Outlook 2008 (Housing): Different up here

For a variety of reasons, Canada is an exception in the housing world, but on the heels of fed legislation this is gradually changing.

As U.S. housing markets experience a breathtaking retreat, will Canadian homeowners necessarily face the same fate? To be sure, Canada has a long-in-the-tooth housing expansion and risks are building. RBC’s nationwide housing affordability measure is at its most stressed level since the early 1990s, but is still shy of where it peaked shortly before that, when interest and unemployment rates both pushed into double digits. Other comparisons like house price-to-rent and price-to-income ratios are also stressed. In some heated western cities, like Edmonton, Calgary and Saskatoon, rapidly cooling housing markets are already evident.

But Canadian house price gains have paled by comparison since the global real estate cycle began in the mid-1990s. Average house prices in Canada’s priciest market, Vancouver, have risen by 80% since the mid-1990s — in sharp contrast to London, England, which saw a 270% rise.

One of the explanations for more moderate price gains in Canada is that laws governing the mortgage insurance marketplace indirectly limited the range of product offerings available to below-average-quality borrowers. Unlike elsewhere, Canada’s Bank Act requires that bank mortgage clients with less than 20% to put down on a house purchase must take out government-backed mortgage insurance, and banks dominate the mortgage market. Until the spring of 2006, however, banks faced little choice in pairing up their product offerings with only two mortgage insurers. This market structure handicapped product innovation such that an insured 25-year cookie-cutter mortgage was the only real product available to riskier borrowers, while the rest of the world saw many generally sound, new products. Such an innovation handicap, however, may well have saved Canada from embracing other products of dubious merit.

Because of this, Canada is the exception on a long list of international comparisons. Mortgage delinquencies have trended down in Canada throughout this decade, while they trended upward in the U.S. Insured mortgages are a much greater share of the Canadian mortgage book than in most countries. Canadian household debt as a share of income is about 40 percentage points lower than in either the U.S. or the U.K. Investor mortgages account for only about 2.5% of Canada’s mortgage market, almost all concentrated upon condominiums, compared with about 10% in each of the U.S., U.K. and Australia. About one-quarter of all Canadian mortgages have tended to be variable rate products, which is similar to the U.S. share but much lower than many European countries. In Canada, however, the low or zero introductory teaser rate mortgages being rapidly reset stateside didn’t start to exist until very recently.

Sub-prime mortgages account for around 5% of newly originated mortgages in Canada; this is somewhat smaller than the U.K., and a far cry from the one out of every four or five new mortgages at the U.S. peak. Outside of the banking mainstream, Canada’s sub-prime market is rapidly developing, but still lacks products like liar loans and no-income-no-job-no-asset (“Ninja”) mortgages that reflected a total collapse in underwriting standards. Canada also didn’t, however, adopt good products from elsewhere, like accordion adjustable rate mortgages (Belgium), multi-currency mortgages (Austria), green mortgages (U.K.) or mortgages with embedded house price options (Australia).

All of this is changing now, but in a gradual, conservative way after the federal government’s decision in the spring of 2006 to allow more global mortgage insurance companies to enter Canada. This is one reason that Canadian mortgage growth is running at a 17-year high and accelerating in defiance of credit crunch talk. Strong fundamentals like job growth and decent interest rates have supported the release of pent-up demand from the 1990s, but mortgage innovation is the more recent added kicker. RBC Economics is forecasting that next year will be the seventh consecutive year in which more than 200,000 homes will be built in Canada, rivalling the eight-year string in the 1970s, with resale price gains likely to be in the modest single-digit range next year.

New products started to arrive only over the past two years, and have included insured self-employed mortgages, a heightened focus upon the new immigrant segments that lack a born-in-Canada credit profile, insured investor mortgages and, most notably, longer-amortization products. Over 60% of monthly insured mortgage purchase applications are opting for longer than 25-year periods, and the 40-year mortgage that recently celebrated its first anniversary already accounts for about half of that activity.

More mortgage insurance competition passes the economist’s tests via lower premiums, greater product access and wider product variety while learning from excesses stateside. Dangers lurk in pockets of Canada, but no one can forecast housing markets today without understanding how change is sweeping through the mortgage business.

Derek Holt is assistant chief economist at RBC.