Increased interest rates.

Whole loans, interest rates and the current market | John Toohig and Nadeem Kassam

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Head of Whole Loan Trading John Toohig (Memphis) and Nadeem Kassam (Toronto) join the podcast to discuss interest rates, loans and what’s going on in the current market, including:

  • Big Picture of the current interest rate environment
  • A look at the housing market
  • What’s the auto loan market saying
  • Expectations going forward

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Chris: Hello and welcome to the Advantaged Investor, a Raymond James Limited podcast. A podcast that provides perspective for Canadian investors who want to remain knowledgeable, informed, and focused on long-term success. We are recording this on March 8, 2023. I'm Chris Cooksey from the Raymond James Corporate Communication and Marketing Department.

Today, I'm looking forward to chatting with two returning guests. John Toohig is Head of Whole Loan Trading based in Memphis, Tennessee, and Nadeem Kassam, our head of Investment strategy here in Toronto. Today we are discussing interest rates, loans, and what's going on in the current market. John, Nadeem, thanks for taking the time today.

Hope you're doing well, John, I know you're traveling and doing all that fun stuff, but thank you for taking the time.

John: I'm usually from Memphis, but today talking to you from San Francisco and it is allergy season in Memphis, so I apologize for a little bit of a scratchy voice, as the trees are in bloom in Memphis.

Chris: Ah, I have them here. So you're just a couple months ahead of where I'm going to be, so I totally understand. It's coming my friend, it's coming for sure. Yep. I was actually at the head office in Florida last week and nap pollen was out pretty big time there as well. So. Absolutely. Anyway, we got a lot to discuss today.

We can jump right in. And maybe John, we'll start with the big picture. Thought maybe thoughts on the current interest rate environment. What's going on for the rest of 2023? Are we higher for longer or higher until it's lower?

John: Well, the jobs number that came out this morning didn't really help that story.

Powell's on the hill, he's saying, you know, another 50 basis points for the next rate hike. It, it does seem like, higher for longer. February was a brutal month. Sticky inflation persistent jobs and wages. So, I'll steal a quote from Morgan Stanley. Not that much higher, but for longer. Okay. And it seems like we'll get at least another 50, if not two or three more quarter point hikes before he pauses.

Chris: Nadeem, what about Canada?

Nadeem: Yes, I think the majority of the move in terms of interest rates are largely behind us. Today we had a Bank of Canada policy meeting and, TIFF Macklem essentially, along with the Bank of Canada left rates more or less unchanged here at 4.5%. So those are overnight rates, right?

Again, they still left the door open for you know further hikes in the event that inflation continues to be volatile over the near term. But I think the expectation is that you know, maybe we get another 25 basis points or even a 50 basis point move in total for this year.

But again, I think unlike the US our latest GDP or fourth quarter GDP came in flat, right? So it’s essentially the economy economy's stagnating. There are factors that are a little bit different than the US economy and are weighing a little bit towards the downside for the Canadian economy.

So maybe there's less impetus to move higher on rates I would say relative to the us. But again, if the US starts hiking we can't be too far behind that because that does impact exchange rates, FX and in terms of trade, et cetera.

Chris: Right? So Okay, well let's move to housing then.

And John, so I guess I read that 30 year fixed a fixed rate mortgages have more than doubled from where they were in the pandemic. Sort of what impact does this have on fundamentals, prices, supply, demand, affordability, rental, all that fun stuff.

John: Well, it looks like we might get back to 7% mortgages.

We saw that in October and we kind of came off that high in October and, and now we're kind of heading back that way. So it's not good news for anybody in the purchase money market right now. It's tough. Anybody who's trying to consider buying a home, is really kind of struggling with what that new payment might be.

So you're seeing kind of a, collision, if you will, between those people who already have an ultra low 30 year fixed rate mortgage, 3%. They're happy to stay in that home, which means they're not lifting. The existing home sales will probably be low, or as the new construction, you have builders who are nervous where they see you know, rising rates and affordability is at a, I think, a three decade low now.

So it's a real kind of crossroads, if you will, for the American consumer trying to decide if they love their mortgage but hate their existing home or if they're willing to date the rate, but love the home and make a purchase with the hope of a refi somewhere down the road.

Chris: Now, in your view, is there any chance we see a repeat of the 2008 credit crisis? Are we heading towards that or are we a little more in a better position than at that.

