Erica Alini – Macleans

Last Friday, rating agency Moody’s announced that almost all of Canada’s biggest banks might be in for a credit downgrade, citing “concerns about high consumer debt levels and elevated housing prices.” It was just the latest warning that, after soaring for 14 years, Canada’s housing market might be finally headed back to Earth.

Now, virtually everyone – from the Bank of Canada and the Finance Department through Canada’s banks to the International Monetary Fund and independent analysts – agrees that housing is losing steam and Canadian wallets are overstretched.

Comment: Except a lot of us do not agree with that. David Rosenberg does not agree. CIBC does not agree. TREB and CREA do not agree. CMHC does not agree. Those are some serious people who are not calling for a correction, collapse or crash.

But is Canada’s housing market headed for a gracious landing or a face-forward crash? When it comes to predicting how rough a ride it will be, opinions vary widely.

Comment: It is heading for a gentle slowdown, nothing more.

To help Maclean’s readers make up their minds, we’ve compiled a review of prominent arguments supporting bullish and bearish positions on four key questions about the future of Canada’s real estate and what it all means:

1. Will housing prices cool or collapse?

Here are the latest numbers from the Canadian Real Estate Association and the Canada Mortgage and Housing Corporation:

* sales of existing homes were down 15% in September 2012 compared to the same month last year. Compared to August, however, they were still up 2.5%.
* during the same period, the seasonally adjusted average price of a Canadian home edged up one% compared to year ago levels. Compared to August, home prices were virtually unchanged, dipping 0.2%.
* housing starts fell to a seasonally adjusted annualized rate of 220,215, down slightly from the August figure of 225,328 but still above the 2012 average of 218,400 units.

Comment: So things are basically the same as they were. Wow, what news…

At least in part, many argue, this slowdown was government-engineered. What we’re seeing is the effect the new rules Ottawa introduced in July, which shortened the maximum length of a government-insured mortgage from 30 to 25 years and capped home equity loans to 80 rather than 85% of the property’s value.

Comment: What? You just said that sales were up in September over August, how is that a slowdown? And you said that prices rose 1% over last year – how is that a slowdown? Housing starts are above the yearly average – how is that a slowdown? How can you say that when you just gave data that contradicts it completely?

And, according to CIBC’s Avery Shenfeld, that was enough encouragement. Discussing the possibility of an interest rate hike – which would make loans more costly and further discourage Canadians from buying homes or borrowing against their own – he writes: “In the face of recent changes in mortgage insurance rules, lofty prices that make taking the plunge a bit less attractive (particularly for speculators), and the end of a catch-up period in which construction has outpaced the trend in household formation, there are good reasons to expect mortgage volumes to settle down in 2013, even without a tightening.”

Although, as Shenfeld hinted, Canadians have been building houses faster than they’ve been forming new households, CIBC notes in another report that they’ve done so to a much lesser extent than Americans did in the run-up to the U.S. housing bust. That’s another reason to believe that an “American-style real estate meltdown” is not in cards.

Comment: US housing starts to household formation was at a ratio of 1.8 when they crashed. Canada is at 1.1 currently – 63% less than the US was. And we have investors lining up to buy condos for renters. I have seen 45 people come to a single loft rental showing. Bidding wars are common for rental condos and houses. Certainly that is not a sign of too much product!

According to economists at TD Bank, home prices are 10% overvalued. If interest rates stay low, TD’s Francis Fong recently wrote in a note to clients, there’s plenty of space for the market to adjust gradually to its “long-term trend levels” in terms of both sales of existing homes and the pace of new construction projects.

Comment: Overvalue by 10% based on what? No one ever has an answer for that. They just throw numbers around without any supporting data.

Besides, real estate agents’ favourite adage – “location, location, location! – still applies. Not every regional market is headed south. As BMO’s Robert Kavcic noted last month, “Alberta and Saskatchewan posted solid gains, with the latter jumping to the highest level since 1983.” Even Moody’s acknowledges this: “A correction in real estate prices looms as a downside risk for Vancouver and Toronto, but average national home prices are unlikely to decline outright.”

Comment: Vancouver, yes, but not Toronto. Trust me, I work in this market every day. Mr. Kavcic does not.

Others aren’t so sure the landing will be all that soft. The 15% drop in resale numbers registered in September, analyst Ben Rabidoux pointed out, was the market’s weakest September performance since 2001.

Comment: And they are directly tied to the new mortgage rules. And a 15% drop in sales only brings us to minor record numbers, not the massive records we had been seeing.

Sales of existing home are falling sharply, and prices will soon follow. That construction of new homes is still robust is bad news, as it means the market is creating excess supply that will only further depress home values.

Comment: Prices follow volume? Says who? Not in Toronto, not while half of houses have bidding wars and rentals have multiple offers.

Capital Economics predicts home prices could drop as much as 25%. The dive will leave Canadian consumers hurting and could wipe out as many as 115,000 construction jobs, the firm predicts.

Comment: And they have been saying that for almost a year now. All that time, prices in Toronto have risen 6-10% NOT dropped. Even nationally we have seen minor increases or flat price growth – NOT any sort of drop. Vancouver, sure, but they have been in the toilet for years now.

Another telling estimate foreshadowing a sharp correction is the Economist’s price-to-rent ratio, which calculates that Canadian homes are overvalued by as much as 76%.

Comment: And price to rent is moot moot moot. Carrying costs to rent makes much more sense. And the mortgage on a $500,000 house is about equal to the rent on a 2-bedroom condo in Toronto. That is why people buy and don’t rent.

