New Mortgage Rules in Canada

This morning Finance Minister Jim Flaherty announced new mortgage rules for Canadians.  The forces for change have been building for a while, and CMHC has started to take action in a covert fashion – see my blog dated January 28, 2010.  Under the new rules, all borrowers will need to meet standards for 5-year fixed-rate mortgages regardless of whether they’re seeking a loan with a lower rate and shorter term.  Also, the government is lowering the maximum amount Canadians can withdraw when refinancing to 90 per cent of the value of their homes, from the current 95 per cent, and requiring a 20 per cent down payment for mortgage insurance on investment properties.

What does all this mean and what are the implications for home owners?  The biggest impact is that now all variable rate mortgages and short-term fixed rate mortgages need to be qualified using the 5-year discounted fixed rate.  For example, today ING’s published 5-year variable rate is 1.95%, the 1-year fixed rate is 2.65% and the 3-year fixed rate is 3.49%.  In order for borrowers to get the above rates, they have to satisfy the debt ratio requirements using ING’s 5-year fixed rate of 3.89%.  Using this method a borrower will qualify for a lower amount of mortgage than before.  Prior to the new rules ING just used the fixed rate the borrower selected to qualify for the mortgage or their 3-year fixed rate to qualify for their variable rate product.

While changes to the refinance and income property mortgage rules also mean a tighter lending standard, it impacts only a minority of home owners.  Most people will be affected by the stricter qualification requirements as detailed above, but the impact will be minimal.  Most people take a 3-year or 5-year fixed rate or a variable rate mortgage, and even before the announcement almost all lenders qualified their variable rate mortgage lending using their 3-year discounted rate or higher.  Whether a borrower is qualified on a 3-year rate of 3.49% or 5-year rate of 3.89%, makes a difference only on the margin.  It will have a negligible impact on borrower qualification.

While the announcement regarding the new rules may have little impact on borrower capacity, it sends a message to Canadians: the Government of Canada is somewhat concerned and we are keeping a watchful eye on the housing market, ready to cool it as needed.  Sometimes a message like this is enough to change consumer sentiment and cool the market by itself…

Franklin Templeton’s Quotential Portfolio

Brant Smith, portfolio manager of Franklin Templeton’s Quotential program did a presentation to financial advisors last week.  The Quotentail Program is Templeton’s flagship product and they market it aggressively.  The reason is simple: Quotential is a fund of funds, so while star fund managers may come and go, Quotential is here to stay with Templeton.  Makes perfect sense since Templeton is a marketing company just like the other big investment companies like CI, Mackenzie or AGF.

Most Quotential programs underperformed their respective indices and peers in 2008.  At the presentation in Toronto the portfolio manager of the program, Brant Smith, got some tough questions regarding Quotential’s underperformance in that year.  He responded the best he could without bashing Templeton’s corporate management, saying that he has a broader range of tools available in his toolkit since 2009, which in his view explains the 2009 outperformance.

What does he mean?  It has been difficult for Quotential to quickly dump underlying fund assets in a quickly changing market like what we had in 2008.  Dumping fund assets in favour of cash would put pressure on the underlying fund to sell of in a potentially declining market thus hurting the fund manager’s performance and unit holder’s return.  After some extended internal fighting and show down Quotential now has the following tools to continue with an improved performance going forward:

• Ability to buy ETFs (can be dumped very quickly for cash as it is a liquid market and not a Templeton fund)
• Enlisted Acuity to manage part of the Canadian component of the Quotential portfolio (addition to Canadian expertise was badly needed in the Templeton lineup)
• Enlisted an offshore portfolio management company out of Luxembourg to manage geographic specific regions (allows Brant Smith to target specific regions for investments)
• Hedging for the Templeton Global Bond fund was instituted (expecting a long-term decline of the US$)

More available tools a portfolio managers has, the better performance he or she could produce for investors.  Brant seem like a common sense, humble guy who knows his trade.  There will be better years ahead for the Quotential program.