John: No, I mean, this is a common question, 2006, 2008. It is a very different situation. It was driven by more credit and, and speculative building.

It was more of a, we had too much supply and not enough demand. And, now it's the opposite. We have more than enough demand and, and not enough supply. We had a housing crisis prior to COVID. We continued to have a housing crisis after COVID. There's not enough units. The builders are the ones that got demolished in 2008.

They never really came back. In the 2000 tens. And so while you know, some economists are saying we might see home values in the US fall five to 10%, particularly maybe in those areas that more of more zoom towns, if you will, that kinda benefited from. You just don't see the fundamentals, the wider crazier credits, the more speculative building that really kind of propped up the debacle in 2008.

Chris: Okay. Now, Nadeem, obviously rates in Canada have risen material two, like roughly two and a half percent up to 6.7. Five year rates have gone. What's the impact so far of the higher rates in Canada on housing fundamentals?

Nadeem: 6.7 is, is essentially prime rate, right? And so if we think about, the trend that we've seen over the past decade, if not longer when, when the mantra was more or less lower for longer, and rates continued to move lower there was this impetus for buyers to move from a five year fix to floating, right?

Because that was directionally where things were. And that's benefited, you know, investors and, and even homeowners that you know, got in 10, 15 years ago. But for the 30% of mortgages that are outstanding, which are floating rate or variable, the jump in prime here to from two, two and a half to 6.7 is definitely causing some pain.

And, it's gonna take time. John probably could attest to this in terms of what he's seeing in the US but, you know, interest rates, they typically operate with a leg, right? And then they impact fx, they impact, you know, overnight rates and various rates across the spectrum immediately, but then the secondary impacts on the economy tend to lag, right?

So, if you have a variable mortgage, well, you're probably going to see that over the next month if you have a five year fixed If not or a three year fixed, well, there's that lag effect, right? So, so far, all these interest rate changes have resulted in about a 15% drop in, in prices from, from the peak that we saw in, in February of 2022.

Some markets have fared better, some housing types have fared better, others, worse sales to listing ratio is at 50%. So what does the inventory picture look like: it's definitely better than what it was, let's say, two years ago where housing stock was sitting at, let's say two months of inventory.

It's sitting at about four months because there's not that much sales activity that's going on right now. A lot of investors are sitting on the sidelines. So Canadian home sales, for example in January began at a 14-year low. So there's a lot of headwinds that are impacting not only buyers, but even, as John touched on, even the developers, you get higher, higher cost of capital, higher land costs. And, even as an extension of all of the pressures on developers, the latest federal kind of restrictions on foreign buyers actually is a headwind for REITs and developers that are looking at buying up land.

Or mixed use properties that are publicly traded and have a foreign investment base. Right? So again, the picture in Canada, like the US is, there's not enough supply. And so what that has resulted in is a lot of growth into the rental market. So the purpose-built and then also the condominium rental market where vacancy rates are less than 2%.

Rents have continued to move higher. Right? So you couple that with higher borrowing costs. Low stock in terms of the inventory environment, strong demand. Still people need to find a place to live. And then immigration that continues. You know rise considerably as we move forward. It's essentially pushing everyone or those that are, are the most I, I guess the most kind of on the bottom of the spectrum in terms of income and what have you to the rental market because affordability is really, really bad here.

We haven't seen affordability at these levels since the 90s.

Chris: Okay. Wow. That's I guess the function of what the interest rates are trying to do right now, I guess.

Nadeem: But Yes, but just based on the last point, like 50% of household disposable income, believe it or not. Right. Just on the affordability, just because I want to hammer that home.

Right. That 50% of disposable income for a given household is dedicated to housing related expenses. Wow. So servicing your mortgage, utilities, et cetera. We haven't seen these again since the early nineties.

John: We were, we were talking about this on the pre-call too, though, how the US market is very different right now than the Canadian market there.

Right? Where in a way, we had a lot of adjustable rate mortgage. And, so the housing market and the consumer was very sensitive to rising rates. We don't have that here in the states right now. In the last three years, more than half of mortgage mortgages have been refinance into a, an ultra low 30 year fixed rate.

ARMs (adjustable rate mortgages) have been two to 10% of originations in the last. Five years, right? I mean, they're just, they're almost non-existent in the US so it's almost as if, as opposed to purchase money and new production homes, the housing market is a little less interest rate sensitive in the US cause homeowners will just sit on that 30 year picture rate that they have right now.

