Alexandre Pestov

The Elusive Canadian Housing Bubble
Summer 2010 Edition: Canary in a Coal Mine
JULY 2010

Alexandre Pestov

July 2010

BRIEFING

In This Edition
―We had an impressive housing recovery in the late spring and summer of 2009. As expected this rate of recovery will moderate in the latter half of 2010 in the face of rising mortgage rates and slowing demand—keeping Calgary’s housing market in balance,‖ Diane Scott, President of CREB® The ―moderation of the rate of recovery‖ describes a year over year 40 percent plunge in Calgary home sales, culminating in June 2010. Just like Vanguard TV3’s ascent into space moderated 2 seconds after its launch, or S&P 500 growth moderated in November of 2007 and then again in January 2008, Calgary home sales volumes felt a ―slight sting of moderation‖ in otherwise absolutely splendid June of 2010. The plunge in sales, which resulted in multi-year low in home sales volumes for the month of June, coincided with a much less dramatic decline in mean home prices, which were below their May 2010 levels. Quite expectedly, the sales collapse marked a noticeable rise in home inventories in Calgary. The summer 2010 of Calgary’s real-estate market could be looked at as either a fine statistical oddity, or a fully warranted effect of some macroeconomic events unrelated to the overall Canadian housing market health. After all, oil, which is the backbone of Alberta’s economic miracle story, is no longer testing triple-digit highs. Despite slightly softer prices per barrel, world demand for Alberta’s oil has increased and shows no sign of cessation. There has been no significant reduction in net economic activity or general employment in the Alberta economy within the past year. In this context, Calgary’s realestate sales slump is so severe in comparison to the overall economy that it should be likened to a sudden canary death in a coal mine. For those with work to do and tools in hand, it is business as usual. But a few dim metres away—it has become critically dangerous. Before continuing with the report, some housekeeping work: This report is an update of the original ―The Elusive Canadian Housing Bubble‖, which described the current housing bubble in Canada. The first instalment of this series touched on key points highlighting the existence of a housing bubble in Canada, while explaining why it didn’t burst alongside the US’s in 2007-2008. Some references made in this edition of the report assume the prior knowledge of the original report material and it is strongly suggested one reads it thoroughly before undertaking this paper. The original document can be found under the following URL: http://www.scribd.com/doc/28454918/Canadian-Housing-Bubble.

Briefing 1 The Numbers
1.1 Prices – Past the Tipping Point? 1.2 Sales Volumes – A Glimpse of Things to Come 1.3 Sales Break-Down – Noticed the New Trend? 1.4 The Supply Side – Cooling Off, But Still Too High 1.5 Inventories and Market Balance – Shifting Away from Sellers 1.6 Rental Statistics – No Shortage of Living Space

1 4
4 5 5 7 8 9

2 The Rates
2.1 Interest and Mortgage Rates – Leaving the Wonderland 2.3 Yield Curve – Re-Normalizing 2.3 Posted Mortgage Rates – Prudent Bankers

11
11 12 12

3 Housing (un)Affordability
3.1 The Present – Not So Bright and Shiny 3.2 The Future – Tighten Your Belts 3.4 Income – You Wish You Were Paid in Houses 3.5 Income and Financing Requirements – Refinancing Pains Ahead

15
15 16 17 18

4 Fundamentals
4.1 Price-to-Income – Severely Unaffordable 4.2 Price-to-Rent – Any Investors Left? 4.5 US and Canada – Trotting Down the Familiar Path

20
20 21 21

5 Canadian Debt
5.1 Mortgages in Arrears – Recent Hiring Helped 5.2 Credit Card Delinquency and Loss – A Short Break 5.3 Debt Levels – An Exponential Rise 5.4 Net Worth – We Own More Because We Owe More 5.5 CMHC – Closing the Barn Door After … 5.6 National Debt

23
23 23 24 26 26 27

6 Musings

28

6.1 Macroeconomic Risks – Where Is the Bright Spot? 28 6.2 Amusing Findings – It’s All Good 30 6.3 Chart of the Day – Remember NASDAQ in 2000? 30

7 Scorecard Data Sources Acknowledgements

32 33 35

This second edition of the report is the first of the semi-annual sequels for the original paper to provide timely updates on the state of the housing market in Canada. This document introduces a structure of the semi-annual releases, and your comments and suggestions regarding it are always welcome. Unlike Toronto and Vancouver, Calgary did not have the shortterm sales-boosting influences of the pending HST introduction. Nor were there any macroeconomic disturbances in the form of volatile energy prices. Thus, Calgary is indicative of the bumps and potholes awaiting the broader housing market in Canada.

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Summer 2010 Edition

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Alexandre Pestov While the true state of affairs in Toronto and Vancouver might be concealed by the HST rollout, Calgary gives us a clear indication of what the future likely holds for the rest of the Canadian real estate market. Between the early 2008 and mid-2010, a potent combination of lax and now-defunct CMHC rules, misunderstanding of the HST and positive feeling of the economic recovery (mid-2009 onwards) created an environment in which home sales flourished, excessive demand pushed the prices higher, and the market shifted in favour of sellers. Conversely, housing affordability worsened, and the hosing bubble, which existed before 2007, was inflated further. The temporary nosedive of home prices in 2008 was quickly reversed by the extraordinary measures implemented to combat any deflationary pressure within the market. As a result, prices shot up by as much as 17 percent year-over-year in some markets across Canada.

July 2010 trapping those inside. However, if there is no spark, the mine’s ventilation systems will eventually bring methane levels under control. During the clean-up operation, the mine will remain highly susceptible to accidental combustion and any careless movement in the mine can trigger an explosion. This is precisely the situation we see today in the Canadian housing market. This is akin to an excessive methane build-up in a mine – at this point, a single spark can set off a major explosion. However, as of midJuly 2010, a possible source of this flare is not yet visible. As such, the market can stay stagnant for an extended period of time, moving sideways or much likely sluggishly sliding to more acceptable valuation levels, unless a trigger for a collapse appears. In the next while, it will be important to closely monitor a number of factors, including changes in inventory levels, a rush to sell (i.e. rapid price depreciation on rising volumes), ability to service personal debt, unemployment and strong macroeconomic shocks. Referring to CIBC World Markets’ economist Benjamin Tal (May 2010): … prices could decline by as much as 10 per cent in the next two years, but that a ―violent‖ correction similar to the one seen in the United States remains unlikely because Canadians will keep paying their mortgages by cutting back on other discretionary expenses. I concur with this view. With no trigger in sight, the violent burst of the bubble is unlikely at this point in time. Presently, Canadians appear to have some buffer capacity for coping with impending interest rates increases. The unemployment rate has levelled, which is helpful for keeping up with mortgage payments. This, however, does not mean that all is safe and sound. According to Benjamin’s analysis, the recovery has overshot what is justified by the economy. His analysis suggests that nearly 17 percent of Canadian homes trade above their fair value. Calgary, Montreal, Toronto, and Vancouver comprise nearly 2/3 of the active housing market and seriously or severely overvalued. With few exceptions, Toronto is overpriced across the board. Home prices in Vancouver are uniformly exorbitant in all districts. Calgary and Montreal, while moderate in comparison to Toronto and Vancouver, has large pockets of properties trading above their fair value, as defined by the commonly used evaluation metrics such as price-to-income and price-to-rent ratios (covered later in this document). These cells of economic distortion are not limited to Canada’s most prominent urban areas. During my recent trip to Muskoka, I was stranded near the Deerhurst resort due to the roadblocks related to the G8 (turning later into G20) meetings. While waiting for the seemingly endless convoys of officials to pass, I wandered into a development-specific real estate sales office on the outskirts of beautiful Huntsville. Tacked in the middle of a

Is the bubble ready to burst?
It is always difficult to call the top or breaking point in any market. That’s been said, the bubble is ready to stop inflating further. Sticking with the coal-mine analogy, it seems all songbirds have suddenly and silently fallen from their perches and lie motionless on the bottoms of their cages. For some reason, the initial warning signs are being ignored or downplayed by a number of pundits. A broad group of analysts and commentators, ranging from industry participants to academics, have been willing to publicly entertain a number of explanations ranging from the somewhat plausible to the laughably arcane. However, the more pragmatic lot is rushing for the exit, trying not to send accidental sparks flying. The combination of factors that led to a violent housing bubble burst in the US is partially present in Canada now. However, it lacks a certain key ingredient to undergo an immediate and catastrophic explosion. On the flipside, this is not the reason to be complacent. Several material developments, including a looming double-dip recession in the US, the recent events in China (as covered later in this edition of the report) and the propensity of Canadians of all ages to have an ―investment property‖ (which may lead to a sudden rush to sell by financially strained investors), introduce a great risk that may tip the scale and lead to an outright price collapse.

