Canada's housing market can't stay hot forever

Juiced by the efforts of the CMHC, our housing market can't stay hot forever.

Canada’s housing boom is beginning to crack. The number of homes sold dropped considerably this summer in two of the nation’s largest cities, Vancouver and Toronto. Condo sales in the latter shrank during this year’s second quarter, the first time that’s happened in 16 years. Resale prices are falling. Yet all this fits neatly with a prevailing opinion among realtors, economists and federal officials: that a combination of new harmonized sales taxes in Ontario and B.C., stricter lending standards and looming interest rate increases “front-loaded” sales into the first half of this year. Activity and resale prices will drift gently downward for the remainder of this year and the next, but Canadians will be too busy enjoying their sound banking system to notice.

This sanguine consensus overlooks how the federal government stoked the housing market over an extended period, particularly during the recession. The result is that sales have been front-loaded for far longer than many suppose. Canadians should brace themselves accordingly for a more jarring correction in residential real estate.

The Canada Mortgage and Housing Corp. plays a critical, if underappreciated, role. Its main activity involves insuring mortgage lenders against the risk of borrowers defaulting on payments. (Canadian law dictates that lenders must insure any mortgage amounting to more than 80% of the property’s value.) Introduced in 1954, this insurance allows higher-risk borrowers to obtain mortgages at terms comparable to others who’ve saved more.

CMHC sets the bar for home ownership through its minimum qualifying standards for that insurance. During the last decade it has lowered them. Whereas mortgages traditionally amortized over 25 years, for example, CMHC began insuring ones stretching as long as 40 years. Extended amortizations lengthen the period during which mortgage holders carry little equity, placing them at greater risk of defaulting. More dangerously, it began insuring mortgages for which buyers made no down payment. “If people were able to purchase houses with zero down, they were doing that,” says Jerry Marriott, a managing director at bond-rating agency DBRS. “If people were able to purchase houses with longer amortizations and therefore have a lower monthly payment, they were doing that…That was partly what was supporting an increase in house prices.” Since 2008 standards have tightened somewhat, but they remain below historical norms.

The Bank of Canada did its part. Officially, it sets the overnight rate (the short-term interest rate at which financial institutions lend among themselves) primarily to keep inflation in check. That rate stood at 5.75% a decade ago but has trended lower ever since. Interest rates are a powerful influence on consumer behavior: lowering them encourages citizens to borrow and spend, while raising them rewards savers and punishes debtors. The housing market is particularly sensitive to interest rates: they’re critical in determining a mortgage’s monthly carrying costs.

Between September 2008 and April 2009, the Teranet-National Bank House Price Index (which measures pricing data from public land registries) lost 8.4%, a drop many observers incorrectly assumed marked the end of Canada’s housing boom. But the market rebounded sharply last year, regaining all that lost ground and more. The average Canadian home price peaked in April 2010 above $344,000. What happened? In its efforts to cushion Canadians from the recession, Ottawa electro-shocked the housing market. “There was this absolutely massive assault on the recession by focusing on the housing sector,” says David Rosenberg, chief economist and strategist at Gluskin Sheff. “And probably that wasn’t an unwise decision, when you consider all the powerful multiplier impacts it has on the rest of the economy.” Housing-related spending ??? a broad category that includes not only home purchases but also furniture, appliances, renovations and a host of other items — accounts for one-fifth of all economic activity. Rosenberg says federal measures to stimulate housing markets accounts for 100% of Canada’s economic recovery.

Two tactics stand out. The first was that the Bank of Canada lowered the overnight rate from already bootlicking levels to a rock-bottom 0.25%, where it languished for much of last year and this. RBC economist Robert Hogue called the resulting low mortgage rates “undoubtedly the rally’s most powerful driver.” The second was that Ottawa authorized CMHC to buy up to $125 billion in mortgages from banks and other financial institutions under the Insured Mortgage Purchase Program (IMPP). The idea was to ensure lenders had a ready source of funding when traditional methods had been closed, which in turn allowed Canadians to keep borrowing. “This was a very good thing,” says Tsur Somerville, an associate professor at the University of British Columbia’s Sauder School of Business. “Financial system meltdown is a whole lot worse than governments taking on some additional mortgage-default risk.”