Nadeem: And what are median prices sitting at? John, if I may.

John: I don't have that number right off the top of my head. I mean, they're high. They're, you know, certainly coming off their peaks. Maybe you look at Case Schiller. Case Schiller's come down six months in a row now. But you also have to realize that housing prices went up 40% during the pandemic.

Yes. Even if we had a 10% drop, we'd still be net positive to where we were kind of 2019 levels.

Chris: Nice. Okay, let's switch gears now. One of the other interest rate sensitive segments of the market, autos and auto loans. John, over the past couple years, automakers couldn't keep up with demand.

Now you're seeing the Tesla keeps cutting prices. They're not the only one. So what's going on there with autos? Have we have we now overproduced the autos to a certain thing and now it's moving back towards the consumer.

John: No, Tesla's a little different. Let's talk about the overall market first.

We still have a shortage of vehicles going to the lot. It's better than it was a year ago, but it's still not back to kind of pre covid level. So there still is that supply chain lag. That's impacting new vehicle sales. Used vehicle prices are very high. They're off their pandemic highs.

The Manheim Index has. For a number of months. It might have found its floor in January or February. It did bounce kind of back up. So hopeful that maybe that stabilizes a little bit. But until we see, you know, true inventories and lots kind of come back to where they were and there's some argument that dealerships don't ever want to get back to, that they like the pricing power that they have right now in being able to just say, Hey, no haggling on price.

The price is the price and you're going to take it. And so the consumer has now to face that. In the EV space and, and specifically Tesla and Ford. The Biden administration rolled out that new package here lately to encourage and extend tax credits. So what Musk has discovered, and he's on record kind of saying he had to drop.

The prices of his Tesla cars to be able to benefit from the tax credit because there's a certain price threshold listed in the regulation that gives, if the value of the car is over a certain number, you don't get the tax credit. So once he found out that he dropped it to that level, guess what?

Sales rose, because American consumers were taking advantage of the tax credits that were associated with it. So you know, and just again, recently dropped prices again because he found out. You know, sticky, how that was, that those incremental changes in price really drove sales. So, he's still trying to ramp up production.

He's still trying to show that he can produce enough vehicles and that demand is there and it does seem to be pretty strong for Tesla.

Chris: Now in terms of delinquencies in the auto market, is there any concerns there or are people pretty much paying?

John: Well, that's a tale of two halves.

The lower end of credit subprime is starting to grow, no question. Younger Americans are struggling to make their car payments. There is a growing worry that when we start restart student debt payment. Later in the year, what might that do to kind of further blow out? Right delinquencies in auto.

So yes, certainly in the younger and lower categories of credit, we are starting to see some signs of crack there. Yes.

Chris: Alright, let's just finish off then with just a general around lending credit products, credit cards. How are the rates looking? There are credit cards going to start going up?

I mean, they already charge a fair amount, obviously in interest. Yep. But what are the expectations going forward there?

John: New York Fed did a great writeup on that. Liberty Street Economics, if you want to look it up, it was their February blog post. Similar story to autos where autos are at least fixed rate loans.

They're high fixed rate loans, but they're fixed credit cards adjust with rates. So, that adjustable rate, higher interest payment is really starting to take a bite. It again, has taken a bite on. You know, younger lower income individuals, those are being impacted. You are starting to see delinquencies break through pre pandemic levels and that's certainly a worry couple that with personal loan lending is at a long time high.

You've got two flashing indicators there that the consumer is struggling to keep up with payments.

Chris: Right. And in Canada, Nadeem, I know we're starting to see headlines around these higher rate mortgage providers and that sort of thing. What's it look like in Canada right now in terms of this?

Nadeem: So we just went through our earning season here and with the focus on the banks, the biggest lenders in Canada. So, they set aside about two and a half billion dollars for provisions against losses, credit losses. Credit losses can be related to commercial loans, credit cards, auto loans, any type of loans, housing loans as well.

Right. That's the biggest number or increase we've seen as an in aggregate than we saw since the COVID crisis. Right? For context in Q1 of 2022, the provisions that were set aside was about 373. We're sitting at about 2.5 billion here. It's definitely higher than where we were a year ago.

The highest we've seen since COVID. That was you know, a very unique type of event that was happening. I think where the expectations are going forward, like we are seeing, higher rates all else equal, they're going to start pinching the ones that are most exposed to the floating side of things.

