Canada's Housing Bubble

Feb 22, 2010 Jonathan Tonge americacanada.blogspot.com

Well then that says it. National Bank tells us that there might be a little shock if interest rates rise, but overall we still have less debt than the USA. So why worry then?

Here is the chart that backs their point:

Courtesy of the Globe and Mail. Read article in full here.

Well that is a significant growth if you look back to 1990 when our debt was only 90% of disposable income, whereas USA had nearly 110%. It does make sense that mortgage debt would be higher in the USA as it is tax deductible.

But certainly Canada's debt growth doesn't look as scary as the growth in US debt. Or does it?

Well to answer that you need to forecast the next three years. Let's assume two different situations. Feel free to add a third.

The first situation is that Canada experiences a USA style housing collapse starting in Q3 2010. At first the contraction is mild, just like it was in the US. By early 2011 home sales and price declines accelerate. For arguments sake, assume that by 2012 housing loses 20% of its value and a further 20% by 2014-5.

The second situation is that Canada doesn't experience a collapse. Housing continues to grow "modestly", at roughly 8% per year just as it has prior to 2008. Fueled by lower interest rates, housing by mid-2012 is 20% more costly then it is today. Nice!

What effect would both of these situations have on the debt-to-disposable income ratio?

First let's talk about the middle black line that falls on 2010. That's us right now. We are in the midst of passing the USA in debt-to-disposable income.

The horizontal yellow line marks what level of debt the USA was at when their credit crisis began. Canada will pass this point by mid 2010.

Our assumption with the green line is that for one reason or another, most likely rising interest rates, a housing bust or a recession, Canada begins the same journey as the USA did but four years later. To make it a similar contraction it would have to materialize primarily in residential mortgages and HELOC's as they make up 86% of household debt (just like the US by the way). That means that a housing bust would either be the cause or the victim of the credit contraction. Regardless, the result would be the same.

The government actively tries to douse the markets with more credit, but eventually by 2012 the market gives. It can no longer afford it. Credit begins its long descent and as it does, the sound of air rushing out the economy can be heard as an inflation of roughly 13% of disposable incomes is replaced by a contraction of 5%. The economy enters recession, unemployment rises by roughly 5-10% and incomes fall by around 5% per year.

The second assumption is that we do not experience the same fate in 2010. Instead, thanks to low interest rates and an absence of a recession, homes continue to appreciate (up 20% by 2012) and home sales remain strong. By mid 2012 Canada's debt to disposable income reaches 180%. The economy then experiences a Japanese style collapse and deflation ensues.

It is important to note that even if credit continues to rise steadily at 10% per year (higher than disposable income growth), we would still experience a parabolic rise in the ratio in the second example. This occurs as the growth is compounded. So as a 10% marginal increase in credit would send the ratio from 100% to 110%, it would similarly take the ratio from 150% to 165%, and then from 165% to 181.5%. You simply multiply the ratio by 110% each time. That's why you would expect a curve. That curve is also why you get a bust.

Credit contracts in both situations. The drop sure does look scary. But in both situations the debt ratio does not return to mid-nineties levels until 2025 (which was still high by historical standards).

Either way, despite National Bank's optimism, Canada is not in decent shape. We are headed towards a bust, one way or another. It's just a matter of time.