12% of Canadian Mortgages in Arrears, Key Oil ETF Hits Snag, Unemployment Continues to Rise

This week saw the release of some grim economic data, a weird twist on the oil problem, some positive days of trading, and the beginning of the reopening process for North America. Canadian investors should be aware of the risks currently on the horizon, which include:

• A growing fraction of Canadian mortgages are in arrears, as borrowers miss or defer payments. This poses risks to both the housing market and the lenders that write these mortgages.

• Unemployment in the US and Canada continues to reach dire levels

• A key oil ETF has lost its clearing partner, which could affect the greater market for WTI

The biggest story of this week, however, is that the chairman of the Canadian Mortgage Housing Corporation warned Parliament that 12% of Canadian mortgages are in arrears. The chairman also expects that number to grow to 20% by September, which is truly a wild number to think about.  

Values of Canadian Homes to Fall More than 10% 

The most obvious effect of Canadian mortgages starting to decline in quality is that lenders will be less eager to provide these mortgages. That, in turn, will cause the great pool of house-buying funds that Canadians draw on to dry up, and the price of Canadian homes to fall. The CMHC projects that the values of Canadian homes will fall by 9-18% in the coming 12 months.

Source: CMHC

There's also a problem that occurs with sudden events like the COVID pandemic. The amount of loans that banks can afford to write off and the amount of loans that banks can afford to write off at one time are very different numbers. Since the COVID pandemic put a lot of people out of work all at once, that puts a lot of loan books and lenders under stress. The risk management model for something like mortgages might not factor in a significant fraction of loans becoming distressed at the same time, so we'll be closely watching regulatory filings from the major financial institutions. 

US Unemployment at the Highest Level Since Great Depression 

The US's April unemployment figures were released this week, and there's not a lot of good news to be found. 14.7% of the American labour force is out of work, with unemployment exceeding 20% in three states.

• Nevada, which has a significant tourism sector, reports 28.2% unemployment

• Michigan, which is probably best known for auto production, reports 22.7% unemployment

• Hawaii, which also relies on tourism, reached 22.3%

Unemployment will continue to remain high as long as broad swaths of the economy are either shut down completely or significantly affected by COVID-19. Note that while tourism is the most obvious victim of COVID-19, states like Michigan (not known as a global attraction) can still be affected.

Unemployment will also weigh on the recovery from COVID-19. A fast, V-shaped recovery relies on a strong consumer with "pent-up" demand, and a consumer who has been unemployed for weeks or months is not going to be eager to book a trip to Las Vegas or Maui, regardless of when restrictions are lifted. 

Important Oil ETF Loses its Clearing Partner 

USO, an ETF that attempts to track the price of oil, has hit a key snag that could send ripple effects through the oil markets.

USO is something of a unique commodity ETF, in that it can't simply buy and hoard a representative quantity of the commodity it's trying to track, the way a precious metals ETF could. The price of oil that USO is trying to track is the price of a front-month WTI contract, which means that every month the fund's managers have to roll their holdings from contracts in one month to contracts in the next month. For example, the market for WTI contracts has recently switched from trading June contracts to July contracts, and as part of that USO would have had to sell its June contracts and buy July contracts.

You might remember USO for the speculation that this rolling process might have played a part in the price of WTI contracts reaching -$37 in March. If there are no buyers willing to take on USO's holdings as contracts approach expiry, and the ETF can't simply hold onto them, we get a very motivated seller in a really bad spot.

Source: Bloomberg, May 22nd 

This week, USO filed a report with the SEC disclosing that it had lost its one and only clearing partner, the financial institution that facilitates all its trades. Without a clearing partner, it's not clear how the ETF can roll its holdings or continue its operations. It's also not clear who's going to be USO's next clearing partner, as selling an already frazzled risk management team on clearing billions of dollars of WTI contracts can't be easy.

To conclude, a big ETF that has a history of moving the needle in the WTI market is experiencing a pretty critical operational problem. How will that affect the already delicate oil market? Nobody knows!

If you'd like to talk about these events or discuss your portfolio, don't hesitate to reach out to us at 604.643.0101.