The Biggest Financial Risks For The Next Two Years

[00:00:00] Welcome to the Canadian Real Estate Investor, where host Daniel Foch and Nick Hill navigate the market and provide the tools and insights to build your real estate portfolio. What is consumer sentiment in why is it so important?

[00:00:18] It's about getting sentimental, I think, right? It's a measure of, it's a measure of how consumers feel. Optimistic or pessimistic about just general affairs, but the state of a con of the economy, especially.

[00:00:32] Exactly, put simply, Dan, consumer confidence gives economists those who measure and keep track of things like this. A window into how people are feeling about the economy. This is generally expressed in how people save and how people spend their money.

[00:00:51] Now, if for some reason consumer confidence declines, consumers become less certain about their financial prospects and begin to spend less money, this in turn affects businesses they begin to experience the decrease in sales and of course, the whole economy can contract and feel it.

[00:01:10] So, this is something that economists and regulators want to keep high consumer sentiment. Good consumer sentiment is a good thing.

[00:01:20] So, here in Canada there is a governing body that was formed back in 1987 who's job it is to contribute to public confidence in the Canadian Canadian Canadian financial system. Now, before the 1980s when this governing body was formed, it all started much further back.

[00:01:45] Let's go all the way back to the late 1800s here in Canada where the establishment of the office of the superintendent of insurance, otherwise known as the OSI was created to regulate insurance companies. That later morphed into the department of insurance, the DOI.

[00:02:06] I think they were calling that the door. So, of course, OC and DOI were created way back. And then, of course, in 1817, Montreal Bank is a granted a charter by the British government to open the first formal bank here in Canada

[00:02:23] and still is one of the leading members of the big six year. And that is BMO otherwise known as the Bank of Montreal. Did I told you a story of how I found this newspaper article from the founding of Dominion Bank in my house?

[00:02:36] In your wall when you were doing those runs? It's like pasted to old barren trust. Very cool. I guess so, the house is like 1850s build and there's a bar in attached to the back of it that I didn't realize.

[00:02:49] When you go in you kind of just look at it and it's like a loft because it was all finished with drywall but then I started peeling it back because I wanted to renovate it. I was in Skylights and stuff like that. And it's old.

[00:03:01] It's a Dominion Bank old. It mentions like this guy who was actually involved in a couple of these institutions who ended up being the sixth Prime Minister of Canada. That's old as hells, yeah.

[00:03:17] In less old times, 1925 the office of the Inspector General of Banks was created after a major bank failure shook things up that if you met remember that period of time was famous for poor public confidence.

[00:03:30] Also known as depression and it was the great depression which is a bad word to describe depression. Great is not depression is not great and that but that one was a depression.

[00:03:40] An economic depression for a long period of time and so there were some bank failures in the US that was like thousands of bank failures. Anyway, this fellow or this group was tasked with overseeing Canada's charter banks.

[00:03:52] Exactly enough as for we go to the 1930s all the way through the 1960s which commissions calls for updates to banking laws and stronger oversight due to you know the evolving financial practices that Canada began to partake in.

[00:04:11] In the 1967 year, the CDIC which still exists today, Canada deposits insurance corporation was formed to protect small deposits by the mid-18 mid-80s increased international competition and the failure of two Canadian banks highlighted the need for better risk management within the financial system.

[00:04:36] Now let's fast forward to 1987, July of 1987 brought Osphe merging the D-O-I and the Inspector General of Banks to supervise federally regulated financial institutions. In 1996 new bills passed clarifying Osphe's rule in minimizing losses and maintaining public confidence in the financial system.

[00:05:01] They are an independent agency of the government of Canada run currently by Peter Routledge, the superintendent who reports the Minister of Finance currently Christian Freel.

[00:05:10] So the office of the superintendent of financial institutions, other wise known as Osphe is an independent agency of the government of Canada and they regulate and supervise financial institutions and our big pension plans.

[00:05:24] They regulate and supervise approximately 400 federally regulated financial institutions or FRFIs which we like to call fry fries here. And 1200 federally regulated pension plans or FRPPs which is crazy. I didn't really realize how many financial institutions are working Canada.

[00:05:54] You know, they always hear in the U.S. it's like perfectly competitive banking industry there's thousands of banks hundreds of them appear to be having bank runs at any given moment in time.

[00:06:05] And actually that's kind of scary too. Like we're you know, I'd send you that news article in China a bunch of banks just vanished like just you know like it wasn't even time to do a bank run there just like yeah piece we're out of here.

