate home price gains are optimistic and would require a immediate stabilization at March levels. The employment picture has slowed down big-time in recent weeks, the credit crunch effects are only beginning to be felt and the inventory has only started to build.

I will venture a guesstimate that the national home price "increase" will be close to zero sometime this summer. And maybe then the CREA will blame the heat...

Monday, April 14, 2008

Housing Bubble Bursting Worldwide

Nice article today in the NY Times (subscription required). It cites housing crashes going on (in various stages) in the US, Britain, Spain, Northern India, Ireland, Hong Kong and southern China.

Ireland's case is striking because its economy has been one of the hottest on the planet. In Dublin, prices are falling as prices simply got too high regardless of how hot the economy was. This is a lesson that those in Western Canada should heed in light of their strong commodity based economy. Vancouver with its $800K housing: look out below!
The boom was worldwide and synchronized.

Why would the bust be confined to the US, which wasn't even the hottest market? And more importantly, why would Canada be exempt from the bust while fully participating in the boom? Bulls, feel free to answer these questions...

"Housing Woes in U.S. Spread Around Globe", Mark Landler, New York Times, April 14, 2008.

Sunday, April 13, 2008

The Chain of Events 2007-2012

This is my big picture view of how this housing crash might play out. I am in the housing bear category as I believe that the massive increase in prices since the mid 90s would likely burst on their own. Add to the mix a global credit crunch and a Canadian recession and things could get real ugly real fast.

1. Housing Affordability declines (2007) as prices and interest rates rise.
In the early part of this decade, rising prices were completely offset by generational lows in interest rates. Also, housing in Canada suffered through some lean years for much of the early 90s as the 1989 housing bubble popped and Canada suffered through a brutal recession (remember Kim Campbell saying that inflation would not drop below 10% in the 90s?). In the past few years, prices have continued to rise, while interest rates have gradually increased. Housing affordability is now at its highest since the 89/90 bubble years.

2. As affordability declines, house sales slow down, price growth slows, inventory builds. (Early 2008) As affordability declines, buyers either buy smaller, pay too much, rent or stay in their current homes. House sales slow, while inventory build due to continued new home construction and lower sales. Prices continue to rise but the momentum of the increases slow down. Financing has become increasingly dubious as 40 year amortizations are all the rage. This allows buyers to take on more debt and lower payments.

3a As inventory continues to build, certain markets begin to slow dramatically and prices actually fall. (Mid 2008?) Inventory building allows balance to return to the market and buyers have more selection. Some of the hottest market reverse as prices rise to unfathomable levels (Calgary & Edmonton?). Lenders begin to tighten their financing as they worry about some of their boom time lending practices (no down payments, low rates)

3b Making the situation worse, a global credit crunch causes most or all of the 6 main Canadian banks to cut the financing available. (Mid 2008?) 3 of the 6 main banks are already having problems (NatB, CIBC, BMO). I would be surprised if at least 1 or 2 more don't have similar problems in the upcoming months. Due to the credit crunch and an economy either near or in recession, bank mortgage lending dries up. Already mortgage rates have creeped up (despite the BoC cuts and drop in bond market yields). In addition, 3a causes banks will begin to ask for higher down payments.

3c The slowing economy leads to higher unemployment and salary freezes. (Mid 2008?) With a slowing economy, companies begin to lay off and institute hiring freezes. Bonuses are not paid. Salary increases are lowered. Consultants and other self-employed individuals lose business. These factors cause people to cut back their housing needs and in some cases sell their houses.

4 A vicious cycle ensues (Late 2008 into 2012?). 3a, 3b and 3c coincide at the same time to pop the bubble. Demand for housing is cut by high house prices, lower affordability, lower mortgage lending, tight access to credit, unemployment and declining incomes. Supply of housing increases as inventories build due to the drop in buyers. Also, new listings can increase (and thus supply) due to unemployment and foreclosures as well as sellers who want to sell before prices fall.

Prices begin to fall precipitously due to lower demand and higher supply. Once prices begin to fall, buyers tend to wait. Houses take a long time to sell as sellers are reluctant to drop prices (remembering bubble prices/not willing to take a loss). Inventories continue to build....