CMHC piercing the housing bubble

The word is that right now CMHC as a crown corporation actively cooperates with the Bank of Canada in slwoing down the housing market in Canada.  As I mentioned in my post on Jan 25, 2010 I had the personal experience where a bona fide purchase in the Toronto area that was listed for $689,000 was sold for $732,000 but CMHC turned around and valued it at $650,000 using their ‘expert’ Emily system.  This has not happened in recent memory on a purchase!

David Wolf delivered a speech on behalf of Tim Lane, Deputy Governor of the Bank of Canada in Edmonton on January 11, 2010 for the Edmonton CFA Society where he stated: “If the Bank were to raise interest rates to cool the housing market now – when inflation is expected to remain below target for the next year and a half – we would, in essence, be dousing the entire Canadian economy with cold water, just as it emerges from recession.”

What he is saying is that they will not raise interest rates in the near future – perhaps not until 2011.  Later he goes on saying that “An array of supervisory and regulatory instruments can be used by the government to restrain the buildup of systemic risks [this is their code word for bubble].  These include capital requirements for institutions, leverage ratios, loan-to-value ratios, terms and conditions for mortgage insurance and a variety of other measures.”

Assuming that we are in the middle of a bubble, the last thing the government wants to do is to blow the bubble up.  That’s because no one wants a crash and a rapid decline in house prices.  Of the tools available at their disposal and listed above, all but one requires a very visible and public announcement that could blow up the bubble.  The one that can be done behind the scenes and without public announcement is the tightening the ‘terms and conditions of mortgage insurance’.  Just like it happened to my client, CMHC may confirm a lower value without an appraisal.  As a result unless there is a significant downpayment, the purchase may fall apart.

Is this a serious problem?  Yes.  I spoke to a number of lender representatives and wherever they can, they try to avoid CMHC for this very same reason.

Is there a way around this to save the consumer?  Yes.  Instead of dealing with CMHC, lenders and mortgage brokers who have access to Genworth direct their business there for mortgage insurance.  Ironic.  A year ago, in the midst of the credit crisis,  no one wanted to deal with Genworth, a private company.  Now they may be our saviour when CMHC fails the consumer.

Housing bubble in the GTA

The recent price increase in housing prices is unsustainable in Toronto.  It is fueled by once-in-a-life-time, super low mortgage rates and the looming deadline of July 2010 for increased Ontario sales tax on the purchase and sale of real estate.  The first one makes homes more affordable and the latter creates an urgency to buy among buyers.  This pent-up demand is chasing the few homes available for sale and thus pushing prices up.

Fast forward 12 months to early 2011.  Interest rates will probably be higher making homes less affordable: demand for homes go down.  The new Ontario sales tax is implemented, making homes more expensive: demand for homes go down further.  The pent-up demand from early 2010 has been all used up so buyers are just sitting on the sidelines: demand for homes go down even further.  Yet on the supply side new condos are springing up everywhere in downtown.  What we will have is a disequilibrium that is resolved only by declining home prices.

Let me illustrate this real estate bubble with a recent example from the horse’s mouth.  CMHC is in the business of forecasting house prices.  They are also in the business of not deflating bubbles too quickly.  In other words they know what they are doing.  My client buys a home mid-December 2009 in the Bloor West Village area of Toronto.  The single family residential detached home is listed for $689,000 and sells in a multiple bidding situation for $732,000.  My client is the successful bidder and I am doing the mortgage for him with 20% downpayment.

With 20% downpayment he does not need CMHC insurance.  Yet some lenders chose to insure the mortgage at their own cost – it has to do with how they get their funding money.  Clients don’t care because it is not an extra cost for them and as long as the rate is good they are happy.  I get my client a 3.74% 5-year fixed rate from one of these lenders and they send it in to CMHC.  CMHC comes back after days of deliberation and drilling that the real value is $650,000 versus the $732,000 that the client paid.