Will it burst?
The answer is disappointingly inconclusive: It may or it may not. To qualify this response, let’s refer to the ―coal mine‖ theme of today’s report. Methane accumulated in high concentrations in coal mines possesses grave danger to miners. A single spark can send a powerful explosion through the mine shaft, killing or The Elusive Canadian Housing Bubble Summer 2010 Edition

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Alexandre Pestov freshly deforested land away from the town center, the subdivision for sale was far from any scenic lakes or rivers. In fact, the only scenic place was a cemetery on the opposite side of a busy country road. Small, no-frills two-bedroom bungalows were slotted for building on lots barely larger than the dwellings themselves. I recall looking outside the window, staring into the wall of trees 5 feet away from the back wall and two neighbouring homes that resided within the arm reach on both sides and thinking ―the price of raw materials to build this place is probably higher than the price I am willing to pay for it.‖ Then came the real shocker: It was $420,000. For a two-bedroom bungalow located in the middle of nowhere away from any scenery on a lot smaller than home backyards in North York. Severe overvaluation is not limited to the four largest cities. Together, Toronto, Vancouver, areas in Montreal and Calgary, and other places across the country suggest that estimates of Benjamin Tal remain in a very conservative range. Using common valuation techniques that are covered later in this document the percentage of homes in Canada trading much above their fair value can be safely put above 30 percent mark. I maintain my view that the housing market in Canada is risky, overvalued, and has been artificially propped up by an injection of Canadian-style subprime borrowers between 2008 and 2009, which should amplify an impeding price correction. The overheating of the late 2009 and early 2010 has only reinforced

July 2010 my sentiment. Fundamental valuations suggest that properties in Vancouver are 35-50 percent above their fair value. Many districts of Toronto are 25-30 percent overvalued. Calgary and Montreal, while not as overpriced as Toronto and Vancouver, decoupled by as much as 20 to 25 percent from their fundamentals. There is evidently a lot of downslide risk. TD Bank anticipates 2.7 percent decline at the national level in 2011, while Benjamin Tal of CIBC sees a 10 percent fall. To my estimation, these numbers are conservative, and real decline in real-estate prices should exceed the bank analysts’ expectations. In any case, the current market offers a unique opportunity to buy a home at the peak of what will be likely known as ―The Fist Canada’s 21st Century Housing Bubble‖. The current housing market has the potential to explode, with a single spark causing a violent collapse in prices. While there is no such trigger present at the moment, the economic realities suggest that home prices will slide 5-15 percent from their present levels in 2010-2011. All in all, rising interest rates, high levels of debt, negative macroeconomic developments in the US, Europe and China, and oversupply of homes in Canada suggest that turbulent times are ahead and outlook remains negative.

Thank you for reading.

Market Risk Rank 7.2 (High)

Outlook Negative

Please direct all inquiries regarding this report to alec.pestov@yahoo.com The Elusive Canadian Housing Bubble Summer 2010 Edition Page 3 of 35

Alexandre Pestov

July 2010

1 THE NUMBERS

1.1 Prices – Past the Tipping Point?
Exhibit 1.1: Teranet Housing Price Index
180

160

140 Index

120

100

80

60

Composite Source: Teranet – National Bank House Price Index;

Calgary

Montreal

Toronto

Vancouver

Canadian home prices in May 2010 (Exhibit 1.1) were up 13.6 percent from a year earlier, according to the Teranet - National Bank National Composite House Price Index™. The 12-month gain was strongly influenced by Vancouver, up 17.1 percent, and Toronto, up 16.0 percent. In the other four markets surveyed, the 12-month rise ranged from 5.6 percent in Halifax to 11.4 percent in Ottawa. In Calgary it was 7.8 percent and in Montreal 8.5 percent1. During the 10-year span between May 2000 and May 2010, housing prices increased 96 percent nationwide, 118 percent in Calgary, 116 percent in Montreal, 69 percent in Toronto and 126 percent in Vancouver. Doubling of housing prices over the 10-year period coincided with the all-time highs in nominal terms in the three major cities except Calgary where prices remain 8.6 percent below their stratospheric highs set in August 2007. Year-over-year and from May to June 2010, nominal home prices edged higher in all key markets without any surprises (Exhibit 1.2). Exhibit 1.2: Nominal Prices Canada June 2009 June 2010 % Change
Source: CREA;

Calgary 392,601 415,431 5.82%

Montreal 276,291 307,403 11.26%

Toronto 403,918 435,064 7.71%

Vancouver 575,949 657,934 14.23%

326,689 342,662 4.89%

1

http://www.housepriceindex.ca

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Alexandre Pestov

July 2010

Despite the ongoing economic uncertainty, housing prices in Canada surged to surpass their pre-recession peak by as much as 9 percent. This trend does not appear to continue in the future, and May 2010 is likely to mark their local price peak. The preliminary readings of the average and mean prices for June and July suggest an impending decline in price indexes due to a widespread decline in sales and signs of weakening home prices. The new housing price index (Exhibit 1.2) rose uniformly nationwide and in all four largest cities, both year-over-year and from the previous month. Exhibit 1.3: New Housing Price Index May 09 Canada House only Land only Montréal Toronto Calgary Vancouver
Source: Statistics Canada;

Apr 10 157.5 167.5 137.4 169.3 148.1 235.7 120.3

May 10 158 168.2 137.7 169.8 149.2 236.3 120.6

April to May 2010 0.3% 0.4% 0.2% 0.3% 0.7% 0.3% 0.2%

May 2009 to May 2010 2.9% 4.6% -0.3% 2.8% 3.2% 3.1% 5.8%

153.5 160.8 138.1 165.2 144.6 229.1 114

1.2 Sales Volumes – A Glimpse of Things to Come
The significant decline in sales year-over-year was observed uniformly across Canada (Exhibit 1.4). The new mortgage regulations and exhaustion of an adrenaline boost from the HST scare in British Columbia and Ontario inflated sales volumes in the months preceding June 2010, and led to very disappointing, albeit predictable, results in June. According to Diane Scott of CREB: We are seeing continued moderation in Calgary’s home sales in the face of higher mortgage rates, increased inventory levels and a decreasing number of first-time homebuyers entering the market. Our sales trends in June reflect much of what we saw in May. Changes to mortgage rules meant a good portion of homebuyers wanted to get in before the new regulations took effect in April. This, along with rising interest rates on the horizon, pulled forward sales we might have expected in May and June. Diane’s statement might suggest that the slowdown is attributable solely to May and June as a result of new regulations, hinting a one-time event. Undesirably, this weakening in volumes is expected to accelerate in coming months, as market is turning from a seller’s boon into a seller’s bane. Exhibit 1.4: Sales Volumes Calgary June 2009 June 2010 % Change (YoY)
Source: CREB; GMREB; TREB; REBGV;

