Cana­di­ans are buy­ing homes at a blis­ter­ing pace, bing­ing on new debt. But all that cheap money can come at a high cost

Tara Perkins, Kevin Carmichael and David Ebner – Globe and Mail

Nick Burzese and his fiancée Di Pham recently real­ized the North Amer­i­can dream – they bought a house of their own.

And the couple’s new home is not just any­where. It’s in Van­cou­ver, one of the country’s prici­est mar­kets. Hav­ing rented for years, the cou­ple, who both work in the mort­gage busi­ness, thought they’d never be able to afford a house in the city. They were doomed, they felt, to live in a dis­tant sub­urb. As they house-hunted, they saw to their dis­ap­point­ment that the reces­sion hadn’t damp­ened the mar­ket much.

“Every­where we went, there were so many peo­ple there,” says Mr. Burzese, 36, a bro­ker at MPRO Mort­gage Architects.

Even­tu­ally, they came across an old 11/2-storey “char­ac­ter” home on a leafy street of detached houses near the Pacific National Exhi­bi­tion grounds, on the city’s east side. “We imme­di­ately fell in love with it,” Mr. Burzese says. “It’s really an area that’s start­ing to transform.”

Ms. Pham, 28, and Mr. Burzese put $57,000 down on the $570,000 house early this year. The cou­ple says they’re com­fort­able with the debt. They make good money and are installing a base­ment apart­ment as a “mort­gage helper.” But they might not have been able to get into the mar­ket were it not for the inter­ven­tion of the Bank of Canada and the fed­eral gov­ern­ment – in the form of a con­tin­ued low inter­est rates and fed­eral poli­cies aimed at main­tain­ing the flow of lend­ing and spending.

The inter­est rate on the their mort­gage? Just 1.5%.

By tak­ing advan­tage of ultra­cheap inter­est rates to buy some­thing they couldn’t pre­vi­ously afford, the cou­ple are doing exactly what the gov­ern­ment wants Cana­di­ans to do to restore growth to the econ­omy. Mr. Burzese and Ms. Pham may well be able to han­dle the new debt. But mount­ing con­sumer debt loads across the coun­try are wor­ry­ing some econ­o­mists — and even the bankers who are prof­it­ing from it.

Cana­di­ans are in the midst of a mort­gage binge, tak­ing out home loans at a pace that’s nearly 8% faster than a year ago. The point of a record-low bor­row­ing rate and new fis­cal incen­tives, such as allow­ing first-time home buy­ers to use a big­ger chunk of their reg­is­tered retire­ment sav­ings plans as down pay­ments, was to stir the ani­mal spir­its of con­sumers spooked by the finan­cial cri­sis. But now, as the reces­sion eases, offi­cials in Ottawa and the ana­lysts who advise large insti­tu­tional investors on where to put their money are sud­denly pay­ing closer atten­tion to the effect of all this stim­u­lus on the longer-term prospects of Cana­dian consumers.

The con­cern is that peo­ple are tak­ing on too much debt on the assump­tion that inter­est rates will stay low for a very long time, mak­ing Cana­dian con­sumers far more sen­si­tive to the effects of real estate and other asset-price bub­bles. There is a grow­ing con­sen­sus among lead­ing econ­o­mists and pol­icy mak­ers that the finan­cial cri­sis might have been less severe had they not bought into for­mer Fed­eral Reserve Board chair­man Alan Greenspan’s asser­tions that noth­ing can be done about bubbles.

In Canada, econ­o­mists are wor­ried about con­sumers’ will­ing­ness to pile on debt so soon after an eco­nomic cat­a­stro­phe that was trig­gered by Amer­i­cans’ will­ing­ness to do the very same thing. “We know that cheap money in the past caused some prob­lems. This is a time to be pru­dent,” says Ben­jamin Tal, an econ­o­mist at Cana­dian Impe­r­ial Bank of Com­merce in Toronto.

“Right now, the rates being what they are, peo­ple just say, ‘I want that house,’” says Darin Bauer, a Toronto bro­ker with Mort­gage Intel­li­gence Inc.

