Canada's Housing Bubble

Jan 16, 2010 Jay Bryan, The Gazette

Home prices are up by more than 13 per cent in the past year.

Montreal – Not too long ago, there were those who predicted that Canada's housing market would inevitably follow the U.S. into the same sort of catastrophe that began there more than three years ago.

And about a year ago, it looked as if they were right. Prices here finally went into a steep decline late in 2008, about the time Canada was falling into recession.

But as it happens, the Canadian collapse was merely a hiccup. Ironically, as home prices stay severely depressed in the U.S, economists here are worried by the prospect of a housing bubble.

By our most widely-watched measure, the Canadian Real Estate Association's raw average of home transactions across the country, the average price in December was up by 19 per cent from a year earlier, perching at about the same elevated level it reached at the 2008 peak.

The truth is a bit less dramatic, because this national average is pushed up when there's a particularly big jump in the number of transactions in high-priced markets like Vancouver and Toronto, as there has been.

But even when you hold the weight of different cities constant, home prices are up by more than 13 per cent in the past year, a figure that's clearly unsustainable.

Why unsustainable? Because average incomes are rising at a small fraction of this pace. When prices rise faster than incomes for long, homes become unaffordable, sales falter and prices stagnate. Sometimes they fall sharply.

By early this week, the Bank of Canada felt compelled to deny that there's a home-price bubble in Canada, and some think it's right. But even so, it could be only a matter of time, worry a number of private-sector analysts - and quite probably the central bank, too.

It may seem shocking that conditions could be so different in this country and our closest neighbour, but it's not really much of a puzzle.

Banks in Canada are a bit stodgy, and so are regulators. That's not always a good thing, but it saved our bacon during the housing meltdown that struck the U.S, Britain, Ireland, Spain and other countries.

In Canada, sub-prime loans represented only about one-quarter the proportion of lending it did in the U.S, and sub-prime in this country had a different meaning: it included people who didn't quite qualify for prime loans, but were never hopeless deadbeats.

As well, the securitization phenomenon that let U.S. banks sell dubious mortgages to unsuspecting buyers never developed in Canada. Only about one-quarter of Canadian mortgages were securitized in 2007 (it was 60 per cent in the U.S.), and they were solid, government-insured mortgages, not sliced, diced, leveraged subprime junk.

Which brings us back to the potential housing bubble.

Ironically, you could say it's the strength of Canada's banking system that is to blame for the worries about an overheating housing market.

In the U.S. and elsewhere, near-zero interest rates haven't inflated housing prices because the banking system is so sick that there just isn't much lending. In Canada, monetary policy still works normally, which means that when you hand out nearly free money, it's like jabbing a syringe full of adrenaline into the housing market.

Up to now, the effect has been almost entirely positive. Revived housing prices have given consumers the confidence to begin spending more freely and homebuilders the incentive to rehire many of their laid-off workers, creating 33,600 jobs in the past six months.

The problem occurs when housing stays too exuberant for too long. This scenario, which is one of the things economist Derek Holt at Scotia Capital has been worrying about, would raise the prospect of a nasty crash in home prices if it continues until next year or the year after.

But there's still a good chance that the problem will prove to be self-correcting. There are several factors that could conspire to bring this about:

First, high prices bring new sellers into the market and spur increased home construction, easing the supply shortage that's been behind a lot of the price gains.

Second, mortgage lending regulations, loosened not long ago, could be tightened a bit in this spring's federal budget.

Third, low interest rates and impending real estate taxes in the big markets of Ontario and British Columbia will stop supercharging the market by late summer, when the rates could be rising and the taxes will have arrived.

If markets cool by then, it's quite likely that the market will work off its excesses by simply standing still for two or three years, believes economist Benjamin Tal at CIBC World Markets.

If they don't cool, it could indeed be time to worry about a bubble and a future crash.