Montreal 4,163 3,371 -19%

Toronto 10,955 8,442 -23%

Vancouver 4,259 2,972 -30%

3,170 1,902 -40%

1.3 Sales Break-Down – Noticed the New Trend?
Calgary
The distribution of sales (Exhibit 1.5) signals a shift of buying preferences to cheaper dwellings. Surprisingly, sales of million-dollarplus properties increased by nearly 42 percent year-to-date, compared with the same period a year ago. The emerging trend of sales

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Alexandre Pestov

July 2010

clustering in the lower price categories as compared to the same period last year in combination with the rapidly dwindling sales volumes suggests that the Calgary market is set for a price correction. Exhibit 1.5: Calgary Sales Distribution
450 400 350 300 250 200 150 100 50 0

Units

Jun-09 Source: CREB;

Jun-10

Toronto
Exhibit 1.6: Toronto Sales Distribution
3500 3000 2500 Units 2000 1500 1000 500 0

Jun-2009 Source: TREB;

Jun-2010

While sales volumes dropped in Toronto similarly to those in Calgary, the price distribution of the purchased dwellings June 2010 remained roughly the same as in June of 2009 (Exhibit 1.6). Positive short-term effects of the HST introduction certainly acted as a key catalyst that helped maintaining the price balance in check. The overvaluation of housing prices uniformly across GTA signals that the sales distribution curve will shift towards the lower end homes in coming months. The Elusive Canadian Housing Bubble Summer 2010 Edition Page 6 of 35

Alexandre Pestov

July 2010

Montreal and Vancouver
Sales distributions are not available for Montreal and Vancouver due to the limited statistical data published by GMREB and REBGV.

1.4 The Supply Side – Cooling Off, But Still Too High
Exhibit 1.7: Dwelling Starts, Dwelling Completion and Dwellings under Construction
300,000 250,000 200,000 Dwellings 150,000 100,000 50,000 0

Dwelling Starts Source: CMHC;

Dwelling Completion

Dwellings Under Construction

Commencing 2007, the new dwelling starts, completions and units under construction experienced a sizable correction. Despite these changes, the number of units set to be constructed in 2010 now exceeds the long-term average, indicating a continuous oversupply of homes. The sharp reduction in number of new starts and completions was softened by the 2000-2007 swelling of dwellings under construction. The number of units remaining in the pipeline will fuel additional supply of homes released into the market and in spite of the declining dwelling starts the overbuilding is expected to continue for into foreseeable future. Exhibit 1.8: Residential Dwelling Starts

June 2009
Singles Nfld.Lab. P.E.I. N.S. N.B. Que. Ont. Man. Sask. Alta. B.C. Canada
Source: CMHC;

June 2010
Apartment and Other 74 105 171 400 8,579 8,954 259 121 890 2,146 21,699 Total 1,042 300 1,212 1,406 18,502 21,059 1,714 1,289 6,884 6,162 59,570 Nfld.Lab. P.E.I. N.S. N.B. Que. Ont. Man. Sask. Alta. B.C. Canada Singles 500 77 414 348 4,817 9,183 705 914 6,192 3,355 26,505 Semis 2 8 80 166 1,658 1,050 12 40 1,142 463 4,621 Row 14 10 71 80 798 3,573 60 63 836 1,054 6,559 Apartment and Other 74 56 479 194 8,105 6,899 265 150 1,281 3,570 21,073 Total 590 151 1,044 788 15,378 20,705 1,042 1,167 9,451 8,442 58,758

Semis 24 18 132 185 1,682 1,292 64 67 730 468 4,662

Row 18 27 106 61 692 2,874 91 92 523 882 5,366

926 150 803 760 7,549 7,939 1,300 1,009 4,741 2,666 27,843

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Alexandre Pestov Exhibit 1.9: Residential Dwelling Completions

July 2010

June 2009
Singles Nfld.Lab. P.E.I. N.S. N.B. Que. Ont. Man. Sask. Alta. B.C. Canada
Source: CMHC;

June 2010
Apartment and Other 130 34 482 455 8,559 10,869 380 538 4,701 8,876 35,024 Total 1,365 192 1,798 1,694 17,660 29,310 2,049 2,328 13,926 15,692 86,014 Nfld.Lab. P.E.I. N.S. N.B. Que. Ont. Man. Sask. Alta. B.C. Canada Singles 556 100 448 446 3,652 8,415 473 817 4,833 2,435 22,175 Semis 12 8 68 206 1,018 1,088 12 26 876 451 3,765 Row 15 23 84 61 642 2,418 20 27 666 1,040 4,996 Apartment and Other 96 52 68 98 5,221 6,250 254 160 1,712 6,777 20,688 Total 679 183 668 811 10,533 18,171 759 1,030 8,087 10,703 51,624

Semis 80 6 152 248 1,450 1,546 74 81 1,056 796 5,489

Row 78 18 84 70 657 4,607 212 281 1,316 1,619 8,942

1,077 134 1,080 921 6,994 12,288 1,383 1,428 6,853 4,401 36,559

1.5 Inventories and Market Balance – Shifting Away from Sellers
Exhibit 1.10: Inventories

Calgary
16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Jun-2009 Sep-2009 Dec-2009 Mar-2010 Jun-2010 22,500 22,000 21,500 21,000 20,500 20,000 19,500 19,000 18,500

Montreal

Jun-2009

Jun-2010

Toronto
30,000 25,000 20,000 15,000 10,000 5,000 0 Jun-2009 Jun-2010 5,000 0 15,000 10,000 20,000

Vancouver

Jun-2009

Jun-2010

Source: CREB; GMREB; TREB; REBGV;

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Alexandre Pestov

July 2010

Sliding sales volumes were predictably accompanied by a rise in inventories. Buying stagnation in Calgary and Vancouver in the environment of active selling pushed inventories higher year-over-year. The buying frenzy was instrumental to depleting inventories in Montreal and Toronto, which witnessed year-over-year decline. However, June 2010 is expected to be a turning point after which both cities will join their Western peers with inventories inching upwards. Exhibit 1.11: Market Balance in Key Metro Markets (May 2010)

Calgary

Montreal

Toronto

Vancouver

Source: Royal Bank of Canada, May 2010;

Rising inventories and plunging sales helped to bring the housing market in all four cities to or near the ―balanced market‖ range. The continuation of the market weakening is expected to shift the balance further in favour of buyers in coming months.

1.6 Rental Statistics – No Shortage of Living Space
Exhibit 1.12: Vacancy Rates in Privately Initiated Rental Apartment Structures National Oct-01 Oct-02 Oct-03 Oct-04 The Elusive Canadian Housing Bubble 1.6 2.1 2.6 3 Alberta 1 2.3 3.7 4.5 Quebec 1.3 1.2 1.3 1.7 Ontario 1.5 2.5 3.4 4 BC 2.6 3.1 3.1 2.4 Page 9 of 35

Summer 2010 Edition

Alexandre Pestov Oct-05 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10
7% 6% Vacancy Rate (percent) 5% 4% 3% 2% 1% 0%

July 2010 2.9 2.6 2.8 2.7 2.6 2.3 2.8 3.1 3.1 3 0.9 0.9 1.6 2.9 2.5 4.3 5.6 6.1 2.1 2.7 2.6 2.9 2.8 2.4 2.5 2.7 2.5 3.7 3.3 3.8 3.3 3 2.5 3.1 3.4 3.4 1.9 1.1 1.1 1 1.1 1 2.3 2.8 3.1

National Source: CMHC;

Alberta

Quebec

Ontario

British Columbia

Vacancy rates continued to climb in June 2010 across all markets, signalling no shortage of living space and a last-minute rush to buy by renters. The rise was especially pronounced in Calgary where vacancy rates breached the 6 percent mark.

