Canada's Housing Bubble

Jonathan Tonge October 19, 2009 americacanada.blogspot.com

So Globe and Mail reported on why the housing market didn't crash.

As usual they based their facts on consumer demand and delinquency rates. Both of these factors are irrelevant in a bull market: there is always demand and assets are liquid so why would you default?

I'm about to offer the absolute best evidence of why Canada's housing market has to crash. It's written into the cards. So here it is in three quick charts.

We can start off by taking a quick snapshot of residential mortgage credit in Canada over the past thirty years. Snap. Got it?

Of course the nominal amount of debt on its own is data but it's not information. We have to compare debt to a related variable.

It could be inflation or GDP. But in my opinion, corporate revenue and profits don't translate into residential mortgage credit - at least not directly. So that throws GDP out as an option. Inflation has its purpose but in my opinion it's useless when you have the option of comparing two nominal amounts instead.

So I settled on comparing credit with incomes. Makes sense since it takes one to get the other. So the type of income was the next question.

It's very difficult to take out a mortgage loan based on your expected earnings from dividends, capital gains and other investment income. Therefore total income is out of the question.

What really fuels residential mortgage debt is wages and salaries. This is your gross pay cheque that you can borrow against. An even better measure would be after tax disposable income. After-tax income is a more accurate measure of what you can spend - as the government increases taxes, you can actually afford less.

But I couldn't find reliable after tax income. So we had to use nominal wages and salaries to compare. You can use your head to figure out which way taxes have moved over the course of the past thirty years and where they are likely to head in the near future ;)

Note that in the past thirty years, home prices have only risen substantially when credit is accelerating.

By accelerating it means that the growth rate in residential mortgage debt is higher year after year. For instance, in the first year total residential credit expands 5%. In the second year total credit expands by 6%. In the third year total credit expands by 8% and so on.

If you look to the chart you can see that the only substantial rise in home prices occurred between 1985-1990 and between 2000 and 2008. Average home prices doubled in each of these periods.

Note that on the graph the only periods where credit growth was accelerating was between 1985-1990 and 2000 to 2008.

Accelerating growth does not mean that credit simply has to be higher the year after next. In fact despite a housing crash in 1990, the credit-to-income ratio did not peak until 1997. A 25% drop in housing prices was clearly not enough to bring residential debt in line with incomes. It took another 7 years of nominal income growth for that to occur.

Further proof in the pudding was 2008. Residential mortgage credit cooled from a 12.5% growth rate in 2007 to roughly 11% in 2008. This deceleration in credit growth cooled the market substantially.

Of course this summer brought to us record home sales and average prices despite stagnating incomes. This was all caused by government stimulus priming the credit markets - mostly thanks to CMHC and the Bank of Canada. This stimulus has clearly accelerated the credit market since the downturn.

So the question you should be asking is what does an accelerated credit growth model look like for Canada. Next you should ask whether it is sustainable.

In 1985 we borrowed 45% of our gross salaries and wages to pay for housing. By April of 2009 we borrowed 110%. This of course is an average of our entire country including those without mortgages.

Two assumptions are made in the model.

The first is that incomes will continue to see compounded growth of 2.4% each year. This is the average post recession growth rate between 1991 and 1996.

The second is that an acceleration of credit growth of just 0.8% each year will cause home prices to continue to rise. This is the average acceleration in credit growth between 2001 and 2008.

Using this model we can clearly see that by 2016 Canadians will owe an average of 263% of their gross incomes to residential mortgage debt.

It's an impossible figure I know. But that is the point. In fact it is unlikely that we will go above 125%, something that will occur by mid 2010.

To the bulls and bears, please put aside your emotions. A real estate correction is written into the cards. It's a mathematical must.

In the next few years the economy will surely hit a debt ceiling. Where that is depends on interest rates, demand and supply of credit, and income growth. But it will and according to this model, within the next year or two.

At that point home sales will begin to rapidly slow. This will result in falling prices. The two will reinforce each other.

This next correction will be unstoppable by traditional government stimulus. Interest rates have only one way to head this time.

With debt levels this high, why would you want to stop a correction? Knowing that the only solution, that is to accelerate the growth of credit, is far from sustainable and will result in more severe punishment on families and taxpayers?

What if interest rates rise? It took only a 2% rise in interest rates to bring down Japan and the United States.

Families will get hurt by all this debt and seeing that, frugality will make its return. The demand for debt will fall, further hammering the cycle.

Regards,

Jonathan Tonge