Canada's Housing Bubble

Apr 30, 2010 2 Cents balancejunkie.com

The only reason a great many American families don’t own an elephant is that they have never been offered an elephant for a dollar down and easy weekly payments. -- Mad Magazine

I’ve heard a lot of people on both sides of the border extolling the virtues of the Canadian mortgage and banking system over the past year. Our mortgages are recourse loans, mortgage interest is not tax deductible, and our banking regulations are more stringent. We crafty Canucks have even managed to inflate a housing bubble during the worst recession since the Great Depression. Wait. Is that good?

If it sounds like that makes no sense, maybe it’s because it shouldn’t. Recessions are supposed to be a pause that refreshes our capitalist economy. Without failure, there is no capitalism. Recessions are like forest fires that clear dead wood and lay the foundation for new, more vibrant growth.

Controlled Burn or Dead Wood Rising?

When the credit crisis threatened to burn down the global economy, governments worldwide poured buckets of money on the fire. The U.S. government, firefighter in chief, rescued Fannie Mae, Freddie Mac, AIG, GM, Chrysler, and many others. Although Canada’s housing market and economy didn’t suffer to the extent of other nations, our government stepped in to provide additional backing to the Canadian mortgage market through the Insured Mortgage Purchase Program.

While the Canadian government didn’t need to rescue the CMHC (Canada Mortgage and Housing Corporation), they did raise the limits on the amount of mortgage debt that it could insure. These supportive measures encouraged banks to lend by effectively offloading the risk of losses onto the taxpayer. To provide further stimulus, the Bank of Canada lowered interest rates to rock bottom levels.

The goal was clear: control the burn. The likely result is not yet clear, but will become so in the near future: we saved the dead wood. With all that dead wood still standing, there’s no way that healthier trees will have a chance to take root and grow. Further, it serves as a huge tinder box that could make a controlled burn impossible should the right spark ignite it.

Potential Sparks

If I’ve lost you in the forest with all of this, let me spell it out here. The CMHC issues mortgage-backed securities, which are basically pools of mortgage debt, and sells them to large financial institutions and pension funds. CMHC underwrites the risk, so that if borrowers default on their mortgages, the lender is not on the hook for the losses. CMHC is. Since the government backs the CMHC, that means taxpayers are on the hook for those losses. (Yep, that’s you and me and our money.)

So far, none of this has come to pass. There’s been no housing crash in Canada and no mass mortgage defaults. On the contrary, many people believe we have a housing bubble in Canada. But they also think that it is on the verge of popping and perhaps triggering the aforementioned price depreciation and defaults. There are a few factors that could spark a housing-led economic crisis in Canada:

• Tighter Lending Standards:  Low interest rates, long amortization periods, and low down payments have caused housing prices to rise beyond affordability. When these factors reverse, many homeowners may find it difficult to afford their mortgage payments.
• Low Savings: Canadians have very little money saved, so there is no cushion in case of financial pressure due to high unemployment and higher interest rates.
• High Debt Levels: With debt levels at record highs, Canadians have limited or no access to more credit should they need it. If lending standards tighten further (as they should), this situation gets worse, causing a slowdown in consumer spending.
• Moral Hazard: Banks have been encouraged to lend to unworthy borrowers (dead wood) because they will not suffer the losses if these people can’t pay their mortgages.

No Country for Old Men

Although Canada is often seen as The Country of Fiscal Prudence, many of the statistics belie that image. From 1999 to 2010:

• Credit card balances are up 458% from $12 billion to $55 billion
• Outstanding residential mortgage debt has grown 242% from $399 billion to $965 billion.
• Personal lines of credit are up 820% from $25 billion to $205 billion.

Like Fannie Mae and Freddie Mac, the CMHC was originally formed to help first-time homebuyers enter the market. Over the years, it has morphed into “a mortgage slush fund which distorts the market. It allows banks to lend recklessly without consequences and pushes up the price of housing for everyone. It rewards those willing to speculate with leverage and discriminates against those who are prudent.” That is a quote from a Financial Post article written by Diane Francis back in October of 2009.

I’m afraid we might be on the cusp of finding out just how true those words might ring. If interest rates begin to rise, housing prices will fall, and those who have borrowed beyond their limits will feel the heat. The dead wood will ignite and those who have been prudently saving will pay the price for the profligacy of their fellow Canadians.

How can we avoid this scenario?