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Alexandre Pestov

July 2010

2 THE RATES

2.1 Interest and Mortgage Rates – Leaving the Wonderland
Exhibit 2.1: Canadian Bank Rate and 5-year Fixed Mortgage Rate (1951 to 2010)
20% 18% 16% 14% Rate (percent) 12% 10% 8% 6% 4% 2% 0%

Bank Rate

5-year Posted Fixed Rate

Source: Bank of Canada;

Over the last 59 years the 5-year fixed rate mortgage rate averaged at 8.8 percent (Exhibit 2.1). At the time of writing of this paper, it stood at 5.59 percent. The overnight rate was 0.75 percent. The relative flatness if the 5-year fixed mortgage rate between 2004 and now in face of the sharp drop in bank rate is reflective of the conviction held by the banking community that historically low rates are not here to stay. Exhibits 2.2 and 2.3 present the forecasted bank rate for 2011. The 5-year fixed mortgage rate is expected to remain near or slightly below the 6-percent mark. Exhibit 2.2: Bank of Canada Rate Forecast Exhibit 2.3: Bank of Canada Rate Forecast (for 2011) BMO Rate 2.5% CIBC 2.25% RBC 2.75% ScotiaBank 2.25% TD Bank 2.5%

Source: BMO; CIBC; RBC; BNS; TD;

Exhibit 2.4: 5-Year Fixed Mortgage Rate 2011 Forecast 2011 Rate
Source: Forecast; Source: Bank of Canada; RBC Economic Research;

5.85 - 6.1%

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Alexandre Pestov

July 2010

2.3 Yield Curve – Re-Normalizing
Exhibit 2.5: Normal (Averaged Between 1986 and 2010) and Current Yield Curves
8% 7% 6%

Yield (percent)

5% 4% 3% 2% 1% 0%

Maturity (years) 2010-02 Source: Bank of Canada; 2010-04 Typical Yield Curve

Exhibit 2.6: Projected Yield Curve Changes Jul-2010 Sep-2010 Canada Yield Curve (30-Year — 2-Year)
Source: CIBC World Markets;

Dec-2010 2.05

Mar-2011 2.00

Jun-2011 1.65

Sep-2011 1.35

Dec-2011 1.25

2.16

2.10

Exhibit 2.5 displays the difference amongst the typical yield curve, a yield curve observed at the time of writing of the original ―The Elusive Canadian Housing Bubble‖ paper, and the yield curve posted by the Bank of Canada at the time of writing this report (these data series are updated on or near the first business day of each month, with a three-month lag). The most recent curve shows a rise in short- and mid-term rates (between 1 and 10 years), highlighting lender’s expectations of an imminent rate increase. The expected moderate increase in the 5-year fixed mortgage rate implies only marginal changes in mortgage payments for home owners who borrow under the 5-year fixed mortgage scheme. However, it doesn’t automatically bode happy days for all mortgage holders. During the recent times, a substantial portion of borrowers accepted short-term loans to benefit from a well pronounced discrepancy existing between the short and mid-term rates. The anticipated 200 basis points upward shift in bank rate will translate into an approximately 20 percent rise in mortgage payments these borrowers should anticipate 12-24 months.

2.3 Posted Mortgage Rates – Prudent Bankers
Closed Mortgage
Institution AGF TRUST ALTERNA SVGS/ALTERNA BK 6 Mth n/ 4.60 1 Yr 4.25 3.30 2 Yr 3.85 3.50 3 Yr 4.45 3.84 4 Yr 5.44 4.09 5 Yr 5.79 4.34

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Alexandre Pestov ATB FINANCIAL BANK OF MONTREAL BANK OF NOVA SCOTIA BANK WEST CAISSES DESJARDINS CANADIAN WESTERN BANK CANADIAN WESTERN TRUST CIBC COAST CAPITAL SAVINGS CU COMMUNITY TRUST COMTECH CREDIT UNION CONCENTRA FINANCIAL DUCA FIN. SERVICE C.U. EFFORT TRUST EQUITABLE TRUST FIRST CALGARY SAVINGS FIRST NATIONAL FIN. LP HOME TRUST COMPANY HSBC BANK CANADA ICICI BANK CANADA ING DIRECT INVESTORS GROUP TRUST ITALIAN CDN. SAVINGS C.U. LAURENTIAN BANK MACQUARIE FINANCIAL LTD. MANULIFE BANK MERIDIAN CREDIT UNION MFL RIGHTMORTGAGE MRS TRUST NATIONAL BANK ONTARIO CIVIL SERVICE C.U. PACE SAVINGS & C.U. PARAMA CREDIT UNION PRESIDENT'S CHOICE FINAN RESMOR TRUST COMPANY ROYAL BANK ROYAL TRUST SO-USE CREDIT UNION STEINBACH CREDIT UNION TD CANADA TRUST VIRTUAL ONE C.U. Updated on 10/07/24
Source: Canoe.ca;

July 2010 4.75 4.75 4.95 n/ n/ 4.75 4.75 n/ 4.75 4.95 6.60 4.75 4.40 3.60 n/ 4.75 4.65 n/ 4.85 n/ n/ 4.75 n/ 3.95 n/ 4.40 4.65 n/ 2.85 4.50 7.00 4.75 n/ 6.44 n/ 4.25 4.25 6.30 n/ n/ n/ 3.50 3.50 4.40 5.25 3.70 3.50 3.50 3.50 2.65 3.70 3.09 3.50 2.99 3.50 3.50 2.99 2.70 2.85 3.60 3.05 2.80 3.50 3.50 2.59 3.19 3.00 3.50 3.06 3.10 3.50 2.70 3.50 3.20 2.90 3.64 3.10 3.10 2.75 3.40 2.70 2.60 3.85 3.85 4.25 5.50 4.20 3.85 3.85 3.85 3.25 4.05 3.99 3.85 3.49 3.80 3.85 3.59 3.45 3.50 3.95 3.55 3.45 3.85 3.85 3.95 n/ 3.50 3.85 n/ 3.70 3.85 3.10 3.85 3.60 3.40 n/ 3.85 3.85 3.85 3.80 4.20 3.50 4.40 4.40 4.70 5.75 4.65 4.50 4.50 4.50 3.75 4.70 3.99 4.40 3.75 4.50 4.50 3.79 3.50 3.50 4.60 3.89 3.79 4.50 4.50 4.45 3.69 3.90 4.40 3.52 4.20 4.40 3.79 4.40 3.85 3.75 3.75 4.40 4.40 4.00 4.00 4.75 3.75 5.44 4.29 5.44 6.00 5.44 5.44 5.44 5.44 3.85 5.64 4.09 5.44 3.99 5.40 5.44 4.19 3.89 4.25 5.54 4.10 4.29 5.44 5.44 5.44 n/ 4.10 3.95 n/ 4.60 5.44 4.44 5.44 4.50 4.24 n/ 4.29 4.29 4.50 4.10 4.29 4.00 4.39 3.99 5.79 6.50 5.79 5.79 5.79 5.79 3.95 5.99 4.09 5.79 4.09 5.75 5.79 4.29 4.19 4.25 5.89 4.39 4.39 5.79 5.79 4.39 4.29 4.29 3.98 4.08 4.65 5.79 4.39 5.79 4.90 4.34 4.24 4.39 4.39 4.60 4.20 4.39 4.13