That atti­tude is lift­ing house prices faster than many econ­o­mists expected, given the sever­ity of the reces­sion. Higher real estate prices are cre­at­ing wealth for the sell­ers, loos­en­ing the recession’s grip on the econ­omy and help­ing to explain why the Bank of Canada esti­mates that Canada’s first reces­sion since 1992 ended in the third quar­ter. In the fight against the worst global eco­nomic down­turn since the Sec­ond World War, pol­icy mak­ers have effec­tively drafted Cana­di­ans en masse. It’s work­ing, but at a price.

Middle-age mort­gagors

Cana­dian con­sumer debt loads were already head­ing in a wor­ri­some direc­tion before the cri­sis. The trend is now accel­er­at­ing, dri­ven by a large increase in mort­gage bal­ances among middle-aged people.

U.S. con­sumers, chas­tened by the destruc­tion wrought by their profli­gacy, have lifted their sav­ings rates to lev­els above 3%, up from zero ahead of the crisis.

Cana­di­ans are going in the other direc­tion. House­hold debt rose 3.4% in the first half of the year, as per­sonal dis­pos­able income fell 0.2%, accord­ing to Mr. Tal. The debt-to-income ratio has risen to 140% from 131% in the past year.

Much of the new bor­row­ing is mort­gages, which have grown even as Canada’s broader econ­omy was con­tract­ing. Adjusted for infla­tion, mort­gage growth in the reces­sions of 1991 and 2001 was vir­tu­ally non-existent. It cur­rently tops 7%, adjusted for infla­tion. Thanks to Mr. Flaherty’s Jan­u­ary bud­get, many first-time buy­ers can now take as much as $25,000 from their RRSPs to use as a down pay­ment, com­pared with $20,000 pre­vi­ously. Novice buy­ers are jump­ing into surg­ing real estate mar­kets in Van­cou­ver, Cal­gary and Toronto with lit­tle under­stand­ing that the value of the asset they covet can disintegrate.

Hous­ing prices don’t typ­i­cally sur­vive reces­sions. In April, 1989, the value of an aver­age exist­ing home in Toronto was $261,650. This was the peak of the 1980′s boom, with prices 267% higher than at the begin­ning of decade. The bust that fol­lowed was nearly as dra­matic: The trough didn’t come until August, 1993, when the aver­age price sunk to $189,620. The aver­age price didn’t top the 1980′s peak until Jan­u­ary 2002. Whether they’re first-time buy­ers or trad­ing up, con­sumers are using low rates to take on a big­ger loan than they would in nor­mal times.

Cus­tomers of Mort​gage​Bro​kers​.com took out mort­gages worth an aver­age $196,599.49 between June and Sep­tem­ber, com­pared with an aver­age of $150,840.44 dur­ing the same period a year ago, accord­ing to the com­pany. From the height of the cri­sis in Octo­ber, 2008, and last month, the five-year mort­gage rate declined 1.75 per­cent­age points.

But the deci­sion to take on big­ger mort­gages isn’t the result of big­ger pay­cheques. In 2004, mort­gage credit amounted to about 74% of per­sonal dis­pos­able income. Now it’s 96%.

The hurt of higher rates

The crux of the con­cern in Ottawa and on Bay Street is the impact that ris­ing rates will even­tu­ally have on highly lever­aged homeowners.

“We know that inter­est rates will rise – the only ques­tion is when,” Mr. Tal says. “Even if you lock in a five-year mort­gage rate, you have to real­ize that five years from now, they will be sig­nif­i­cantly higher than they are now. Clearly peo­ple have to be much more pru­dent in this kind of environment.”

Bank of Canada Gov­er­nor Mark Car­ney reit­er­ated this week that his overnight tar­get likely will remain at 0.25% until next June. But cen­tral banks in Israel, Aus­tralia and Nor­way have begun revers­ing their extra­or­di­nary eas­ing cycles amid signs of incip­i­ent infla­tion and some con­cern that asset prices, includ­ing real estate, are get­ting a lit­tle too hot.

Cen­tral bankers in the U.S. and else­where have also indi­cated in recent months that once they decide it’s time to begin rais­ing inter­est rates, they may do so at a faster pace than con­sumers and investors are used to.

