On the Canadian housing market

Today’s commentary

Fitch, the ratings agency, has reversed itself on Canada. It now believes that the housing market there is poised for only modest declines at worst. Previously, Fitch had said that Canada’s housing market was well overpriced and that a major correction was a serious risk. I believe the combination of high prices and high household debt means the risk of a major correction is still there.

Every survey of global house prices one consults, shows Canada’s residential property market to be significantly overvalued. And this dates back some time now. Let me chronicle how the housing market run-up in Canada has been covered in the media. 

When the Economist surveyed house price gains in 2005 during the global housing bubble. Canada was only middling in terms of gains. In the eight years to 2005, house prices had soared by 244% in South Africa, by 192% in Ireland, by 154% in Britain, 145% in Spain, and 114% in Australia for example. But Canada’s gains at 47% did outstrip inflation. By comparison, the US, the Netherlands and Denmark had burst housing bubbles with 73%, 76%, and 58% house price gains respectively in those eight years. While Sweden and France have not had crashes despite 84% and 87% house price run-ups.

When the financial crisis hit, Canada was scarred like most other economies across the globe. By the end of 2008, the central bank had cut interest rates to the lowest level since 1958 and then cut again in 2009 to 0.25%. In 2009, we saw the biggest drops in GDP since record-keeping began in 1961. Even while we saw Greater Toronto Area house prices fall 10% year-on-year by October 2008 and cracks appear in Vancouver’s condo boom, the market did recover and begin to scale new heights.

The mantra even then was that Canada’s housing situation is not the same as in the US – meaning there was no bubble. Part of Canada’s strength came from the banking sector’s reliance on traditional deposits instead of on wholesale funding because the crisis can be seen as a run on wholesale interbank funding markets. But underwriting standards at Canadian banks were also superior to the standards in the US. Subprime was less of an issue. Equally, the adjustable, no-doc, teaser rate mortgage situation in the US never made its way to Canada. Moreover, the originate to distribute model related to mortgage-backed securities meant that Canadian banks had ‘skin in the game’ and that certainly should help mortgage underwriting standards. And very importantly, most loans are backed by a government guarantee, making the banks less vulnerable to housing shocks and therefore less prone to runs.

Here is a list the Canadian Home Builders’ Association drew up in December 2008:

Summary

There are enormous differences between the situation in the Canadian housing market and the dramatic downturn that is afflicting the U.S. housing market. Significant differences between the situations in Canada and the U.S. are discussed in detail in this report – in summa ry, key differences between the Canadian and U.S. housing markets include:

• Unlike the situation in the U.S., underwriting standards for qualifying mortgage borrowers in Canada have been maintained at prudent levels. As a result, mortgage borrowers in Canada have been much more creditworthy than in the U.S.
• Canadian mortgage lenders never offered the type of low initial ‘teaser’ rate mortgages that led to most of the difficulties for mortgage borrowers in the U.S.
• Most mortgages in Canada are held by their original lender. They are not packaged and sold to third parties as is typical in the U.S. Consequently, Canadian mortgage lenders have a vested interest in ensuring that their mortgage borrowers are creditworthy and not likely to default.
• Arrears experience confirms the creditworthiness of mortgage borrowers in Canada – 0.3% of Canadian mortgages are in arrears at present. In contrast, 4.5% of U.S. mortgages are currently in arrears and more than 2% were in arrears even in the more buoyant economic times of 2002-2006.
• Mortgage insurance in Canada is mandatory for all high-ratio (80%+ loan to value ratio) mortgage loans – so mortgage holders are protected in the event of default. In the U.S., borrowers could avoid mortgage insurance by taking out ‘piggy-back’ loans, which were uninsured – and, therefore, much more risky for mortgage holders.
• CMHC mortgage backed securities (MBS) are packaged mortgage loans which are backed by the government of Canada. Investors in CMHC MBS therefore have protection in the event of default.
• The Canadian ‘sub-prime’ market is only one quarter the size of the U.S. sub-prime market. Also, the Canadian below prime market is better described as ‘near-prime’. Due to the higher-quality of Canada’s ‘sub-prime’ mortgages, the incidence of defaults will be much lower than in the U.S.
• Canadian homeowners typically have much greater equity in their homes than U.S. homeowners – in part because mortgage interest deductibility in the U.S. reduces the incentive of homeowners to pay off their mortgages.
• In the event of mortgage default, Canadian lenders (and mortgage insurers) generally pursue borrowers and attempt to seize assets and garnishee wages. This is less prevalent in the U.S., so delinquent borrowers can ‘walk away’ from their obligations more easily than is the case in Canada. Homeowners in Canada have a greater incentive to work their way out of mortgage difficulties than U.S. homeowners.
• Canadian banks are recognized to be among the strongest in the world. Unlike in the U.S., the availability of mortgage funds is not an issue in Canada. Housing price increases in Canada were generally more moderate than the precipitous increases in housing prices in the U.S. – and the easing of housing prices in this country has been correspondingly mild.
• Inventories of new unsold homes in Canada are small and manageable. There is nothing in Canada to compare to the vast oversupply and plunging housing prices that characterize many U.S. housing markets – nor is such a scenario likely to occur for the foreseeable future.

