Canada's Housing Bubble

Jan 26, 2010 Robert Pozen ft.com

While the US housing market has crashed over the last few years, the Canadian housing market has remained relatively strong. On a trip to Toronto last week, I learnt about three important features of that market that have helped Canada avoid the boom-and-bust cycle in residential housing.

First, Canadian banks routinely require home purchasers to make down-payments of at least 20 per cent of the purchase price of their home. Even in the government programmes to help low-income families buy their first homes, the minimum down-payment is still 5-10 per cent of a home’s price. With substantial personal net worth at risk, Canadian homeowners are very reluctant to default on their mortgages.

By contrast, America has been the leader in no-equity mortgages. Since the credit crunch, the US government has continued this tradition – in the name of preventing further declines in the housing market. Almost half of the US mortgages are now insured by an agency of the federal government. These mortgages typically have a down-payment requirement of only 3.5 per cent of the home’s purchase price.

Even this minimal requirement is easily avoided. Developers used to form non-profit organisations to “donate” the down-payment to homebuyers. This donation was quietly incorporated into a higher price for the home. More recently, Congress has offered first-time home buyers a refundable tax credit of $8,000 (€5,650, £4,950). For example, if a family buys a home for $200,000 with a $7,000 down-payment (3.5 per cent of $200,000) and a government-insured mortgage for $193,000, that family can collect $8,000 from the Internal Revenue Service promptly after closing – even if the family is not paying any income tax.

Second, in Canada, when a homeowner defaults on a mortgage, the homeowner is personally liable for any deficiency that remains after a foreclosure and sale of the home. Suppose a Canadian buys a luxury apartment for $800,000 with a $640,000 mortgage, and later defaults on that mortgage. If the bank forecloses on the mortgage and sells the apartment for only $600,000 the Canadian will be personally liable for $40,000 (the $640,000 mortgage minus the $600,000 sale price).

By contrast, many American states immunise local homeowners from personal liability on any deficiency that remains after a bank forecloses on a mortgage and sells the home. State laws minimising personal liability on mortgage foreclosures are especially protective of homeowners in California, Arizona and Nevada. It is no coincidence that these three states have much higher mortgage default rates than the American average.

Third, Canada does not provide a tax deduction for interest paid by homeowners on their mortgages. By contrast, US law allows Americans to deduct the interest on the mortgages for their principal residence as well as for their vacation homes. Moreover, US law allows homeowners to deduct the interest on ”home equity” loans. These loans are typically second mortgages used to pull out some of a home’s equity built up over the years.

For example, an American family buys a $500,000 home with a $475,000 mortgage. After a decade, the house is worth $650,000, so they take out $100,000 in cash through a second mortgage. Homeowners often do not use this $100,000 to improve their home; instead, the money is frequently used to purchase cars, take vacations or pay college tuition. Such home equity loans were one of the main reasons why the US personal savings rate turned negative during 2006. In that year alone, Americans pulled out $350bn in cash through home equity loans and similar refinancings.

All of these American subsidies are justified as necessary to promote home ownership in the US. Indeed, the rate of home ownership in the US rose to 68 per cent by 2006. Yet, without these governmental subsidies, the rate of home ownership in Canada also rose to 68 per cent in 2006. This comparison suggests that the large American subsidies for home purchases have led to higher home prices in the US rather than significant increases in the rate of US home ownership.