The Music Just Stopped – Housing Prices, Home Capital and Moody’s

I hope readers all remember the childhood game of musical chairs.  Kids walk in a circle around a set of chairs while music plays – when the music stops every kid tries to quickly sit in a chair – the catch, there are fewer chairs than there are kids, and for those kids that don’t find a chair they lose the chance to keep playing.  Fewer kids and fewer chairs and we start the music again.  The game ends with everyone standing but the one kid sitting in the last chair.

For those who have already forgotten, way back in 2008 we had something called a financial crisis.   Even though the most famous event in the crisis was the collapse of Lehman Brothers on September 15, 2008, the seeds for the crisis were sown much earlier.

With the US housing market peaking at the end of 2006 and coinciding with the introduction of new FASB ‘mark to market’ accounting rules for mortgages the US was irrevocably headed towards a crash that could no longer be avoided based upon the pent-up pressure from years of selling ‘subprime’ mortgages to people that could not afford any increase in interest rates.

In July 2007, Chuck Prince, then CEO of Citigroup said “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing”.  Anyone can be forgiven for not thinking about the implications for Mr. Prince’s comments in 2007.  Those were good times, the music was wonderful and no one had yet been unable to find a chair when they needed one.  But fast forward to 2008 and Lehman Brothers and suddenly there were not nearly enough chairs and almost everyone found themselves sitting on the floor crying because the fall really hurt.  I think there were three guys who found a chair – the most famous was Michael Burry.

Toronto the Brave

I grew up just west of Toronto in Mississauga, started my career in Toronto, and still visit Toronto every month for work.  Everyone I have ever met that lives outside Toronto understands what I mean when I say I need to go to Toronto because it is the Center of the Universe.  If you are American, you probably mistakenly think that the Center of the Universe is Times Square – but that is just a nickname like Detroit is Hockeytown – come on folks…just because you say it, it doesn’t make it true.

Since Toronto is the Center of the Universe, two things happen.  First, lots of people want to live there to be where the action is (I am clearly not one of those people although you might change my mind if you gave me a free membership to St. George’s Golf & Country Club).  Second, the rest of Canada, and maybe the world, watches to see what people in Toronto are doing.

It has been impossible to miss the story of the last five years of Toronto’s raging housing market.  As far as I can tell, either everyone in the world wants to move to Toronto, or in fact there are a few million people in the middle of a dangerous game of musical chairs.  We are about to find out.

Stop the Music

Most Canadians had never heard of mortgage lender Home Capital Group Inc. until a few weeks ago.  Suddenly HCG is front page news as the company scrambles to shore up its financial resources in the wake of the disintegration of investor confidence in its ability to stay solvent.  We don’t know for sure, but I am willing to bet dollars to donuts that a bunch of the HCG mortgages are high leverage loans in Toronto (I get that with inflation over the last 30 years the dollar to donuts wager doesn’t connote the short odds it once did – but I still like the expression).

So, who cares if a mortgage lender is in trouble?  Certainly, all the capital lenders rushing in with support will ensure that the company stays solvent so where is the problem?  The problem is that the injected capital is coming at interest rates well above the rates at which borrowers pay on mortgages and none of our Big Five Banks are at all interested in taking over this book of business because the loans are, to use an industry term, sketchy.  So HCG is headed for a hopefully orderly demise and if shareholders are lucky, the ultimate sale of existing mortgages will bring them more than the value of the stock today – but no one is getting the value it was worth two years ago.

So far so good – no serious casualties other than the long-term investors in HCG and it is hard to feel sorry for equity investors because they should know going in that more reward comes at the price of more risk – some investments are winners and some are losers.

Unfortunately, it doesn’t stop here.  As the HCG mortgages come due they will need to be refinanced.  And with the big banks uninterested in taking up the loans some other firm needs to come in a close the gap – who will that be?

Bad Moody’s

On Thursday, Moody’s downgraded the rating on Canada’s big banks.  Why?

“Today’s downgrade of the Canadian banks reflects our ongoing concerns that expanding levels of private-sector debt could weaken asset quality in the future. Continued growth in Canadian consumer debt and elevated housing prices leaves consumers, and Canadian banks, more vulnerable to downside risks facing the Canadian economy than in the past.” said David Beattie, a Moody’s Senior Vice President

If you can’t parse this welcome to the club – but I think it is code for ‘housing price increases in Toronto have been irrational and we are worried that with the collapse of Home Capital that the music just stopped’.

I hope things don’t spiral down the way they did in 2008 – but I sure think that this moment is the wake-up call that many prospective home buyers needed to curb the unbridled enthusiasm that housing prices in Toronto always go up.  Hold on tight.





About the Author

Stay up to date
with newest articles

Sign up for our newsletters and receive our webinar specifically designed for lawyers. This webinar will get to the heart of how engaging an independent actuary can support lawyers in conducting audits, and provide valuable information for senior partners. Join 700+ subscribers who stay up to date with insightful articles from Actuarial Solutions.