This is all positive for Canada. But many other markets had some or all of these features yet still had housing bubbles that popped. The Netherlands and Denmark come to mind. So the mantra of no-bubble isn’t entirely accurate.

In any event, the rise in house prices continued when the Canadian economy recovered in 2009. By December of that year, I was asking “Is the Canadian housing market a bubble?” My answer has been yes. But that doesn’t mean the bubble will pop anytime soon.

In February 2010, the Wall Street Journal wrote a post explaining that the housing rebound in Canada was spurring talk of a new bubble with house prices having risen 23% already from a trough in January 2009. Sales volumes were up 70% in that time frame. By April, I spotted what I considered bubblicious mortgage deals for no money down mortgages being hawked in the Canadian housing market, a telltale sign of froth. But the Canadian regulators tightened up on mortgages and those deals soon disappeared. Canadian economist David Rosenberg who saw a bubble in February switched to a more bullish outlook on Canada housing.

If we fast-forward to early 2012, however, it then becomes clear that the Canadian housing boom was unstoppable. House price-to-income ratios outstripped the norm by a full 35% according to the Bank of Canada. The Central Bank was alarmed as the price to income ratio of 4.75 compared unfavourably to the norm of 3.5. And household debt was above 150% debt to GDP and rising. Canadian policymakers did have some success in slowing the rate of house price growth in 2012 via macroprudential regulation but the prices kept rising afterward.

By early 2013, Moody’s had had enough. They downgraded the entire Canadian banking sector, writing that “high levels of consumer indebtedness and elevated housing prices leave Canadian banks more vulnerable than in the past to downside risks the Canadian economy faces”. And since then all housing market surveys show that Canada’s market is wildly overvalued.

In January 2013, the Economist pegged Canada’s housing market as 34% overvalued on a price-to-income basis, similar to the Bank of Canada but they also saw Canada as 78% overvalued on a price-to-rent basis. Just this month, the Economist updated the figures. What they saw was Canada as 31% overvalued on a price-to-income basis and 76% on a price-to-rent basis, almost the same as 2013. And the latest figures for household debt show household debt at a near-record 163.7% of disposable income.

So where is this headed? I believe the end of the commodities boom will slow growth in Canada as it has done in the Australia. The Canadian jobless rate topped the US rate for the first time in five years this month. And economic figures are softening.

Against this backdrop, we are seeing record building in Toronto, one of the major boom markets. There are 116 condo projects in Toronto, compared to only 32 in the larger New York City. Meanwhile, In Toronto, a record 20,000 new condos will be finished in 2014 – a total of 60,000 are being built.

A historical perspective of condo building in Toronto (GTA) via @TorontoBubble pic.twitter.com/TXWoP5xELS

— Edward Harrison (@edwardnh) January 21, 2014

And profits are dropping in the Toronto condo market. Yet everyone is optimistic. 

“I think we’re entering into a new cycle in terms of new condo sales,” says Shaun Hildebrand, senior vice president of Urbanation and a long-time market watcher. “We’re moving out of this volatile period and entering a new period of stability.”

Record housebuilding, high levels of consumer debt, overpriced housing, and general optimism make Canada look a lot more like the US than it did in 2008. The mortgage market is more sane in terms of underwriting. However, that does not mean that Canada is immune from house price bubbles. I believe the evidence is clear that Canada’s housing boom has crossed the line into bubble territory. And when bubbles pop, they do so violently. Canada may be poised for a modest decline in 2014 but the house price situation will eventually end in big losses for house prices in Canada, losses greater than the 10% we saw in Toronto in 2008.