I know that the lender is not lying – CMHC truly believes that it is the true value of the property.   I know the client is not lying – I’ve known him for many years, we went to graduate school together and played on the same soccer team.  So I turned around, went with another lender who does not go through CMHC as long as the client has at least 20% downpayment.  The new lender did an independent appraisal on the property which confirmed a value of the house at the purchase price of $732,000!

This kind of valuation discrepance has never happened with CMHC on a clean and fair purchase!  Market forces dictate that the price of the home is $732,000 yet CMHC believes it is worth 11% less!  What is this if not an official confirmation from CMHC that we are in the midst of a housing bubble in some parts of Toronto?

Is the market going to crash again?

It would be about time. It cannot just keep going up and up. A healthy correction here and there is good. It shakes people off who believe the stock market is a one-way joy ride and presents a buying opportunity for the rest of us. I have to explain this concept one day to my daughter, although I may have to wait a year or two since she is only two now.

The S&P is down about 5% from its high. I have been waiting for this for a few months now. In fact, ever since Christine Hughs, the celebrated and now ex-AGF fund manager (she left AGF a few days ago), made her prediction in April that we will have another low in May, I have been waiting. And waiting. And waiting. Then nothing happened of course. – it always does the opposite of the consensus view. The market just kept going up and up ever since. Made two lows – one is Nov 2008 and another in March 2009 – but no real lows since then.

So while everybody has been waiting for a market correction, the market just did the opposite. If we could have a healthy market correction now – another 10% to 15% off the S&P – then finally all the Bears would say: ‘Here is the third correction! I told you so! After this it is time to buy!’

Once the nay-sayers start buying, they will create the demand that the stock market needs to go up. By then almost all my personal holdings will be converted from corporate bonds to equities. There is still some juice left in corporate bonds, but global equities will offer a better return over the next two years.

If the market keeps going down next week, I will convert some of the 10% I still have in corporate bonds. As it keeps going down, I will just keep converting and buying equities at a lower and lower price.  This will be beautiful!

Mackenzie Financial shifting gears

I attended a lunch meeting organized by Mackenzie this week. The key presenter was Chris Kresic who is the head of Mackenzie’s Sentinel group. They have recently expanded their investment offering within this group to better compete with CI and capture the demographic shift in our country.

The Sentinel group focuses on income generating investments such as money markets, bonds, corporate bonds, dividend paying stocks etc. When big investment marketing companies like Mackenzie make a product expansion decision like this, I usually like to know their motivation.

One reason is of course the credit crunch. Everyday folks got a third degree burn in their stock portfolios, so now they are extra cautious. A less volatile portfolio like the ones offered by Sentinel is an obvious place for those investors.

The second reason is that there is an aging population in Canada that will shift their asset mix more towards income generating investments in the coming decades. Mackenzie is out there supplying the market with what they need.

Neither of the above is very interesting to me. What was interesting is what Chris said about why in his view it makes sense to get into income producing equities. To paraphrase him, there will be a lot of institutional pension money moving into this asset class as people age, creating excess demand. As any good economic student knows, when demand goes up while supply is somewhat fixed, the price (of assets) must go up.

Here you have it: the case for solid fixed income portfolios for this decade.

CI Harbour’s Gerry Coleman

I’ve just listened in a conference call with CI. The legendary Gerry Coleman was on the line who manages the CI Harbour ($6 billions in assets) and the CI Harbour Growth and Income ($8 billions in assets). Down to earth investment manager pushing 65. Common sense stock picker cool as ice.

His funds have to hold at least 50% of their assets in Canadian companies. He focuses on about 40 names and the Growth and Income fund has almost 70% of its asset in equities with holdings almost identical to those of the Harbour Fund.

We have a problem. Gerry is the victim of his own success. His funds got so big that it is hard for him to move around: he is the elephant in a market that appreciated a lot in 2009. I am gradually moving my clients’ money out of the two funds and on to greener pastures.  His protegé Steve Jenkins looks particularly good at the Harbour Foreign Equity at just over $500 million in assets.  He could be the next guy coming up once Gerry retires – like tomorrow…