Carleton University's Nick Rowe left a comment in a previous post that deserves a wider readership. With his permission, I'm recycling it as a guest post:
House prices in many Canadian cities have increased a lot in the last couple of years, and I see no reason why they can't decrease by the same amount in as short a time. If they did, many households would have negative equity, and many of those mortgages would default.
We need to look at the variance of house price declines, not just the average decline across the country. Let me explain why:
Assume that the percentage of mortgages which default is proportional to the drop in prices. Assume also that the percentage loss on a defaulting mortgage (when the bank sells the foreclosed house) is also proportional to the drop in prices. Then the percentage loss on all mortgages is proportional to the square of the drop in prices. So a 20% drop in prices would cause four times the losses of a 10% drop in prices. So a 20% drop in prices in half the country, with no drop in the other half, would cause double the losses of a 10% drop in prices across the whole country.
That's what worries me; even if average house prices across Canada are only slightly too high, the possibility of very big price declines in some parts of Canada could still cause big losses on mortgages.
As far as I can tell, all Canadian mortgages with original Loan To Value ratios greater than 80% must have mortgage insurance. As far as I can tell, there are three insurers of Canadian mortgages: CMHC, AIG (familiar name?) and Genworth (which is still in business, despite a very big fall in share price, and is trying to sell off its mortgage insurance business). I can't tell what shares of the total market those three have, but I suspect that CMHC has by far the biggest share.
According to its 2007 Annual Report (if I read it correctly) CMHC had $334 billion of mortgages insured, and about $7 billion capital. I couldn't find any information on the distribution of LTV ratios across those mortgages. On the one hand, since CMHC insurance is only required for LTVs greater than 80%, we might expect to see a lot of high LTV ratios represented. On the other hand, many of those insured mortgages might be old ones, that have been paid down over the years while house prices have risen, so will have low LTV ratios.
Here's a back of the envelope guesstimate of likely CMHC losses if house prices drop 20% in half of Canada:
Assume a uniform distribution of LTV ratios, so if prices drop 20%, 20% of houses will be in negative equity. Assume half of those mortgages default, so 10% default. The average defaulting mortgage would be 10% underwater, but the losses could be double that with transactions costs of foreclosure, so 20% losses on a defaulting mortgage. 10% defaults x 20% losses per default = 2%losses on the mortgages insured, and if the 20% price drop happens in only half of Canada, that's 1% of the $334 billion, which is $16 billion losses for the taxpayer (who owns CMHC). Or $9 billion if we keep the $7 billion CMHC capital off the books. Not too bad, and the banks come through fine, because the taxpayer pays all the losses. And it might be much worse, if my assumptions are wrong, or if house prices fall more.
As for the Canadian banks: I have heard a number of people say the banks are in good shape, but all of them either work for the banks, or are in government, so "they would say that, wouldn't they?" I have no reason to disbelieve them, and actually think they are probably right, but I would like to see some informed independent analysis.
My biggest fear for Canada though, is not house prices, falling commodity prices, falling export demand, etc., but sheer financial contagion. It's NOT just a US financial crisis (we read too much US news). There are very similar stories being told in the UK, Spain, Ireland, Australia, New Zealand, Eastern Europe, China too I believe, of falling house prices and financial institutions in trouble. The TSX seems to have a very high short term correlation with the S&P500 recently. Why, if we are safe here?
Quite apart from any fundamental channels for contagion, financial markets, and financial institutions, nearly always seem to have that multiple equilibrium (like Diamond/Dybvig bank runs) character. If the rest of the world sees a sunspot, and runs to the bank, I can't see Canadians failing to join the herd. We have already seen that run on asset backed commercial paper.
One reason for definite optimism is the superior fiscal position of the Federal Government. If we really need to, the government could borrow about one trillion, pushing the debt/GDP ratio up to 100%. We've been there before, and survived, and this time we would be borrowing to buy assets, so the net debt/GDP ratio would be less.