[00:06:15] So their goal is to kind of make sure that stuff like that doesn't happen in Canada. They do this by developing rules interpreting legislation regulations rules would be like the stress test might be an example or the that 5x income portfolio rule for banks.

[00:06:35] So and then they they so that that one's like where basically banks can't if you combine all of the income of your borrowers because I think we described it wrong when we did it because it was before they had to they actually updated this statement maybe because of our episode on around.

[00:06:48] I'm I'm happy to road-litch hope you're listening but because we we misinterpreted it but basically it was like if you are at the income of all of your borrowers, you can't lend out more than 5x that income.

[00:06:59] It wasn't like because they gave you the word portfolio I believe but what they actually meant was the loan portfolio of the bank not your real estate portfolio couldn't exceed 5x income. Yeah, that's interesting because we are providing regulatory approvals for certain types of transactions contributing to new accounting auditing and actual where you'll standards.

[00:07:18] And they supervise these institutions by analyzing financial and economic trends to detect any issues assessing financial conditions non financial and material risks in evaluating the quality of governance risk management and compliance with which is interesting because it's kind of it's different than fin track like not.

[00:07:37] Because fin track is also doing that and kind of giving some banks and slaps on the wrist as of late for money laundering which apparently became an issue in Canada in the last year even though.

[00:07:48] People been talking about it for decade and so this organization is what we hear to talk about today we're actually here to talk about how this organization is doing have they accomplished their goals of contributing to public confidence here in the Canadian financial system.

[00:08:05] Canadians are now more in debt than ever before battling inflation high interest rates and a housing and affordability crisis not to mention Dan as you just said.

[00:08:17] Our big banks have made into the news recently for some bad behavior lots of fraud lots of money laundering and our pension funds are selling commercial real estate assets for pennies on the dollar.

[00:08:30] Welcome back to the Canadian real estate investor podcast and thank you for tuning in today. This show I mean I guess they're a little late in the show to be welcoming but this show is all about real estate here in Canada.

[00:08:43] We cover the latest news you need to know we break down relevant reports and studies investing principles and fundamentals how to structure deals and grow your portfolio.

[00:08:53] My name is Nikil I'm a more good region real estate investor and I'm Daniel Foschin in this episode we take a close look at the office of the financial superintendant financial institutions or Aussie also.

[00:09:08] More commonly called off see which is not the right way and their annual risk outlook for 2024 to 2025 which includes a current an overyear current risk environment providing context for the top risks.

[00:09:21] The Canadian financial system faces but before we do that let's quickly dive in and read this wonderful review that one of you took the time to leave us on audible of all places.

[00:09:34] This five stars to it great and well articulated Canadian dudes if you want to know anything about Canadian real estate these are the guys to check out extremely informed a very smart well articulated.

[00:09:46] And I believe they do very hard work to bring relevant knowledge to their listeners and they know their craft inside now would recommend to anyone looking to invest in Canadian real estate thanks fellas and that is from anonymous user.

[00:10:01] Well thank you so much anonymous user we appreciate it. And thanks so much for the reviews they let us know where on the right path and delivering the value that you need to be successful as a real estate investor so.

[00:10:14] I mean this is good feedback for us and honestly like we do put a lot of time energy into this podcast and it's a little way to make it worth our while because like hearing things like that really really does.

[00:10:25] Does kind of make you want to wake up in the morning and keep rip and pods.

[00:10:30] Let's get to the report it starts with they call the the heading the current risk environment elevated interest rates and market uncertainty and it says inflation has slow globally including in Canada but is not yet reached target.

[00:10:45] Titer credit conditions and sustained higher interest rates have reduced aggregate demand and a peer to anchor inflation expectations. It is expected that average interest rates and market volatility will result in continued higher borough and costs increased mortgage renewal refinancing risk decrease consumer spending and business investments.

[00:11:05] Yeah and you know unfortunately we were seeing this live in real time right reduced consumer spending we just talked about consumer sentiment we've seen business in solvents sees rise and market volatility at all time highs so we are we are living what this report is talking about.

[00:11:25] It goes on to say that deposit taking institutions are adjusting our approach to loan renewals pricing strategies and investment plans accordingly. Let's talk about insurance and pension plans high interest rates may actually help increase investment income and decrease the value of future liabilities however.

[00:11:45] I think the change in institution and consumer behavior could have unexpected effects on actuarial experiences policy design risk modeling and other institutional decisions so.