Open Mortgage
Institution ALTERNA SVGS/ALTERNA BK BANK OF MONTREAL BANK OF NOVA SCOTIA CAISSES DESJARDINS CANADIAN WESTERN BANK CANADIAN WESTERN TRUST CIBC The Elusive Canadian Housing Bubble Variable 3.50 2.60 2.75 n/ 2.60 6 Mth Op 6.45 6.45 6.65 6.75 6.65 6.65 6.70 6 Mth Con n/ 4.75 4.95 n/ 4.75 4.75 4.75 1 Yr Op 6.45 6.45 6.70 6.70 6.45 6.45 6.45 1 Yr Con n/ n/ n/ n/ n/ n/ n/ 2 Yr Op n/ n/ n/ n/ n/ n/ n/ Page 13 of 35

Summer 2010 Edition

Alexandre Pestov COAST CAPITAL SAVINGS CU COMTECH CREDIT UNION CONCENTRA FINANCIAL DUCA FIN. SERVICE C.U. EFFORT TRUST EQUITABLE TRUST FIRST NATIONAL FIN. LP HOME TRUST COMPANY HSBC BANK CANADA ICICI BANK CANADA ING DIRECT MACQUARIE FINANCIAL LTD. MANULIFE BANK MERIDIAN CREDIT UNION MFL RIGHTMORTGAGE MRS TRUST NATIONAL BANK ONTARIO CIVIL SERVICE C.U. PACE SAVINGS & C.U. PARAMA CREDIT UNION PRESIDENT'S CHOICE FINAN ROYAL BANK ROYAL TRUST SO-USE CREDIT UNION STEINBACH CREDIT UNION TD CANADA TRUST VIRTUAL ONE C.U. Updated on 10/07/24
Source: Canoe.ca;

July 2010 3.45 4.75 2.25 n/ 2.00 2.25 2.75 2.25 2.15 2.55 3.25 1.90 2.25 n/ 3.30 2.50 2.25 2.60 2.60 5.00 2.75 2.35 5.75 8.40 6.60 n/ 6.65 6.40 n/ n/ 7.00 n/ n/ n/ n/ 6.55 n/ 3.40 7.00 n/ 6.60 n/ n/ 6.75 6.75 8.20 n/ n/ 6.25 n/ 6.60 4.75 4.60 n/ n/ n/ n/ 4.85 n/ n/ n/ n/ n/ n/ 2.85 n/ n/ n/ n/ 6.44 4.25 4.25 6.30 n/ 4.65 n/ 4.15 9.00 6.75 5.75 6.65 6.70 n/ n/ 7.45 n/ n/ n/ 4.00 6.55 n/ n/ 6.75 n/ 6.75 n/ n/ 6.75 6.75 8.55 n/ 6.70 n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ 3.15 n/ n/ n/ n/ 2.90 n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/ n/

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3 HOUSING (UN)AFFORDABILITY

3.1 The Present – Not So Bright and Shiny
Exhibit 3.1: Housing Affordability in Key Metro Markets (May 2010)

Calgary

Montreal

Toronto

Vancouver

Source: Royal Bank of Canada, May 2010;

In its November 2009 edition RBC states: The string of significant improvements in housing affordability in Canada finally came to an end in the third quarter [of 2009]. Affordability hasn’t improved since November 2009. Rising home prices in all key metro areas (rising up to May-June of 2010) contributed to the worsening affordability in three major markets with Calgary being the lone exception (Exhibit 3.1). As RBC’s report describes the current state: Affordability erodes again in the first quarter of 2010 Canada’s housing markets started 2010 the same way they ended 2009: firing on all cylinders. While a boon to sellers, the resulting strong home price increases, however, have hurt housing affordability across the country. Housing affordability in Canada remains above its long-term average, suggesting that home ownership costs in this period of historically-low interest rates were inflated by high property prices. At this point, this situation is not viewed as dangerous, as affordability stays below the recent peak reached in 2008, and, in many regions, below the levels seen during the late-80’s housing

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bubble. Housing affordability index is expected to rise nationwide in 2010-2011 to approach the levels set in 2008, which will be above the average seen during the emergence and subsequent bust of the 80’s housing bubble. In the major real-estate markets, Calgary was the only city to beat the general upward un-affordability trend, hovering around the long-term average. Montreal appears determined to challenge the worst-ever affordability recorded in the late 80’s, while Vancouver residents aim to finally start using 100 percent of their pre-tax household income towards home ownership costs. Toronto exhibits only moderate rise in un-affordability relative to its long-term average. However, wearing the crown of the second most expensive major city in Canada in terms of home prices, and ownership costs are clawing their ways towards consuming 100 percent of aftertax household income. Exhibit 3.2 shows the mortgage carrying costs for the key real-estate markets. Predictably, rising interest rates pushed mortgage carrying costs higher all across the board. Exhibit 3.2: Mortgage Carrying Costs in Key Metro Markets (May 2010)

Calgary

Montreal

Toronto

Vancouver

Source: Royal Bank of Canada, May 2010;

3.2 The Future – Tighten Your Belts
Exhibit 3.3 visualizes the forecast of housing affordability for the last quarter of 2011. The estimates are based on a 200 basis points interest rates rise and home prices remaining unchanged from today’s levels. RBC Economics Research’s housing affordability measures show the proportion of median pre-tax household income required to service the cost of mortgage payments, property taxes and utilities. According to the forecast, should the housing prices remain at the current levels, residents of Calgary and Montreal will have to spend nearly 2/3rds of their after-tax income towards their home ownership costs. In Toronto, this number The Elusive Canadian Housing Bubble Summer 2010 Edition Page 16 of 35

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will approach 90 percent, while in Vancouver an average household will have to spend in excess of 90 percent of their pre-tax income to service the ownership costs. Exhibit 3.3: Adjusted Affordability in Key Metro Markets Affordability Measure
Detached bungalow
Current Forecast 42.4 46.2 57.1 85.3

Standard two-storey
Current 38.3 49.4 58.5 80.9 Forecast 44.5 57.4 68.0 94.1

Standard townhouse
Current 29.8 35.2 41.4 52 Forecast 34.6 40.9 48.1 60.5

Standard condominium
Current 23.2 32.4 32.7 40.5 Forecast 27.0 37.7 38.0 47.1

Calgary Montreal Toronto Vancouver

36.5 39.7 49.1 73.4

Source: Royal Bank of Canada, May 2010; Forecast;

3.4 Income – You Wish You Were Paid in Houses
Exhibit 3.4: Comparison of Income to House Price Changes (1996 to 2009)
200% 180% 160% 140%

Change (percent)

120% 100% 80% 60% 40% 20% 0%

Salary - Toronto Home Prices - Toronto

Salary - Montreal Home Prices - Montreal

Salary - Vancouver Home Prices - Vancouver

Salary - Calgary Home Prices - Calgary

Source: Statistics Canada;

Exhibit 3.4 serves as a reminder of a wide gap that emerged between the growth of income and housing prices appreciation over the last 14 years. Exhibit 3.5 visualizes income and hose price changes over the period of 16 months, as estimated using the hourly wages and housing price index changes. With the exception of Calgary where wage recovery has outpaced the home price inflation since January 2009, all major markets have experienced the continuation of the trend whereby home prices grew at a more rapid pace than personal income.