The IMPP got off to a blistering start during the fall of 2008. But interest had waned considerably by its termination this spring, and CMHC ultimately bought just $69.4-billion worth. While some took that smaller-than-expected sum as proof of Canada’s resilience, it’s still enough to buy 500 F-35 Lightning II fighter jets. (Canada’s recent $9 billion outlay for 65 F-35s ranks among the nation’s largest-ever military hardware procurements.) Or 200,000 typical Canadian homes. Seldom has so much money been spent with so little discussion.

There’s no universally agreed definition of bubble, but telltale symptoms include a dramatic run-up in prices accompanied by surging debt. Canada exhibits both. Home prices nearly doubled since the turn of the millennium. Incomes didn’t. Rather, the value of outstanding mortgages surged from $427 billion to nearly $930 billion during the same period, which helped catapult the average debt-to-income ratios of Canadians to 145%, just shy of current levels in the U.S. and Britain. The Bank of Canada is mildly concerned. “Household balance sheets are still a significant source of risk,” it reasoned in its latest review of Canada’s financial system, “since the rapid expansion of consumer and mortgage credit implies that a greater proportion of households are likely to become vulnerable to adverse income and wealth shocks as interest rates rise from their exceptionally low levels.”

Excessive exuberance is another symptom, and if this year’s annual RBC/Ipsos Reid Housing Poll is any indication, Canadians expect home prices will continue appreciating well into the future. Released in March, the Ipsos survey found that 91% of Canadian homeowners think real estate is a good investment — “the highest level in 12 years,” the pollster observed.

More than a quarter of respondents also said their home would provide their primary source of retirement income. That suggests many of them haven’t considered how changing demographics might affect their investment. The surge of postwar births provided a surging supply of homebuyers over the past few decades as baby boomers bought their first homes and then upgraded over time. Now the earliest boomers are entering their retirement years. And seven in 10 Canadian households own their residence — a remarkable level of home ownership witnessed in only a handful of other nations, including Britain, Australia and the U.S. before its crash. In other words, most Canadians who can afford to own a home already do. Barring a sudden influx of wealthy foreigners, it’s tough to guess who will drive long-run demand.

Here’s the thing about bubbles: they can persist for lengthy periods, and are evident only in retrospect. But the unwinding of powerful housing-market stimulus is already underway. Ottawa terminated the IMPP on schedule in March. It has tightened CMHC’s lending standards, albeit modestly. And the Bank of Canada began ratcheting up interest rates this year. Renewed government intervention cannot be ruled out, but it would be expensive and only delay the reckoning.

When Canada’s correction arrives, it’ll likely prove less traumatic than America’s ongoing catastrophe. The latest statistics from the Mortgage Bankers Association shows that around 10% of American mortgages were behind in their payments, not including the nearly 5% that are in foreclosure. Canada has never witnessed such levels, and likely won’t anytime soon for a host of cultural, regulatory and financial reasons. For one thing, Canadian lending practices remain more conservative than those witnessed in the U.S. during the mid-2000s. Even the zero-down, 40-year mortgages CMHC insured between 2006 and 2008 seem restrained compared to American NINJA (no income no job or assets) loans. Furthermore, tax deductibility of mortgages encouraged more debt accumulation south of the border; Canadians, who typically borrow for five-year terms, have more incentive to pay down mortgages faster, and do.

Canada’s lenders generally have legal recourse to borrowers, meaning they can pursue a borrower’s other assets in court in the event of foreclosure. That makes it more difficult to simply abandon a home that has become a financial albatross, as countless Americans have done. Rather than a cataclysmic surge in mortgage defaults, most overextended Canadians will likely absorb the damage on their personal balance sheets. This should contain the slide in prices — but it might also mean more Canadians retiring in poor financial condition in the years ahead. And it would also imply a substantial reduction in labour mobility, with stricken homeowners shackled to their real estate.

It would be more painful still for Ottawa. CMHC’s mortgage insurance portfolio grew 235% over the last decade, and it covers many of the nation’s riskiest mortgages. Reduced lending standards suggest elevated future claims await. CMHC has accumulated reserves that could absorb substantial losses. But Rosenberg warned clients earlier this year that while Gluskin Sheff is not predicting a taxpayer bailout of CMHC, that eventuality “is near the top of our concern list.”

Canada’s economy would sustain damage as the wealth effect shifts into reverse. Still, a correction is the solution, not the problem, and preferable to allowing the bubble to persist. Ottawa’s activities during the recession spared us greater misfortune, but we have yet to pay the bill. It’s in the mail. And it’s going to sting.