5 Eventually, prices bottom (2012?). Eventually, prices drop to such a low level and inventories fall as the low prices attract enough buyers. As time goes on, a new generation of house buyers enter the market. I have chosen 2012 but it could be a year or two sooner or later. These things take time. Nominal prices finally begin to creep up. However, it could take a decade or more for homes to regain their real (not nominal) prices of 2008.

Friday, April 11, 2008

Go Habs Go!

I am a Montrealer so it has to be said:

"Go Habs Go"

The city is hungry for #25. It has been 15 years since a championship (and many lean years) and we lost our Expos. The energy in the city is awesome. It has also been a long and unbelievably snowy (albeit mild) winter, so probably "cabin fever" is also part of the equation. Montreal comes alive in April and especially this year, with one of the best teams since the late 70s.

Tuesday, April 8, 2008

First the US, Now Britain...

"British house prices fall sharply in March, by MATT FALLOON, Reuters, April 8, 2008 "

House prices fell 2.5 per cent during last month, the Halifax said, more than six times as much as analysts had forecast and the largest monthly decline since September 1992.

The annual three-month rate of house price inflation stood at 1.1 per cent. Six months ago, that rate was in double figures.

House prices do not usually fall 2.5% in a healthy market. The housing bulls in Canada (I've been reading some of these real estate agent blogs out there) keep saying that Canada is different than the US. We have no subprime. Our economy is growing. We are producing jobs. The housing market remains healthy.

Look, I don't dispute most of these facts, with the exception of the economy is growing possibly.

However, you could probably have said the same thing in Britain a few months ago.

A bit of history here based on my limited knowledge of British real estate:

The funny thing is that in 2004-05, Britain's housing market slowed sharply for a few months (to no growth after 20% appreciation in earlier years) after the BoE raised interest rates sharply. The British economy had a magical soft landing. And then housing and the economy reignited in recent years. I believe the same thing happened in Australia.

Some of the more worldly US real estate bulls in 2005/06 used the British example to say that the same will happen in the US. Housing would rest for a few months or quarters and then grow nicely and the economy would have a soft landing. Now we know that housing didn't just slow, it cratered in the US. Soft landing? Whatever (even the bulls don't believe that bull anymore).

And now in Britain, in 2008, their housing is now following the US example as it went from superheated to cratering in just a few months...

If you want to be a bull on housing, that's fine. That makes a market. But to use the "Canada doesn't have a subprime problem" to justify that the Canadian market will not fall is silly. Not every bubble is the same. Was there a subprime market in Canadian housing in 1989? Was there a subprime market in the Nasdaq in 2000? To look for the same catalyst to end a bubble is a starting point but not an ending point.

Besides, I don't believe that subprime was the true cause of the bubble in the US. There were a host of problems in the US of which subprime was but one factor. Some of the others were low interest rates, lax regulation, government encouragement as a way to lessen the impact of the imploding Nasdaq bubble in the early 2000s, price, inventory buildups, animal spirits, etc...

Clearly most of the G7 housing markets experienced a boom (bubble?) in the past ten years. There is some correlation between all of these markets, as this is a global economy with correlated financial markets and economies.

Every market has its unique characteristics but most G7 countries had bubbles, in my opinion.

When a bubble turns, it can turn fast. Bubbles don't correct. They implode. They fall farther and faster than 99% of us expect. The US in 2006-08 case in point. Britain in 2008 another. Canada's turn may be coming. Clearly, the turn in Canada is not here as of March 2008. However, this does not mean that the turn isn't coming. (I will outline some scenarios of the turn in future posts)

Remember, we don't have subprime in Canada. We have overprime...Overextended buyers and overly long amortizations.

Monday, April 7, 2008

Canada's Overprime Problem

Many of the housing bulls correctly point out that Canada does not have a huge exposure to US style subprime mortgages. This is true as Canada's Big 6 banks which dominate Canada's mortgage market, did not do much (or any) US style subprime lending.

However, what the bulls won't point out is that we have our own version of subprime: 0% down and the 40 year amortization. I'll call it "overprime" as it is due to mostly prime borrowers overleveraging themselves and due to overly long amortization periods.