[00:11:57] I think that we are seeing this in things like loan loss provisions right I just pulled this article from Reuters here it says Canadian banks are bracing for a few months of uncertainty with low loss provisions expected to rise if interest rates for main elevated.

[00:12:13] As their deal making an investment banking businesses improves according to some executives from our major banks here now most lenders beat earning expectations.

[00:12:25] In Q2 of last year with the exception of BMO who we just described is the first bank to be opened here in Canada but six of the major banks set aside to combine 4.36 billion dollars in low loss provisions which is 26% higher than just one year ago.

[00:12:46] Yeah this one is interesting and I'll add a little color to that because I think let me just define low loss provisions first so just as a reminder a low loss provision is an income statement expense set aside is an allowance for uncollected loans loan payments.

[00:13:00] This provision is used to cover different kinds of loss loan losses such as non-performing loans consumer bank receipts and renegotiated loans that incur lower than previously estimated payments. So the fact that they're 26% higher shows you where the banks think sentiment is and where reality will follow.

[00:13:17] And if you listen to our pod fathers that Canadian investor podcast you might know that banks also have a history of adding these back as profit later because if they're unrealized as low losses so today they're setting it aside there are you know their stocks are already suffering right like most banks are trading down pretty significantly and we can we can look at that a little bit too.

[00:13:37] But obviously out of scope for us to chat on this podcast but in a year or two years or whenever we're in recovery and they see still in Quincy's trending down again they have all this money that they set aside left and they can just add that back in right and so because they don't no longer need it for low loss provisions.

[00:13:53] So it's a good way to kind of game like your income right as a is it.

[00:13:57] Yeah, you're almost you're almost gaming your own system there like hey we're putting these aside here for when you know what hits the fan and if the fan isn't hit as hard as they're predicting.

[00:14:10] But actually could be kind of a positive thing because you know you've got several hundred million dollars sitting there for you know almost your emergency fund that is never realized for that emergency and that can be.

[00:14:23] Look at as you're saying almost almost as as profit so not really sure how that works but just complex banking stuff that you know just they move things over here and back over here and and all ends up working out for the banks the banks always win.

[00:14:39] Unless they unless you're one of the 40 Chinese banks that vanished into the near so let's let's get back on track here down. Let's look at the next piece this one this is on debt Canada's new favorite thing unfortunately.

[00:14:55] The subtitle here is rising a household debt cost in a reads Canadian labor markets remain relatively strong with unemployment hovering near pre pandemic levels.

[00:15:08] Labor market strength has counterbalance some risks such as higher household debt levels but if labor markets weakened the effects on credit quality could be material in the landscape could change dramatically.

[00:15:23] Their signs that higher mortgage payments are taking up a larger part of households income leading to increases in the number of borrowers not being able to make payments on their loans and their debts.

[00:15:37] So let's look at this household debt issue so Canada is the highest level of household debt to disposable income of any g seven countries just as a scanner reported recently.

[00:15:48] The agency revealed that the debt income ratio reached more than 180% and this varies on a quarter by quarter basis like we're kind of up there with.

[00:15:56] The Switzerland I think Australia and Netherlands maybe but so they can kind of consumed a bounce around so we're not always the highest but we're always top five. Both the United States and Germany have rates of 100% so we we're beating them massively right.

[00:16:14] And keep in mind 52% of Americans recently pulled said the United States is too expensive to live in and that's so and we're 80% more debt to income and them.

[00:16:25] Yeah, I'm scary numbers there now damn what you just said that 180% what that means four Canadians is that for every dollar a Canadian household has indesposable income.

[00:16:38] They owe about a dollar 85 so every dollar you have you owe a dollar eighty or dollar 85 now for contrast let's go back to the 80s back when.

[00:16:49] The philosophy was getting established the rate back then was just 66% so in the past you know 40 years we have more than doubled that comfortably almost tripled it.

[00:17:03] And see attributes Canada's high levels of debt to none other than home ownership describing housing as a double edged sword a significant contributor to the overall wealth of the middle class here in Canada.

[00:17:18] Well also resulting in an imbalances between the assets and the debt so for the average household real estate represents about 55% of their wealth and mortgage represents most of their debt hence the double edged sword. Now trends even more pronounced for the middle class or working age families.

[00:17:42] So let's talk back to this off-feet report here.

[00:17:44] Policiled credit stress and changing deposit or behavior so corporate credit and commercial real estate particularly construction and development and all sectors continue to face stress and a high degree of uncertainty while market base and core funding liquidity sources are available.