Those that purchased a house by going to floating rate and kind of reaching, if you will, whether it was on the housing side or, used your house as a credit card. Those are being home equity line of credits. Those will move up with changes in overnight rates again, floating rate.

So what we're essentially seeing is the early signs of losses that are occurring. But it's not on the housing side, it's on the credit card. It's starting to see some on the auto loan side as well.

Chris: the banks are starting to prepare what's going to come.

Nadeem: Yes, exactly.

Like a lot of these are provisions. They're not actual losses that have been booked. Like they're putting these aside in anticipation of losses to come. What we saw during COVID was a lot of capital that was set, but then essentially were not realized. And so that actually went back into the business, or into the lending aspect of their operation. What we're starting to see here is the early signs of this. But I think if we step back a bit, employment levels in Canada, in the US and, and John can add to this, remain very strong. ADP numbers came out in the US, the employment pictures is fairly robust.

And I think that is the key kind of silver lining here. Where it may not be a perfect match for investors or job seekers that are looking for a job. But there four jobs available, then there are active applicants, right? As long as that picture remains relatively skewed towards you know, employees or those looking for jobs, they can borrow from their credit card on your MasterCard and pay Visa...

You know, use their income to cover their expenses. But it's usually when the job losses start moving up that we start seeing these losses and delinquencies start inching up.

John: Yes. Echoing that on, on the US side. If we think back to 2008 and everybody wants to draw parallels, but it's two totally different instances of the cause.

But if we are higher for longer and inflation does hang around for longer, I think the better indicator for credit will be those income thresholds. I think the people who are lower wages, lower incomes, 50, $75,000 a year, if they have an 800 FICO or a 600 fico, it doesn't matter.

They have to stretch a dollar further to make it work and they have to prioritize payments, whether it be the mortgage, whether it be the car, whether it be the card, those are all things that I think are starting to come into focus because inflation isn't going away as quickly as many hoped. And, rates are not making it any easier for consumers if they do indeed want to get more credit.

So it's going to be a real interesting next 12 months, particularly if we're looking at kind of a similar rate environment, say six, nine months from now.

Nadeem: One more thing I just might add, and John, I'd love to get your thoughts on this, one of the things that we've done is we looked at context.

Everyone wants to look let's say 2007, 2008 or even 2000. But in both of those periods or even the lead up of those periods, we never saw the sheer magnitude of a tightening cycle that we're seeing today. And for listeners, in fact, we haven't seen this level of tightening since the seventies, eighties in terms of the steepness and, the sheer pace of the change, right?

It's easy to draw parallels to whether it's COVID crisis or 2008, in 2000. But again, the sheer magnitude of what we're seeing in this environment is not even comparable to what we've seen over the past 20 years. So I just want to add that to the context and the discussion, because again, we're seeing things move very quickly the last cycle.

From the beginning to the end from tightening to pause and cuts, it essentially was way longer than what we're seeing here in this cycle, which has only been one year, and there's talks of a peak. I just wanted to highlight that we could start, we can say we're seeing early signs of decay here, or delinquency and, in a matter of a few months, we could be back on here saying a different narrative, just to get your thoughts.

John, what's your perspective on that?

John: Well, no, you're, you're absolutely right in that there's a couple of arguments that say, you know, the world's more instantaneous. You make a hike and it's immediately impacting on the economy. I don't subscribe to that. I think it takes six months for a hike to work its way through the system.

So if you think about that, we only started the hiking process in March of last year, and we didn't really start the 75 basis point hikes in the States until the latter part. . So those haven't really rolled through yet. And, that's kind of what a lot of the bankers are sitting around in, in our space, kind of wondering when is that going to hit us?

When is that going to drag us down a little bit more? Or is there something that we're missing? Is the consumer more resilient? Do they still have savings because we didn't save. We did get thrown 5 trillion during you know, during COVID. What happens when we eat through those and, and how does that, what breaks, I think is the question that a lot of people are asking that we haven't seen yet and, and we're still looking for.

Chris: Well, John and I want to thank you very much. Of course, we'll invite you back so we can continue to monitor this important part of the economy and, get the information out there to the listeners. So, I hope you will join us again. And, John, safe travels.

John: Yep. Thank you. And apologies to the listeners for the scratchy voice.

Maybe next time, I'll sound a bit more normal, but really enjoy this conversation. Thanks for the invitation. Thank you.

Nadeem: Thanks again, Chris.

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