Ellen Roseman wrote a good article in the Toronto Star recently about 40 year amortization:

"About 60 per cent of first-time buyers are opting for a 40-year mortgage," says Craig Alexander, deputy chief economist at TD Bank. His explanation: Houses are now less affordable because prices have grown faster than household incomes.

There's a "huge adoption" of 40-year mortgages in Toronto, Calgary and Vancouver, where people stretch for affordability, says Catherine Adams, vice-president of home equity financing at Royal Bank of Canada. "I think it's given the housing market a boost and allowed prices to go up further than they would have otherwise."
Ellen Roseman also pointed out another potentially disturbing piece of news:

Competition in mortgage insurance has accelerated new product development by lenders.

Canada Mortgage and Housing Corp., a federal government agency, used to have the market to itself.

Now it has three private-sector rivals from the United States (Genworth Financial, PMI Group Inc., AIG United Guaranty).

Another big U.S. firm (Mortgage Guaranty Insurance Corp.) has applied for a licence, Murphy says.

Is there too much innovation in lending? And is Canada headed down the same road as the United States?

A free market is supposed to be better for everyone in the long run, as innovation can lower prices and better match buyers and sellers, while generating healthy profits for lenders. The other side of that is that it can lead to a greater boom/bust cycle as lenders compete for business by lowering prices (interest rates) or overlending (lower downpayments, poor documentation). Buyers borrow more than they can afford and drive up prices to unaffordable levels
In the 1980s, home buyers had to put down at least 25%. Then in the 1990s, it was reduced to 5% (albeit with insurance). Then in recent years, no money down and the 40 year amortization (25 years was the previous maximum) were introduced.

All these "innovations" along with low interest rates have allowed buyers to buy a bigger house for the same monthly payments or to save on their payments. There is no free lunch, however, and all these buyers pursuing the same strategies have driven housing affordability to the lowest since the top of the last bubble in 1990 (according to RBC Housing Affordability March 2008) . Most 40 year amortization buyers are simply paying interest on their debt, not completely dissimilar from the US subprimers.

Most new buyers have little equity in their house. I was watching Warren Buffett on CNBC recently and he pointed out that a homeowner with 20% equity has seen most or all of their equity wiped due to the sharp fall in home prices. Scary to think what could happen if you had a huge drop in housing prices here, especially with most buyers putting much less than 20% down. Take Vancouver for example, where the average house price is north of $800K. If you manage to scrape up 10% down (80,000) and house prices fall by a mere 10%, you've just lost $80,000. Even worse, you are on the hook for a near million dollar mortgage.

The recent data has not shown any alarming trends (I will discuss this in my next post) but I believe that this is going to get real ugly in the coming years.

Longer payback loan fuels housing market (Toronto Star, Ellen Roseman, Apr 02, 2008)

Tuesday, April 1, 2008

Recession Fears Over: Canadian Economy Soars in January

Yup, it's official. Now that Canada's economy grew by 0.6% in January, any fears about recession in Canada are over right. After all, 0.6% is actually about 7% annualized. That is the strongest growth since April 2005. Heck, a new boom has started!!

Wait a minute. January did grow by 0.6%. However, December shrank by 0.7% (8% annualized). Clearly, monthly figures have too much noise in them, as both 7% growth or 8% contraction are not sustainable in the current environment.

Let's just conclude that in the December-January timeframe, it is likely that the Canadian economy was stalling out near 0% (if two months can be used as a good indicator, if the two months are averaged out and if these numbers are not significantly revised in the future).

Therefore, I will say it is premature to conclude whether or not the Canadian economy started a recession in December. I think it did but I will keep an open mind about it.

Note that on March 31 (Jan GDP release date) the Canadian dollar sunk despite the "strong" January GDP likely due to the continued sharp sell-off in commodities. The falling Canadian dollar may help the manufacturing sector a little but the move down to 97 cents is much too little and way too late. Falling commodity prices are likely to hurt the Western economy if this implosion continues, as I think it will. I think that the Canadian dollar will likely fall to 92-94 cents over the coming months, but once again "too little, too late" to save the economies of Ontario & Quebec.

Positions in HGD & HOD, Can & US cash