While heftier debt loads obvi­ously make all bor­row­ers more vul­ner­a­ble to higher inter­est rates, con­sumers’ increased expo­sure to real estate also means that they have become more sus­cep­ti­ble to changes in the real estate market.

Bro­ker Darin Bauer says most of his cur­rent cus­tomers are mak­ing down pay­ments of only 5 or 10%, and “not too many” come for­ward with the 20% down pay­ment that is the min­i­mum to avoid the fed­eral government’s oth­er­wise manda­tory mort­gage insurance.

Com­ment: Except it is not. Go to the CMHC site and see for your­self. Even at 35% down there is a pre­mium. Once you get to 36%, that is when you escape the insurance.

“Gen­er­ally, when they’re doing the 5% down, they’re close to the max­i­mum of afford­abil­ity ratios,” Mr. Bauer said. “If rates went up sig­nif­i­cantly, it could be a prob­lem come renewal time.”

Con­sumers with fixed-rate mort­gages might feel secure. But with many mort­gages now hav­ing a 35-year amor­ti­za­tion, they are bound to feel the pinch of higher inter­est rates at some point.

“Con­sumers have to think very care­fully about what they’re going to do in five years when inter­est rates are higher,” says Peter Aceto, the CEO of ING Direct Canada. The finan­cial cri­sis crimped prop­erty mar­kets around the world, but Canada’s eight-month hous­ing cor­rec­tion is now a dis­tant memory.

‘Irra­tional behaviour’

Sales of exist­ing homes slumped in Octo­ber, 2008, but by May, they had returned to pre-recession heights.

Home pur­chases are now back up to the “lofty” vol­umes of 2007, accord­ing to econ­o­mists at Toronto-Dominion Bank, even though the country’s gross domes­tic prod­uct con­tracted in August, accord­ing to report by Sta­tis­tics Canada.

The pace of price increases in Sep­tem­ber was almost the fastest it’s been in 20 years, accord­ing to Bank of Mon­treal econ­o­mist Dou­glas Porter. Real estate prices have gone up in 20 of the 25 largest cities in the past year, and in all 10 provinces.

“There has been no price reduc­tion at all here,” says Elena Levin, a real estate agent with Royal LeP­age in Ottawa. “Yes­ter­day I worked on two deals with mul­ti­ple offers.”

In Hal­i­fax, Re/Max agent John Lin­ders says house prices have increased 4% this year and he expects the esca­la­tion to con­tinue. More­over, the stock of houses for sale is becom­ing tighter. “There’s actu­ally fewer prop­er­ties com­ing on the mar­ket com­pared to more sales,” he says. “I’m start­ing to see that for the first time just now.”

On Thurs­day morn­ing, Mr. Lin­ders’ com­puter showed that there were 24 new list­ings and 19 houses con­di­tion­ally sold. “These two num­bers are closer together than I’ve ever pre­vi­ously seen.”

Reports of such con­di­tions in var­i­ous mar­kets are spurring talk of a bub­ble. “It’s envi­ron­ments like these that breed bub­bles,” Mr. Aceto says. “There is what feels to be a lit­tle bit of irra­tional behav­iour in the real estate mar­ket, and I do think it is in a large way fuelled by how low inter­est rates are.”

If a bub­ble is in the works, it hasn’t yet inflated to dan­ger­ous proportions.

Evridiki Tsounta, an econ­o­mist at the Washington-based Inter­na­tional Mon­e­tary Fund, pub­lished a work­ing paper this week that con­cluded that “while house prices might be a bit over­val­ued in the West, over all they are close to equi­lib­rium,” con­sid­er­ing fun­da­men­tal fac­tors such as incomes and com­mod­ity prices.

Mr. Car­ney doused talk of a house-price bub­ble dur­ing par­lia­men­tary and sen­ate tes­ti­mony this week, say­ing much of the cur­rent increase in home buy­ing and prices is the work of buy­ers who put their plans on hold dur­ing the worst of the reces­sion. Mr. Car­ney, who expects the real estate mar­ket to cool off by 2011, also pointed out that con­struc­tion of new homes remains below year-ago lev­els, sug­gest­ing that pur­chases of exist­ing homes in super­hot mar­kets such as Van­cou­ver and Toronto is skew­ing the national picture.