[00:18:00] And so the higher down turns and stress events have demonstrated these conditions can change quickly and they are for sure like and I can I can toss some some anecdotes in here as well.

[00:18:10] Lastly they observed a market change in investor and deposit or behavior and expectations as deposit competition increases a factor that could draw deposits away from traditional savings account.

[00:18:22] So one of the things that I think and this is something that like myself and a couple of other people who are in this world have been trying to sound the alarms on a little bit with Aussie and kind of just want them to acknowledge what's taking place because.

[00:18:38] This is a tough one to talk about in the context of the real estate industry so a lot of condos pre construction condos are negative equity.

[00:18:46] So in order for people to take possession of those a bank has to lend them you know let's say a mortgage and if the appraisal.

[00:18:54] If the value is below mark if they're closing in a value it's below market value and they're borrowing 80% loaned value on that there's a chance that that the bank might be lending 100% loaned value or over 80% which is.

[00:19:07] Aussie sort of depends on or sorry, Aussie sort of enforces the bank act and that's actually technically a violation of the bank act and so this is a bit of a challenge.

[00:19:17] So that's piece number one and actually I'll read an anecdote here from from Mark Morris who's a friend of the show. One of the biggest real estate lawyers in the city of Toronto and it says here we're reaching a critical tipping point in the real estate cycle.

[00:19:31] New developer closing failures are way up reseal products not moving huge number of resets on 2% mortgage rates for product purchase during the peak new product not selling weird in a word screwed and he he would be the person who reviews like a lot of these pre construction contracts and so he would know if they're going sideways earlier than anyone else I would say.

[00:19:50] I knew you know I've been talking about this for a long time probably too much but nobody seems to be listening so that's why I keep talking about it.

[00:19:56] But and I've done been doing a lot of research on it and I got my my estimates there are billions of dollars of losses in the pre construction market and Canada right now and those were unrealized losses at this point correct in.

[00:20:10] Well every time a project needs to close the loss becomes realized right like the buyer who now takes possession of that I would say they're they're not I guess that are unrealized but they're the builder is realizing them like the builder is sitting on the risk so.

[00:20:23] When the builder is sitting on a big construction loan so I go ahead. I guess they just haven't crept their way fully into you know the economy as we know right they haven't hit like the kind of end users for the most part yet the builders are struggling.

[00:20:37] Yes, if you look at like a Jeremiah actually posted this on on Twitter I think it was a great chart and trying to find it yeah so. It says historical economy in completions and then so 2024 has like in Toronto what is that that's like.

[00:20:54] 40 50,000 completions scheduled for this year and then the next in 2025 there's 26,000 and 2026 there's 25,000 so you know for the next three years we have record condo completions right or higher than than we did last year and you know 24 25 26 the way that condo's work.

[00:21:14] is these units were sold in 2020 2019 2020 2021 on the market was ripping and so they were sold at prices that were higher than what they are today typically builders were building in a bit of a profit so.

[00:21:27] Let's say that builder was selling that unit for 1250 or $1,300 a foot and today you know there's a building right across the street from where that building is about to be built or is currently under construction and all of those units are going to close and all of those buyers are going to take possession of those units if they paid 13,000.

[00:21:43] They paid 13,000 a foot for there's a building across the street that's only five years old they're less than five years old that is worth nine hundred and fifty dollars this way foot in the resale market.

[00:21:53] I think that problem is pretty clear right like if it's tough to argue with those numbers yeah yeah and so you know the difficulty with that is somebody has to be left holding the bag and I think that builders and banks don't want.

[00:22:11] The construction loan to be the one who is holding the bag do you know what I mean like it's just it's rich it's a lot of risk because it's only one borrower and then so the probably like the most I mean all of those contracts are contracts so you do have to honor them.

[00:22:28] And so all of those buyers are on the hook to take possession of those so like I would say I like honor it it sucks for all those buyers.

[00:22:34] But the challenge is who's like who's going to lend money on that on that on that unit right yeah exactly that and that is an evolving story that the danis is heavily involved and so don't you where we'll be keeping it posted as that continues to unfold but let's get back to the report here.

[00:22:51] Yeah so actually just quickly like this no this is a really good example of like the risk that awesome like a type of risk at osp is supposed to be managing.

[00:23:00] Yeah exactly and clearly unfortunately not doing such a great job which we'll get to at the end here. Now I just want to quickly recap right construction and development and office sectors continue to face stress and high degrees of uncertainty.