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Alexandre Pestov Exhibit 3.5: Comparison of Income to Home Price Changes (January 2009 to April 2010)
12% 10% 8%

July 2010

Change (percent)

6% 4% 2% 0% -2% -4% -6% -8%

Salary - CAL Home Prices - CAL

Salary - MON Home Prices - MON

Salary - TOR Home Prices - TOR

Salary - VAN Home Prices - VAN

Source: Statistics Canada; Royal Bank of Canada, May 2010;

3.5 Income and Financing Requirements – Refinancing Pains Ahead
Exhibit 3.6: Median Income vs. Qualifying Income for Standard Dwelling Types
$160,000 $140,000 $120,000 Income (dollars) $100,000 $80,000 $60,000 $40,000 $20,000 $0

Bungalow

Two-Storey

Townhouse

Condominium

Extimated Median Income

Source: Statistics Canada; Royal Bank of Canada, May 2010;

Qualifying income is the minimum annual income used by lenders to measure the ability of a borrower to make mortgage payments. Exhibit 3.6 displays the comparison of the median income nationwide and in key markets to the qualifying income requirements for standard dwelling types. At present, the median income in Canada allows to qualify for all but average standard two-storey house. The Elusive Canadian Housing Bubble Summer 2010 Edition Page 18 of 35

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Similar scenario can be observed in Calgary and Montreal where residence with median income will meet mortgage requirements to afford average-priced bungalows, townhouses and condos in these cities. In Toronto, the median income of an economic family will allow to quality only for an average condominium mortgage, with averagely priced bungalows, two-storey houses and townhouses being out of reach for an average family. In Vancouver resident families’ median income will not be sufficient to qualify for any commonly priced dwelling type. This numbers must be viewed in conjunction with the historically low interest rates. 2011 can prove to be a challenging year for refinancing for many present borrowers.

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4 FUNDAMENTALS

4.1 Price-to-Income – Severely Unaffordable
Exhibit 4.1: Demographia’s International Housing Affordability (2005 to 2009)
12 10

Price-to-Income (ratio)

8 6 4 2 0

Canada

Vancouver (BC)

Calgary (AB)

Toronto (ON)

Mortreal (QB)

Source: Demographia 2010; On annual basis, Demographia compiles a report to cover price-to-income ratios in 270-plus markets in Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States. The Demographia International Housing Affordability Survey employs median house price divided by gross annual median household income in each market to rate housing affordability values. Demographia uses the following scale to rate housing affordability:     Severely Unaffordable 5.1 & Over Seriously Unaffordable 4.1 to 5.0 Moderately Unaffordable 3.1 to 4.0 Affordable 3.0 or Less

The scale calibration is derived from historical values observed over a period of time. According to Demographia, the Median Multiple has been remarkably similar among the nations surveyed, with median house prices being generally 3.0 or less times median household incomes. In late 2009, Calgary and Montreal were rated ―seriously unaffordable‖, scoring 4.6 and 4.9 respectively. Toronto made it to the ―severely

unaffordable‖ hall of fame with a score of 5.2. Vancouver ranked the most unaffordable city amongst the 272 markets surveyed with a price-to-income ratio of 9.3 (Exhibit 4.1). Exhibit 4.2 presents the price-to-income ratios calculated using the latest census values, hourly wages and average home prices reported by CREA. Using Demographia’s scale, in June 2010 Canada (nationwide), Calgary and Montreal firmly reside within the ―seriously unaffordable‖ category. Toronto and Vancouver remain ―severely unaffordable‖ with Vancouver’s price-to-income ratio reaching the same dangerous levels witnessed at the peak of the housing bubble in the US. Exhibit 4.2: Major Markets – Price-to-Income (June 2010) Canada Price-to-Income
Source: Statistics Canada; CREA; Estimates;

Calgary 4.75

Montreal 4.30

Toronto 5.33

Vancouver 8.93

4.46

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Exhibit 4.3 shows the price-to-income ratios for different income earning groups. The ratio was calculated based on average income reported by Statistics Canada adjusted for changes from the last census and median dwelling prices reported by RBC, The ratio north of 6 for an average working single individual suggests that an average single income-earner in Canada is financially incapable of buying a real-estate property. The severity of this situation is magnified in severely unaffordable markets, such as Toronto and Vancouver.

Exhibit 4.3: Price-to-Income Ratio for Four Income Earning Groups Detached Bungalow Economic Families Unattached Individuals Non-elderly Male Non-elderly Female
Source: Statistics Canada; RBC Economic Research; CREA;

Standard Two-Storey 4.8 11.5 9.3 11.1

Standard Townhouse 3.4 8.2 6.6 7.8

Standard Condominium 2.9 6.9 5.6 6.6

4.2 10.2 8.2 9.8

4.2 Price-to-Rent – Any Investors Left?
Exhibit 4.4: Price-to-Rent Ratio in Select OECD Countries

250

200

Price-to-Rent (ratio)

150

100

50

Canada Denmark Source: OECD 2010;

United States Spain

United Kingdom Ireland

Australia Switzerland

Price-to-rent ratio remains elevated in Canada, and on comparative basis it is 30 percentage points higher than that of the US.

4.5 US and Canada – Trotting Down the Familiar Path
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Alexandre Pestov Exhibit 4.5: Comparison of the US and Canadian Housing Price Indices – Select Cities
300% 280% 260%

July 2010

Index Change (percent)

240% 220% 200% 180% 160% 140% 120% 100%

Los Angeles Boston Calgary

San Francisco Las Vegas Montreal

Miami New York Toronto

Tampa Seattle Vancouver

Chicago Composite Canada

Source: Case-Shiller; Teranet – National Bank House Price Index; Exhibit 4.5 visualizes the direction of the housing prices in the US and Canada between January 2000 and May 2010. The correction experienced in the US brought the housing prices closer to the long-term norms. At the same time, the home price recovery witnessed in Canada in 2009-2010 moved price indexes further out of sync with fundamentals.

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5 CANADIAN DEBT
This section of the report employs the following acronyms:       CC – Consumer Credit GDP – Gross Domestic Product ML – Mortgage Liabilities NW – Net Wealth PDI – Personal Disposable Income TA – Total Assets

5.1 Mortgages in Arrears – Recent Hiring Helped
Exhibit 5.1: Mortgages in Arrears
0.70% 0.65% 0.60% 0.55% Percent 0.50% 0.45% 0.40% 0.35% 0.30% 0.25% 0.20%

% of Arrears to Total Number of Mortgages Source: Canadian Bankers Association; Since the beginning of the financial crisis in 2007, mortgages in arrears have jumped above their 20-year average. However, the improvements in state of the Canadian economy observed over the last six months helped to alleviate the rising problem and bring it down to the long-term average. On the downside, these economic advances appear to be temporary, as unemployment rate inched higher in July 2010 prompting Bank of Canada to revise its growth forecast. In the coming months further worsening is expected to be seen in the mortgage in arrears readings, reflecting the diminishing ability of Canadians to service their mortgage debt.

5.2 Credit Card Delinquency and Loss – A Short Break
Credit card delinquencies rose between mid-2008 and 2010 reflecting the waning ability of the Canadian public to service its debt. A respite in delinquency rates’ ascent can be seen in early 2010, as the unemployment rate dwindled and consumer confidence rose. This, however, is expected to be a short break in the delinquency rate climb due to the unexpectedly rising unemployment.

