Canada's Housing Bubble

November 26th, 2009 Garth Turner greaterfool.ca

As I was working on my new book this week I ran a few numbers. The inspiration came from this blog. Actually a few bloggers have been included in the text. But I will not reveal who. Paparazzi being what they are these days.

The argument put forward by several is that, yeah, houses are probably overvalued and, yep, the market will correct. But they do not foresee any large dump of America-style epic proportions – such as the 50% drop in Miami condos or the 70% plunge in two-storey suburbans in Phoenix or southern California.

Instead, they like to contemplate a 10% or 15% decline to ‘more normal’ levels, which they  believe will then remain in place for a number of years. The rationale behind this soft landing is a conviction interest rates will stay frozen at current levels from here to the horizon. This is a comforting scenario to many homeowners for obvious reasons. Then they don’t look like financial idiots for buying in 2008 or 2009.

soft landing1

But I disagree. That gentle-decline scenario is not going to happen.

Nonetheless, if we did have a 15% decline and prices went into a long-term holding pattern, what might a recent buyer expect? As mentioned here the other day, a majority of new purchasers have been  getting in with 5/35 mortgages. This means any kind of correction would be hard to stomach, since the only rational reason for a 35-year am and a weensy down is the certainty of a bull housing market to cover up your mistake.

So, let’s imagine you are one of the legions of people who have bought a first home in an idyllic wonderland like Mississauga, for $528,000 with 5% down.

Chart 1

Now let’s suppose the housing market declines in late 2010 when the Bank of Canada starts raising interest rates, Dubai sinks into the sea under its own debt weight, unemployment continues to rise, Obama is handed his shorts in the US mid-terms, the HST clicks in and the reality dawns on folks the economy is entering into a few years of stagnant, side-sliding ennui. In that case, a 15% drop in market prices might well occur. Suddenly our homeowner realizes he owes more in mortgage debt than he owns in house.

So, is selling an option? Let’s look:

Chart 2

In other words, for this guy to unload the house, he’d have to show up on closing day with a cheque for $82,440. And, of course, he’d have lost almost $120,000 on the deal itself – not to mention a couple of years of mortgage payments and all that stuff he bought for the new home. That would be a loss on invested capital in excess of 300%.

Now I hear some blog dogs yelping, ‘So what G? Why wouldn’t he just keep the house and wait for better days?’

Absolutely. That’s an option. But not a long-term one if the scenario of multiple years of slow growth unfolds. For all that time, while house prices remain below bubble levels, this guy is feeding a mortgage worth more than his home. Every month it is a drain on wealth, cash flow and manhood (hey, it’s a guy thing). I’m betting than a significant number of recent first-timers will freak at that, and bail. Personal bankruptcy rates will rise as a result. And house prices will decline further.

But, as I said, I don’t expect that to happen.

Instead, markets that rise exponentially tend to decline in the same fashion. The longer current conditions last, the higher prices go, the more elbows raised in anger at condo offerings, the more denial, the more bidding wars and the more time emergency interest rates are in effect, the more reactive will be the consequences.

Unless, of course, it’s different this time. But it hasn’t been yet.