[00:23:16] And then of course behavior deposit or behavior and expectations are completely off so we've chatted on this stuff.

[00:23:23] And so we've talked about that on a ton of times right the challenges and the commercial office space that has been facing since the pandemic and some of Canada and honestly North America's largest CBD central business districts.

[00:23:35] You know the work from home movement has really had major detrimental effects on some of these markets and the assets existing in those markets.

[00:23:43] And I just saw a study that Americans on average this is going to hurt lose 400 and eight days of their lives at city traffic which which is a pretty probably a pretty big argument we made for the work from home movement.

[00:23:57] And kind of the general change in what's expected in the workforce then you look at the challenges the developers are facing right where to even start with this and we've talked about this numerous times red tape development charges skill labor shortages land shortages.

[00:24:14] You know the list goes on and on. It's also important to note the piece about investor and deposit or behavior and expectations we've seen a big disconnect and expectations from buyers and sellers and investors.

[00:24:24] And then the next piece of the report gets a little bit geopolitical so they talk about the integrity and security and mid geopolitical uncertainty especially tensions conflicts state state on state conflict political crisis democratic events and global power rebalancing efforts continue to create global security and economic uncertainty.

[00:24:44] And I think like a lot of part that's not really mentioned explicitly here is you know we're hearing a lot about like election. Meddling for interference and they mentioned you know cyber attacks here for interference money laundering.

[00:25:00] That intensify integrity and security risks at institutions and and eventually can manifest as financial risks and I think you know this is really like the global reputation. I mean to me like when you talk about consumer sentiment etc.

[00:25:14] It's really just a branding thing right it's like 100 percent yeah well said is the brand of can is of Canada's banks are under threat with all of these things happening now or is the brand of Canada under threat with all of these things happening.

[00:25:29] Now it says that Canada and its allies have expressed concerns and are taking measures to measures related to increasing its foreign interference and osp is.

[00:25:42] Operationalizing coverage of its new man to account for those risk associated with again as you said, damn things like integrity security and and the you know stopping foreign interference so. I guess that will be us you know working or trying to save the brand.

[00:26:00] So regulatory and political uncertainty and markets that are consequential to Canadian institutions could also increase over the rest of the year.

[00:26:08] More than 54 percent of the global population representing close to 60 percent of the world GDP will likely participate in national elections including in the United States, Mexico and the European Union and India while globally there's a rise in authoritarian populism and the continuance of.

[00:26:27] And that's a dictatorial interesting word regimes. That's places with dictators by the way.

[00:26:34] Now if you listen to the show, you know that we don't get political. We avoid it. However into the he's world everything is so connected right I mean a war breaks out in Russia or pivotal election happens in the USA.

[00:26:49] Those things will have an effect on Canada and the global economy for that matter.

[00:26:55] Well, especially in a place like Canada where we have such a multicultural influence because our population growth depends on people moving here from all places all over the world and you know what you mentioned in the global economy like I mentioned earlier in the episode.

[00:27:08] We just saw on Twitter that there was 40 Chinese banks that have completely vanished in a week and of course this could have a horrible impact on China itself but again we're exposed to these markets.

[00:27:21] And a lot of Chinese capital investing in Canadian real estate Peter Routledge was actually the guy who made that clear to Canada. And so you see a negative wealth effect maybe if people start selling houses in China to cover losses and China something could happen there.

[00:27:38] Yeah, I mean the stuff that is coming out of China right now you know, you know, you and I have been falling it for for the years now basically since since the early ever ground kind of whistleblower was was like hey there's an issue here.

[00:27:50] And so years later to see you know 40 banks have completely vanished and do even have 40 banks here in Canada it is crazy to think that you know those 40 banks.

[00:28:02] Each one would have had you know tens of millions if not hundreds of millions if potentially billions of dollars in holdings gone how the hell does that happen.

[00:28:13] It kind of good segue into the next piece here, which is probably one that you have been waiting for if you're listening to the show because it does a deep dive into real estate and the risks of secured lending and mortgages.

[00:28:28] So starts off by saying mortgages outstanding as a February 2024. The year of the year that everyone's scared is the end of 25 and early 26 when all of these mortgages that were got when rates were super cheap they all come out for a new.

[00:28:54] Now this payment shock will be the most significant for homeowners to take up mortgages when interest rates were low back in 2020 to 2022 and households that are more heavily leverage and have mortgages with variable rates but fixed payments will feel that shocks more acually.

[00:29:14] We expect payments rate we as in Aussie.