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Alexandre Pestov Exhibit 5.2: Credit Card Delinquency and Loss Statistics - VISA and MasterCard
1.40% 1.30% 1.20% Percent 1.10% 1.00% 0.90% 0.80% 0.70%

July 2010

6.00% 5.50% 5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00%

Delinquency Rate (90 days & over) Source: Canadian Bankers Association;

Net Loss Rate (annualized)

5.3 Debt Levels – An Exponential Rise
Exhibit 5.3: Debt to GDP, Personal Disposable Income, and Consumer Credit and Mortgage Liabilities
150 140 130 120 110 Ratio 100 90 80 70 60 50

Debt to GDP Source: Statistics Canada;

Debt to PDI

CC and ML to PDI

Canadian debt is on the rise all across the board. Personal debt to GDP, personal debt to personal disposable income, and mortgage liabilities have been steadily ascending since the early 1990’s. The short reversal seen during the last economic slowdown of the early 2000’s was quickly reversed, and Canadians continued accumulating excessive amounts of debt. This trend is expected to continue into the foreseeable future. The consumer credit and mortgage liabilities have been rising exponentially since early 2001, as Canadian consumers discovered new riches in cheaply borrowed money. The unfortunate notion of getting wealthy quick by buying

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real-estate at any price is reflected in the unsustainably high debt that Canadians carried in 2010 (Exhibit 5.3). At the same time, owner’s equity as a percentage of real estate has been on the decline signalling that the ―paper‖ wealth of rising nominal home prices of many Canadians is disappearing while debt of borrowed funds remains a reality (Exhibits 5.4 and 5.5). In fact, the Canadian household wealth and net worth as a percentage of debt at the historically low levels sending a strong signal of Canadian ―wealth‖ being merely paper-based gains recorded against real debt that requires servicing and eventual repayments (Exhibit 5.5). Exhibit 5.4: Owner’s Equity as a Percentage of Real Estate
72 71 70 Percent 69 68 67 66 65

Owner's Equity as a Percentage of Real Estate Source: Statistics Canada;

Exhibit 5.5: Canadian Household Wealth and Indebtedness
25 24 23 22 21 Ratio 20 19 18 17 16 15

Debt to TA Source: Statistics Canada;

Debt to NW

CC and ML to NW

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5.4 Net Worth – We Own More Because We Owe More
Exhibit 5.6: Net Worth and Real Estate as a Percentage of Personal Disposable Income
700 650 600 Percent 550 500 450 400

310 290 270 250 230 210 190 170 150

NW as a Percentage of PDI Source: Statistics Canada;

Real Estate as a Percentage of PDI

Frequently, the growth of net worth is accompanied by a commensurable rise in real-estate owned by Canadians. Despite the levelled out home prices between 2007 and 2009, the net-worth fell. This is a strong indicator of the limited real net worth growth recorded between 2001 and 2010, with the largest bulk of nominal net worth rise coming from the real-estate price inflation.

5.5 CMHC – Closing the Barn Door After …
Exhibit 5.7: NHA Mortgage-Backed Securities
$160 CMHC Issued MBS (billion $) $140 $120 $100 $80 $60 $40 $20 $0

Issued Amount Source: CMHC; The issuance of new MBS by Canada Mortgage and Housing Corporation fell to its 2006 level in July 2010. As of July 2010, CMHC had the grand total of $694,246,415,930.59 in MBS outstanding, an equivalent of approximately 30 percent of the Canadian economy.

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5.6 National Debt
Exhibit 5.8: Accumulated Federal Deficit
$600 $500 Deficit (billion $) $400 $300 $200 $100 $0

Accumulated Deficit Source: Statistics Canada;

Forecast

A decade of national debt repayments came to a sudden stop in 2008 with the announcement of budget deficit by the Harper government. The gains in debt repayment made over the 11 years between 1996 and 2007 will be fully erased by the end of 2011.

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6 MUSINGS

6.1 Macroeconomic Risks – Where Is the Bright Spot?
China The Chinese miracle appears to be coming to a big pause to say the least. Historically, the mystery of the double-digit Chinese GDP growth during the global financial crisis sent the vibes of a seemingly unstoppable Chinese economic expansion. Much ink has been spilled over the economic achievement of this country. However, very rarely the other side of the Chinese makes headlines. The staggering emergence of the Chinese economy from the global recession was undeniably supported by an array of diverse factors. While some of them can be described as fundamentally sound, the others were the typical carnival charlatan’s ―smoke and mirrors‖. A $1.7 trillion lending program rolled out in 2009 certainly left its mark. If a similar program was implemented in Canada, it will equate to giving away nearly $19,000 Canadian dollars to each person living in Canada, or $47,000 per average Canadian household. If today your and every other typical 2.5-person Canadian household receives a letter with an enclosed cheque for $50,000 signed ―James Michael Flaherty‖, you can envision a nation-wide party it will cause. You can also picture the economic boost it will give to the country. Homes, cars, and HD TVs sales will skyrocket overnight. The GDP will confidently grow in double-digit. The real question is the growth sustainability and the long-term consequences of such give-away program. Many will argue that it was a lending program, not a money give away. At the expected loan repayment rate of 73 percent, the program was evidently structured for providing ―free money‖ to everyone without major provisions for recovering these loans. Things to watch for in China are:       Handover caused by the $1.7T lending spree Loan write-downs and losses incurred by lenders, and subsequent needs for raising additional funds Effects of widespread large-scale non-productive projects, e.g. the ghost city of Ordos, 64.5 million mainland houses allegedly lying vacant in China2 and other unknown, but equally engaging, fun and GDP-boosting projects Home prices 20-50 times of average household income of citizens who live in them Possible housing market collapse, as forecasted by a vast assortment of investors and academics Stress-testing announced by the Chinese banking regulators assessing the risk of a 60 percent price slump3

Some fear that developments in China will lead to an asset prices collapse on a massive scale. Others argued it may cause sluggish growth, but nothing beyond it. In either case, the flow of ―free money‖ to be invested in overseas vacation homes will cease, and it is highly likely that margin calls and loan repayment requests will demand a fire-sale disposal of investment properties abroad. Most certainly, some of the foreign-owned properties will be used as assets tacked safely out of reach of domestic creditors. However, this notion alone will not be enough to sustain the Canadian real-estate growth, if you believe it was financed by foreign investors. Moreover, if worse-than-the-best scenario materializes, the demand for raw materials provided by Canada will dwindle, impacting the broader Canadian economy. Easy come, easy go. The US As a major trading partner of Canada, the US and the health of its economy have direct effects on Canada. As much as the world wants to see the US emerging from the Great Recession as quickly as it did in 2003, all signs suggest that the world’s largest economy is not out of the woods quite yet. A quote from David Rosenberg of Gluskin Sheff (July 26, 2010) summarizes it all: YOU KNOW YOU ARE IN A DEPRESSION WHEN Congress moved to extend jobless benefits seven times, as has been the case over the past two years, at a time when almost half of the ranks of the unemployed have been looking for at least a half year.

2 3

Fitch on Chinese Banks: http://www.scribd.com/doc/34351417/Fitch-on-Chinese-Banks-7-2010 http://www.bloomberg.com/news/2010-08-04/chinese-regulator-said-to-tell-banks-to-test-for-60-drop-in-home-prices.html

