Canada's Housing Bubble

Feb 02, 2011 Ben Rabidoux financialinsights.wordpress.com

There’s been quite a buzz about Vancouver detached homes hitting a new all-time high.  I will address that data in my monthly tour of board stats just as soon as the data packages are released at the other big boards, which should be on Friday.

In the meantime, let’s consider an article from the Globe and Mail (kind thanks to my number 1 fan Mango for the link):

Why a rate hike won’t be a blow to most

“And given that some 30 per cent of Canadians rent, about 58 per cent of households pay no mortgage interest. Coupled with that is the fact that the net equity of owners in their homes is “very high,” more than 60 per cent, compared to 39 per cent in the United States.”

And it includes this lovely graph showing equity levels in Canada and the US, as well as the percentage of households who own their home.

58% of Canadians pay no mortgage interest

Let me remind my readers that real estate prices are set at the margins.  In other words, in a stable demand environment, real estate prices fall simply if a small number of home owners run into trouble and are forced to sell.  If you doubt this, consider the sub prime fiasco in the US which blew sky high in 2005-2006.  Although in the year prior to the bust, subprime mortgages were roughly 20% of all new mortgage originations, as a total percentage of all US households they were still quite small.  And yet the market tipped and began its descent as these homeowners at the margins first ran into problems.  Keep that in mind as you read the rest of this post.

Let’s start by deconstructing the first fallacy:  Many Canadians do not pay mortgage interest, therefore a rise in interest rates is not a major concern.  Consider the fact that 58% of Canadians pay no interest, as noted in the article.  First off, 55% of Americans pay no interest on their mortgages, and it’s even higher than that given the massive amount of delinquent and foreclosed homeowners who still have a mortgage but who aren’t paying.

The math is simple.  Home ownership rate in America has fallen to 66% from its high of 70% meaning that there are 34% of households who now rent.  Of the 66% that are home owners, 31% own their home outright (roughly 21% of the total population).  Sprinkle in the millions of delinquent mortgages and we find that Americans likely have a greater percentage of homeowners who pay no interest than we do.  Given this fact, we might expect the US Fed to take a muted tone on prospects of rising interest rates.

Nothing could be further from the truth.  In fact, the Fed in the US is so terrified of higher interest rates that they have engaged in two rounds of quantitative easing in an attempt to lower them.  Why would they do that?  Their consumers are less indebted that we are and they have a comparable portion of homeowners paying no interest.  They should be able to shrug it off as the article suggests.  They can’t do that because it is precisely the marginal home owners who would be affected the most.

Let’s discuss some Canadian-specific data.  CAAMP data suggests that 11% of households would run into financial trouble if mortgage rates rose only 1.5%.  That’s not an insignificant number.  It is plenty to squeeze the market at the margins and ensure that distressed properties would hit the market at a time of falling demand.

The bottom line is that the fact that 58% of Canadians pay no mortgage interest means very little to the direction of real estate prices as it is the most vulnerable borrowers (evidently over 10% of households meet this criteria) who set the price trend if they are forced to sell due to financial reasons.

Home owner equity as a predictor of price movements

That brings us to home owner equity.  The average American homeowner currently has 39% equity in their home while the average Canadian home owner has 63%.  No comparison.

It’s been suggested by the mainstream media and commenters on this blog that our relatively high percentage of homeowner equity should act as a cushion during a potential correction, limiting downside pressure.

Before we discuss the dynamics that make this assertion false, let’s have a gander at how our American friends looked just prior to their bust (thanks to RP1  for this graph)

If you deduced that the average US homeowner had 60% equity in their home just prior to their real estate bust, pat yourself on the back.  As I have said many times, home owner equity always looks good at the tail end of a real estate bull run, but it has absolutely zero predictive value.  If home owner equity was distributed evenly, it absolutely would have the effect of supporting home prices.  But equity is not distributed evenly, and therein lies the rub.

To understand why, it’s important to know just how a major real estate bust unfolds.  All major real estate busts have two things in common, neither of which is high interest rates.  Both Japan and the US imploded even with record low interest rates.  Rather, all real estate busts begin when a group of borrowers run into trouble and are forced to sell their homes under distress.  At the same time, the illusion of perpetually rising real estate values which is central to any real estate bubble, for whatever reason finally lifts.

The small amount of distressed home owners find themselves having to sell at a time of stagnant or falling demand, thereby putting price pressure on the overall market.  The houses sold under distress become the new comparables to which others are compared.  As house prices begin to fall, buyers ironically become scarce.  Remember that one of Bob Farrell’s rules of investing is that people buy most at the top and least at the bottom in any financial market.  Where lower prices are seen as a good thing for consumer items, they are viewed inversely when it comes to investments, strangely enough.

As prices fall, more home owners find themselves in negative equity positions.  With the illusion of perpetually rising real estate values now gone, they consider defaulting.  Negative equity, not affordability, is the number one predictor of mortgage default, even in recourse jurisdictions.

As more and more distressed homes enter the market, either in the form of those trying to lock in potential gains (speculators) or by way of default and foreclosure, prices fall further.  Even more home owners find themselves in negative equity positions.  Rinse, repeat.

Indeed the average home owner equity position masks the fact that many home buyers in the past few years have little to no equity once transaction costs are taken into account.  It’s these home owners who would be the first domino to fall in the event of a real estate bust.  While our percentage of homeowner equity has remained stable, this in itself suggests a worrisome trend given that the rapid rise in home prices should be translating into a corresponding rise in equity position.  That it’s not is a reflection of either dwindling down payments, equity withdrawals, or both.

Ultimately we need to look no further than the US experience to see that homeowner equity has zero predictive value when it comes to forecasting real estate price movements.

Cheers

Ben