Canada's Housing Bubble

Dec 31, 2009 Canwest News Service

Federal Finance Minister Jim Flaherty has floated trial balloons as of late on the prospect of reining in borrowers before they inflate the Canadian housing market into a bubble — which assumes we are not already there. Options include scaling back Ottawa's guarantee of Canada Mortgage and Housing Corp.-insured mortgages from 35 years to perhaps 30 years, or requiring a larger down payment beyond the five per cent now required.

If the federal government moved on such musings, such actions would be in addition to previous actions to ward off a bubble taken by Ottawa in 2008 whereby the 40-year mortgage was taken off the table and zero-down mortgages were also done away with. One option not on the table is a rise in interest rates; responsibility for such an action is in the hands of Mark Carney, governor of the Bank of Canada, where it properly belongs.

But interest rates will rise. Carney has only promised to hold rates down until mid-2010 at which point all bets are off. Timing of an interest rate rise will depend on the recovery of the Canadian economy, but they will spike up at some point, precisely why Flaherty is right to be concerned about how that will affect the ability of borrowers– especially those who took on too much debt in the artificially low-interest-rate environment.

There are differences between Canada and the U.S. Less supply was built in Canada relative to demand (the condominium market perhaps being the exception). More importantly, a smaller percentage of Canadians and their banks availed themselves of risky sub-prime mortgages — though before Ottawa's actions in 2008, too many first-time home buyers were headed in that exact direction. And unlike the United States, borrowing costs for one's primary residence are not tax deductible, another contributory factor to the U.S. bubble. What properly concerns the finance minister is the ability of borrowers to finance their mortgage should interest rates spike–which they will eventually. And that's where problems can begin.

A $300,000 mortgage on a condominium financed over 25 years with a five per cent downpayment (so $285,000 borrowed) and a floating rate of 2.15 per cent today means monthly payments of $1,227; when interest rates rise, say to six per cent, which for years was not unheard of and was once considered a good rate, that same borrower would pay $1,823 monthly.

Similarly, a young couple who decided to put only five per cent down on a half-million dollar house, financing $475,000 of it with a floating rate, would pay $2,045 now and $3,039 in a six-per-cent world.

Locked-in rates would help avoid that shock scenario, but only temporarily, until the mortgage renewal date; thus, the day of reckoning for cheap money borrowing would only be pushed ahead.

The finance minister is right to be worried and to consider all options to prevent Canadians from over-leveraging themselves in the current, temporary low-rate environment. It won't last forever.