[00:29:17] Expect payments to increase to lead to higher incidence of residential mortgage loans falling into a rears or defaults and you know if you listen to the show that's something that we've been tracking for years now is mortgage or rears and defaults.

[00:29:32] We've even hosted webinars on them on things like power of sales and distress deals on our on our free course realist.ca so go check that out if you're interested I believe the next one in September is going to be on vendor takebacks.

[00:29:47] Anyways mortgages have always sorry mortgages have already experienced payment increases due to renewals or product type such as an adjustable rate mortgage those already showing higher rates of non performance but should residential real estate markets weaken.

[00:30:04] This could lead to higher defaults lower recovery rates and therefore higher credit losses for institutions and thank rectum if I'm wrong but I feel like we're in the early days of seeing all of those things that Aussie just mentioned.

[00:30:19] It's interesting to because you know like now that the risk is being realized in the market there's a very interesting like kind of political position for Aussie to be in and this is where it's really surprised me what we're seeing take place in Canada.

[00:30:34] I added to the notes here like a little piece about the B20 stress test which I want I'm going to ask you to read in a second but basically we see all this political pressure on tiff maclom right like so you've got like politicians I think all three potential prime ministerial candidates.

[00:30:53] I think jugg me saying Justin Trudeau and I think a Pierre Pauli have was the first one to kind of put to criticize tiff maclom right in the bank of Canada for the job that they're doing in managing the economy.

[00:31:09] But you know they have this this independent or so they have this this inter governmental organization Aussie that it surprises me that we're not seeing and maybe they just don't need to put the pressure on him publicly because they just walked down the hall or whatever you know and kind of knock on his door and say hey like.

[00:31:25] But it surprises me that we're not seeing political pressure from all these folks all the premieres and everybody who are writing these letters public letters about tiff maclom which.

[00:31:37] I do not like by the way at all because it's disrespectful to the institution the political autonomy of the bank of Canada and tiff maclom actually. Warren premieres against undercutting confidence in the bank of Canada's independence.

[00:31:49] Globin mail did not club that towards the end of 2023 and I was really sounding alarm when these letters were coming out saying this was not good on us that our politicians have no respect for the political autonomy of the bank of Canada, but there is a place where they could actually go to somebody who could who could literally have as much of an impact on.

[00:32:08] The potential for people to buy homes like the accessibility of homes is not real affordability, but if you really wanted to make it easier for people to qualify for more ages to buy houses.

[00:32:17] You could remove the B20 stress test right which would instantly add bit like where rates are currently 200 basis points to the. The buying power sorry removed 200 basis points from the qualifying rate so adding the equivalent amount of buying power to mortgage borrowers in Canada.

[00:32:34] So quickly run me through the B20 stress test and then we'll get back to the support I apologize for sidetracking but it's an important important.

[00:32:41] For sure now B20 you might think it sounds like a vitamin but unfortunately it is quite the opposite the P20 stress test here in Canada which we've done.

[00:32:49] A full episode on so go back and find that when if you're unfamiliar with it, here's a quick refresher though it's set by the superintendent of financial institution. Of course that is our friends at ospie.

[00:33:00] Now what it does is ensures borrowers can afford mortgages if interest rates rise. That's pretty freaking important and it sounds like a job rate up the ospie's alley.

[00:33:12] Now borrowers must qualify at a higher rate than their mortgage so either the contract rate, so let's say you have a 5% rate, it'd be plus 2 which would be 7 or the bank of Canada's benchmark rate. Now this test aims to stabilize the housing market and prevent excessive debt.

[00:33:33] So again you either qualify at the benchmark rate of 5% or the contract rate plus 2, so whatever you're doing there's a buffer of a few basis points there to make sure that when rates do inevitably change, you're not caught not being able to pay your mortgage.

[00:33:50] Well now we're at contract rates of 5 to 6% and so people are qualifying at 7 to 8% which makes it basically impossible to buy a house.

[00:33:58] So yeah, this worked and when we're talking about now like in this report going back to the report here, we're talking about managing the risk of variable rate mortgages and fixed rate mortgages.

[00:34:09] That's what B20 was designed to do and you mentioned ensuring borrowers can afford mortgages if interest rates rise.

[00:34:14] Well, interest rates rose. We're in a cutting cycle now so that risk isn't really as apparent as it was before and so that's kind of where the conversation shifts from my perspective to hey is there is there some relief that can be found from the stress test year.

[00:34:28] Variable rate mortgages with fixed payments or VRMFP are a very specific concern according to osfies report.