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The unemployment rate for adult males (25-54 years) hit a post-WWII this cycle and is still above the 1982 recession peak, and the youth unemployment rate is stuck near 25%. These developments will have profound long-term consequences – social, economic and political. The fiscal costs of the depression continue to mount, with the White House on Friday raising its deficit projection for 2011 to $1.4 trillion from $1.267 trillion. That gap in the forecast – $133 billion – was close to the size of the entire budget deficit back in 2002. Amazing. You also know it is a depression when you find out on the weekend that the FDIC seized and shuttered another seven banks, making it 103 closures for the year. What a recovery! Meanwhile, how are the surviving banks making money? By cutting their provisions for bad debts (at a time when the household debt/income ratio is still near record highs of 120% and at a time when one-quarter of the consumer universe has a sub-600 FICO score – which means they are also ineligible for Fannie or Freddie mortgage financing. The banks thus far have reduced their loan loss reserves between 23% (Cap One) and 73% (First Horizon) – as Jamie Dimon said last week, these are not real earnings. You also know it's a depression when a year into a statistical recovery, the central bank is still openly contemplating ways to stimulate growth. The Fed was supposed to have already started the process of shrinking its pregnant balance sheet four months ago and is now instead thinking of restarting Quantitative Easing. Of course, we are in this bizarre environment where bank credit continues to contract – last week alone, bank wide consumer credit outstanding fell $2.2 billion; real estate lending contracted $9.2 billion; and commercial & industrial loans slid $5.1 billion. What did the banks do this past week? They replaced cash with government securities – the $47.5 billion net buying was the second largest in the past three years. As the banks find few opportunities to lend – households are either not creditworthy enough to lend to or are busy paying off debts and companies that do have any expansion plans have enough cash on their balance sheet to finance their initiatives – they are likely to use their $1 trillion in excess reserves buying government and related securities, especially with the yield curve so steep and the Fed ensuring that it has no intention of taking the 'carry' away for a long, long time. Did we mention that you also know you are in some sort of depression when after two years of record $1+ trillion deficit financing to kick-start the economy, the yield on the 5-year note is sitting at 1.8%? What do you think that tells you? It tells you that the private credit market is basically defunct, especially when it comes to the securitized loans, which played such a critical role in promoting leveraged economic growth from 2001 to 2007 – the amount of securitized credit that has vanished since the credit bubble burst two years ago is $1.4 trillion – 40% of this market is gone. And what replaced it was this rampant government intervention into the economy – aimed at putting a floor under the economy. But insofar as the government stimulus fades and the contraction in credit persists, it will be interesting to see what sort of spending, output and income growth we are going to see in the near- and intermediate-term4. Europe Unlike the US, Europe is in ―great shape‖. Only 7 out of 91 banks failed the much-assuring stress test. Sovereign default risk is nonexistent… Ah, who are we kidding? Unless Irish leprechauns found an endless supply of gold at the end of each rainbow to hand over to ECB, the looming sovereign default risk, propensity of continental Europeans to engage in civil unrest, unclear debt and deficit prospects of several EU members and great disparity between Euro as measured by the German economy strength and PIIGS weakness will continue to cast a long dark shadow over Europe’s potential to lead the way out of this recession. Canada While Stephen Harper is scribing in his memoirs (leisurely sitting on a sandy shore of the artificial lake and listening to sounds of artificial loons) about the once in a lifetime $1-billion party he managed to arrange, the Canadian unemployment rate edged a bit higher.

4

http://pdf.cyberpresse.ca/lapresse/dufour/DRDepression.pdf

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July 2010

6.2 Amusing Findings – It’s All Good
Going through the latest Toronto Real Estate Board report 5 , I noticed the following number: ~30 percent. This is a TREB affordability Indicator calculated by the board. The number is by a large margin out of sync with the estimates compiled by Demographia and recent affordability measures calculated by RBC. It surely provides much-needed comfort to the Toronto-based buyers, as many know that it is far below the ―danger zone‖. Back-of-the-envelope calculations (using the latest average home price ($435,064) and TREB’s assumptions for the city suggest that the average household income in Toronto is approximately $115,000. Using the reported number of $485,000 for the average home price, the average Torontonian’s income rises to $125,000. Doesn’t the mean $115,000-125,000 income in Toronto make an accomplished Bay Street banker feel a bit underpaid?

6.3 Chart of the Day – Remember NASDAQ in 2000?
Exhibit 6.5: Vancouver – Average Prices (1977 to 2010)

Source: REBGV;

No comments necessary (see the comparison chart below).

5

http://www.torontorealestateboard.com/consumer_info/housing_charts/index.htm

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Alexandre Pestov Exhibit 6.6: NASDAQ (1995 to 2000)
5500 5000 4500 4000 3500 Index 3000 2500 2000 1500 1000 500

July 2010

Source: Bloomberg;

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7 SCORECARD
Exhibit 7.1: Summary of Housing Market Indicators

Risk of Defaults

Price-to-Income

Component Rank

9

9

8

6

5

10

6

4

Total Risk Rank Outlook

7.2 Negative

The scorecard explained: Price-to-income remains excessively high Price-to-rent is near its historical highs Un-affordability in Canada is above average, reaching explosive levels in Vancouver Home supply remains slightly elevated Inventories are in balance nationwide Personal debt reached unprecedented levels Risk of default is a notch above average Rush to sell rather resembles ―rush to buy‖ at the moment Macro factors signal turbulent times ahead

The scorecard measures the risk of buying real-estate in today’s market from the value perspective. The scale ranges from 0 to 10 where 5 is a historical average for each component. Component values below 5 indicate better than average conditions (the lower the better), whether values above 5 signal the opposite. The final ranking is an average of the 9 factors important to the market health. Generally, the Risk Rank below 3 suggest an exceptional conditions for buying, while the rank above 7 suggests avoiding realestate market altogether. The ―outlook‖ shows an estimated direction of near-term market changes. The Elusive Canadian Housing Bubble Summer 2010 Edition Page 32 of 35

Macro Factors 8

Personal Debt

Price-to-Rent

Affordability

Rush To Sell

Inventories

Supply

Alexandre Pestov

July 2010

DATA SOURCES
Bank of Canada Statistics http://www.bankofcanada.ca/en/rates/index.html Canada - Consumer Price Index (CPI) History http://www.rateinflation.com/consumer-price-index/canada-historical-cpi.php Canada Mortgage and Housing Corporation (CMHC) http://www.cmhc-schl.gc.ca/ Canada Mortgage and Housing Corporation (CMHC) MBS http://www.cmhc-schl.gc.ca/en/hoficlincl/mobase/index.cfm Canoe Mortgage Rates http://money.canoe.ca/rates/mortgage_close.html Case-Shiller http://www.standardandpoors.com/home/en/us Citizenship and Immigration Canada http://www.cic.gc.ca/english/resources/statistics/facts2008/permanent/10.asp CREA http://www.crea.ca/public/news_stats/statistics.htm# CREB – Calgary Real Estate Board http://www.creb.com/public/seller-resources/housing-statistics.php Demographia http://www.demographia.com/dhi.pdf GMREB – Greater Montreal Real Estate Board http://www.cigm.qc.ca/indexen.aspx MLS http://www.realtor.ca Organisation for Economic Co-operation and Development (OECD) http://www.oecd.org Organisation for Economic Co-operation and Development (OECD) Annex Table 60: House price ratios http://www.oecd.org/dataoecd/6/5/2483894.xls Organisation for Economic Co-operation and Development (OECD) Production and Sales (MEI) http://stats.oecd.org/Index.aspx?DataSetCode=MEI_REAL Organisation for Economic Co-operation and Development (OECD) Statistics http://www.oecd.org/statsportal/0,3352,en_2825_293564_1_1_1_1_1,00.html REBGV - Real Estate Board of Greater Vancouver http://www.rebgv.org Statistics Canada http://www.statcan.gc.ca/ Royal Bank of Canada - RBC http://www.rbc.com/economics/market/pdf/house.pdf

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Alexandre Pestov Teranet – National Bank House Price Index http://www.housepriceindex.ca/Default.aspx TREB – Toronto Real Estate Board http://www.torontorealestateboard.com/consumer_info/market_news/index.htm

July 2010

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ACKNOWLEDGEMENTS
I am grateful to Jeff Stuart for his editing assistance. Jeff Stuart is the President of King James Capital, a private corporation that provides comprehensive services to publicly listed companies in a professional and cost effective manner. Services include corporate finance, investor relations and corporate communications. In addition, Jeff provides a range of editing, sales and marketing services for select newsletter writers in the mining sector. A frequent speaker at mining investment conferences, Jeff’s years of experience as an insider and background as a licensed investment advisor provide him with unique and balanced insights into the successful development of junior resource companies. More information on Jeff’s business development process can be found at kingjamescapital.com

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