All things being equal, higher prices should encour­age more peo­ple to put their houses up for sale, which in turn should lower prices by increas­ing supply.

The prob­lem is it’s dif­fi­cult to spot a bub­ble for sure until it bursts. “That was the point that Greenspan used to make about why this is a prob­lem for cen­tral banks,” says Craig Alexan­der, an econ­o­mist at Toronto-Dominion Bank.

Mr. Greenspan’s approach was to let bub­bles burst, then attend to the dam­age by low­er­ing inter­est rates. The Bank of Canada, like many of its coun­ter­parts, doesn’t have the lux­ury of sim­ply resort­ing to manip­u­lat­ing inter­est rates. If Mr. Car­ney became wor­ried about a real estate bub­ble, the econ­omy remains too frag­ile to raise inter­est rates. Doing so would also carry the risk of dri­ving up the value of the Cana­dian dol­lar, which already is at uncom­fort­able heights for the country’s exporters.

‘Mon­i­tor­ing the situation’

Canada’s real estatemar­ket is cer­tainly not stained by the sort of excesses that char­ac­ter­ized the U.S. mar­ket before the crash. Sub­prime lend­ing in Canada is esti­mated to rep­re­sent less than 5% of the mar­ket, com­pared with more than 20% in the U.S. prior to the crisis.

But an ironic sce­nario could still unfold. In an effort to com­bat a reces­sion that had its ori­gins in a U.S. real estate­bub­ble, Cana­dian pol­icy mak­ers have responded with low rates that might cre­ate a bub­ble here, giv­ing the mort­gage mar­ket too much of a kick-start through low inter­est rates and a pro­gram of buy­ing bil­lions in mort­gages from the banks.

Fed­eral Finance Min­is­ter Jim Fla­herty says he is con­fi­dent he has a han­dle on it. He noted that in 2008, the gov­ern­ment decided it would no longer insure mort­gages with 40-year amor­ti­za­tion peri­ods, reduc­ing the max­i­mum accept­able term to 35 years. It also boosted the min­i­mum down pay­ment to 5%. Both Mr. Fla­herty and Mr. Car­ney said mea­sures of that type could be taken again if Cana­di­ans get in over their heads in the mort­gage market.

“We’re mon­i­tor­ing that sit­u­a­tion,” Mr. Fla­herty told reporters in Toronto yes­ter­day. “Inter­est rates are very low, and that is no doubt con­tribut­ing to some addi­tional activ­ity in the real estate mar­ket. We’ll watch, and what we’ve done before we can do again if we need to.”

The Bank of Canada is pay­ing spe­cial atten­tion to house­hold debt, and it will include an analy­sis of the debt bur­den of all income classes when it releases its bian­nual review of the finan­cial sys­tem in December.

For now, Mr. Car­ney says the sit­u­a­tion is under con­trol because the cost of pay­ing for that grow­ing debt is much lower than its his­toric aver­age. While total house­hold debt rose by $44-billion dur­ing the first six months of the year, inter­est pay­ments on debt actu­ally fell by $3-billion, accord­ing to econ­o­mists at CIBC.

Still, Mr. Car­ney reminded mem­bers of Par­lia­ment and Sen­a­tors this week that rock-bottom inter­est rates can only move in one direc­tion. Accord­ingly, he encour­aged both bor­row­ers and lenders to act “prudently.”

And even though he dis­missed the idea of an immi­nent bub­ble, Mr. Car­ney still encour­aged dis­cus­sion of the sub­ject. The rea­son: The more peo­ple talk about real estate bub­bles, the less chance they form. A key ingre­di­ent in the U.S. sub­prime mort­gage cri­sis was the lack of atten­tion that was being paid to the prob­lem as it brewed.

“We wel­come the dis­cus­sion of this issue because it is antic­i­pa­tory,” Mr. Car­ney told the Sen­ate bank­ing com­mit­tee. “Peo­ple are antic­i­pat­ing a poten­tial vul­ner­a­bil­ity as opposed to look­ing in the rear-view mir­ror and see­ing a vul­ner­a­bil­ity that is already here. That is one of the ways that one pre­vents that.”

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