[00:34:36] Some of these mortgages are negatively amortizing meaning the scheduled mortgage payments no longer cover the full interest costs or the principle so you hear about negatively amortizing mortgages actually at woa.ca puts it like a really good report on the total percentage of negatively amortizing mortgages on a regular basis and every single month I posted on social media pretty often.

[00:34:57] In these situations lenders offset the shortfall by increasing the remaining outstanding principle. While most institutions the shortfall is extended amortization periods that contractual mortgage term does not change unless and until the mortgages refine it.

[00:35:12] So this is technically like a slight violation of that bank act and basal three requirements where mortgages are supposed to be paid down by law like does not just that it's a good idea like all of us can logically say hey we appreciate it.

[00:35:25] Yeah, like these are rules and so this is one of those ones where it's like I mean though those were supposed to get fixed and they just didn't so anyway.

[00:35:33] Or was with uninsured VRMFPs will need to address higher outstanding principle balances in there are therefore at risk of suffering significant payment shock whenever that takes place which again it still hasn't really seemed like.

[00:35:47] Anyone is making an a real effort to fix that so borrowers have an option to make a large lump sum payment or injure larger monthly payment increases in the mortgage to return to their original contract term alternatively if circumstances weren't borrowers can refine it so existing mortgage however this.

[00:36:06] Will not or may not eliminate monthly payment increases now variable rate mortgages with fixed payments that's that lovely new acronym VRMFP make up about 15% of outstanding residential mortgages in Canada.

[00:36:24] That's a pretty good chunk now if mortgage rates from main elevated the financial commitment required by borrowers of those mortgages to return to their contractual amortization then you just mentioned right these are contracts they they need to be a buy to buy.

[00:36:39] And that's the example a lump sum payment or mortgage payment increases they may be put on financial strain because guess what you likely weren't expecting for your mortgage payment or a massive lump sum to be required.

[00:36:54] Now with the current interest rate environment loan to income and loan to value ratios on new mortgage rich nations are at near record lows.

[00:37:04] Changes to the economic environment such as weakening labor markets declining rates could reduce the payments shocks that we just spoke about however the effects of potentially higher unemployment rates could increase the debt strain on households and contribute to higher losses for our large financial institutions.

[00:37:26] So in the report they present this issue like mortgage risks we just covered and below that off fee present their response to the issue which is I guess I'll just read that and and off Caesar's response says they continually monitor the risk profiles of institutions residential mortgage lending activities.

[00:37:45] And regularly conduct examinations to ensure they follow a sound underwriting standards and use prudent lending portfolio and accounting management practices still trying to figure out whether or not they're going to have anything to say about these condo closings at above 80% loan to value.

[00:38:03] But I imagine they'll probably eventually have to issue a statement on it and if I was that might just be like look it's necessary for the integrity of the Canadian economy like if we stop doing this.

[00:38:13] Your construction trades are getting laid off a bunch of people go bankrupt builders go bankrupt blah blah blah that would be I would be satisfied with that response but anyway they're developing in institutions specific loan income limits which we did mention in that the earlier on that that x percent of total income.

[00:38:32] At the portfolio level for uninsured mortgages to prevent build up of highly levered borrowers so that that's that 5x total income of the banks entire loan portfolio. These actions will consider the size nature complexity and risk profile of each federally regulated financial institution.

[00:38:48] And they do not expect these limits to bind under the current interest rate environment these loan to income limits are supervisory actions. And the key cannot disclose more details due to bank act regulations sounds a little ominous but.

[00:39:03] They engage with the industry to ensure institutions assess risk from variable rate mortgages with fixed fixed payments it is like I think the risk of that one's already been fully realized so I'm kind of like you know let's just maybe move on from that and focus on the next set of problems which is again that one that I'm describing with the pre-contractions based probably more important.

[00:39:22] For my lens but this wouldn't like recommend just to just ignore that just let banks let's a little at banks take high leverage loans to get these get all these pre-con buyers.

[00:39:33] I mean the crazy part is all these pre-con buyers are negative equity and negative cash flow so like you know by like it's like. That's it. I mean it's a positive at this.

[00:39:44] Oh yeah exactly but you know it's like we let's get the risk transferred from the builders construction loan to all of these buyers like I get that because you're taking one party the builder and now spreading that risk out over 500 or 1000 condo investors.

[00:40:01] But the problem is they they they aren't in good investments and so that you're eventually the risk is going to be realized either that or like you know maybe you just have the income of all of these individuals to start supporting that negative cash flow and negative equity position.

[00:40:18] But that's that's a that's just a draw in the Canadian economy anyway that we mentioned or so we go on where they mentioned they they're maintaining the minimum qualifying rate right that was that stress test that you mentioned any other things in here that we really need to to mention or should we just wrap up I feel like.

[00:40:35] Yeah I mean they they they talk about the kind of just other key areas of of robust risk and stuff that they're monitoring you know they do go on to cover.

[00:40:45] Proposed responses to issues that they're seeing in banking and insurance and of course the pension sector all of which they are responsible for for monitoring and and keeping that confidence level high you know they talk about a liquidity risk and liquidity shock which.

[00:41:02] Which is as kind of a scary thing as well just as a quick reminder liquidity shock for the economy as a whole liquidity crisis means the two main sources of liquidity and the economy which are bank loans and commercial paper markets becomes suddenly scarce and this you know equals people doing bank runs and that kind of stuff so.

[00:41:21] It's a good report it's detail I feel that they've done a good job outlining the issues and maybe an okay job at their responses to these issues.

[00:41:33] I do think they have there they certainly have their work cut out for them that's that's kind of my main main takeaway from from this report.

[00:41:41] I think so as well and I think that there are some some problems that they need to start thinking about sooner rather than later like I do really think that this pre construction pipeline is a massive risk for the Canadian market right now and they've really ought to be doing something about it thinking about it like I've said and I've you know I mean people who listen to the show.

[00:42:02] No that we've had that as a minister and shadow as a minister on this I've literally told them I'm like look guys like this is what it looks like.

[00:42:08] I showed them all of the research that I've been doing for groups of individuals who are short on Canadian banks and understanding you know they have a. I've had a very perspective on the Canadian economy and I said from my perspective like.

[00:42:23] You need to fix this problem otherwise builders are going to go bankrupt borrowers are going to go bankrupt at scale.

[00:42:29] Lenders are going to be forced to take high loan value mortgages and it's not like this is like you know if it was like a couple hundred units I'd be like okay cool yeah like like just let that happen it's economic Darwinism whatever.

[00:42:41] It's not it's tens of thousands hundreds it's it's a hundred twenty five thousand units over the next five years so and that's billions of dollars with condos that are all negative majority negative equity and all negative cash flow at current interest rates and.

[00:42:55] That doesn't account for all of the builder inventory that doesn't that that builders will be sitting on that they're going to be paying inventory loans on that is going to be costing them 10% and they can't sell that at a discount right because.

[00:43:07] They sell it at a discount if they sell it current market value then they'll devalue the whole building and screw everyone in the building.

[00:43:12] Who already closed which is a reputation risk for them as a developer but it's also a debt risk for all of those borrowers who now just lost even more equity than they already have so I maybe we should just do a whole episode on this I'll get better.

[00:43:25] And I'm going to talk about it because Ben and I have both been researching this like at length it's just like I've honestly been reluctant I've been researching this for over a year now I've been reluctant to really talk about it because.

[00:43:35] It's probably the scariest thing that I think our country is faced in like our economic lifetime so but I think it's probably worth bringing to light now I think because.

[00:43:45] It's happening every day with these buildings closing so yeah, and I think it's important subject to to to get out there right there's no sense in keeping this stuff in in the dark and elongar and I mean look.

[00:43:59] With all that being said Dan yes, that's 100% doing episode and as the governing body of Canada who's job it is to contribute to public confidence in the Canadian financial system.

[00:44:09] I think the office of the superintendent of financial institutions has its work cut out for it like it never has before.

[00:44:19] Stay tuned as we continue to do episodes on covering this issue and many others and the reaction that we see both Canadians and our governing bodies in the space react to it and hopefully overcome these challenges over the next couple years.

[00:44:37] Thank you so much for listening as always hope you got a ton of value and some cool insights out of today's episode.

[00:44:44] Use this to form your own investment thesis or just your own investment thesis as you build out an understanding as we see the risks in the Canadian economy become more apparent adapt and overcome as always. Thanks so much and we'll see you soon.

[00:45:03] The Canadian real estate investor podcast is for entertainment purposes only and it is not financial advice Nick Hill is a mortgage agent with premier mortgage center and a partner in the G and each mortgage group.

[00:45:17] Licent number one zero three one seven agent license M two one zero zero four zero three seven. Dino photos are real estate broker licensed with rare real estate a member of the Canadian real estate association the Toronto real estate board and the Ontario real estate association.