2. Will Canadians start defaulting on their mortgages like Americans did?

According to the latest estimate by Statistics Canada, which just revised its methodology for calculating the ratio of debt to disposable income to adjust to standards set by the IMF and the UN, Canadians are even deeper in the red than previously thought, owing $1.63 in debt for ever dollar they make.

The BOC called household debt “the biggest domestic risk” to the economy and recently suggested the state of Canadian families’ balance sheets will play a role in its interest-rate setting decisions.

Canadian households got the message about debt, and have already started reining in the borrowing. As of March of this year, household credit was growing at the slowest pace since 2002.

Comment: And some months it even decreased. It is a problem yes, too many big screen TVs being bought on credit. But we have to differentiate between bad credit and good credit. Credit used to buy a TV is wasted, the TV is essentially worthless. Credit used to buy a house turns into equity.

And CIBC’s Benjamin Tal notes that the debt-to-income ratio in Canada has been rising much more slowly than it did in the U.S. prior to the crisis.

Besides, when it comes to mortgage debt, a larger share of Canadians own their homes outright than Americans did at the onset of the U.S. housing crisis: 39% vs. less than 32% south of the border as of 2007.

Finally, according to Moody’s: “Home equity loans and second mortgages have complicated the U.S. foreclosure crisis immensely because of the conflicting incentives of first and second lien mortgage holders. Second liens have limited the ability of some borrowers to refinance their mortgages to take advantage of record low rates. Loan servicers have also run into barriers when trying to modify first mortgages, as the co-operation of second lien holders is needed to preserve the legal rights of the first mortgage-holder during a loan modification. Even if the Canadian housing market should falter and foreclosures should rise, the limited volume of second mortgages among Canadian homeowners suggests that the legal and procedural issues that have plagued the U.S. market would be largely avoided. This would mitigate the spillover effects brought on by the U.S. housing bust. A Canadian housing crisis would likely be shorter and shallower than the U.S. experience.“

Canadians are now more indebted than Americans were pre-crisis.

Comment: Except that it does not take into account health care costs (theirs out of pocket and ours through taxes), nor housing asset values, or many other things. It is not that simple to compare their income and debt to our income and debt.

Though proportionally fewer Canadians are carrying a mortgage, according to the BOC, the most vulnerable borrowers, those who are channeling 40% or more of their income toward interest charges, are carrying a disproportionate share of debt. While these borrowers amount to just over six% of Canadian households, they account for over 11% of household debt.

Comment: And yet our mortgage arrears rate hovers around 0.4% – while the US saw default rates as high as 30% in some states at one point. That is a full 75 times higher than here. And we worry about 6% of buyers…

And Canadians look more vulnerable than Americans in one important respect. While a standard mortgage term south of the border is 30 years, in Canada it is typically five years, meaning that homeowners here are much more exposed to the risk of rising interest rates.

Comment: Only IF they rise.

Finally, Moody’s notes that, although Canadians’ credit ratings look good for now, so did Americans’ before the onset of the crisis.

“Rapidly expanded lending,” writes the agency, “can lead to low delinquency rates in the short run, as new loans contribute to outstanding balances while contributing little in the way of new delinquencies for the first few months or quarters after origination. A relatively stable and expanding economy can also mask underlying deterioration in credit quality, as even distressed borrowers have greater flexibility in paying back their loans.“

Comment: But we have had low delinquencies in Canada forever.

3. Are the banks safe?

BOC Governor Mark Carney called household debt the greatest domestic danger to Canada’s financial institutions. A 3% rise in the unemployment rate, the Bank reckons, would double the rate of mortgage arrears.

Comment: Who in their right mind thinks that Canadian unemployment is going to skyrocket from 7.4% to 10.4%? That is the stupidest thing I have ever heard. We have not seen a number like that since June 1994.

Canadian regulators have also becoming concerned with loosening standards among Canadian lenders. Subprime-like mortgages, typically offered to the self-employment and recent immigrants, have become “an emerging risk” to the banking system, according to the Office of the Superintendent of Financial Institutions.

Comment: What? Seriously? We just had our mortgage rules TIGHTENED for the 4th time. And our standards are loosening? Do the people talking know anything about what they are talking about?

According to the BOC, before the financial crisis, “In the United States, the subprime market had grown to account for about 14% of outstanding mortgages… compared with about 3% in Canada.” Non-prime mortgages in general, which include subprime and other rather lax types of mortgages, accounted for 46 percent of all U.S. subprime mortgages in 2006, according to Credit Suisse. While mortgages that require little income documentation may be on the rise today in Canada, they still account for a very small share of the market – probably under five%, CIBC’s Tal told Bloomberg News.

Comment: So we are talking about our sub-prime mortgages, which barely exist, admitting they are 1/10th of what they were in the US by percentage, meaning 1/100th in total volume.

Moreover, Canadian banks are largely sheltered against potential losses from residential mortgages, as 75% of them are insured by either the CMHC or private-sector insurer Genworth. And all federally regulated financial institutions are required to insure residential mortgages with a downpayment of less than 20% of the property’s value.

Also, residential mortgages make up 23% of total bank assets, which is relatively low among developed economies.

Comment: So banks have tiny exposure, that is what you are saying. They have only 23% of their assets in mortgages, only 5% of those being sub-prime. And 75% of the total mortgages are insured, 100% of the low-quality ones. All of which is considered low among G20 type countries. And somehow we are trying to make this something to be worried about? Right…

No one is predicting that a housing downturn would nearly bring down the financial system as the last one did in the States. But many are warning that Canadian banks may not be as sheltered as one might think.

“The over-leveraged household sector and a potential deflation of the housing bubble would continue to pose significant risks to the banking system stability in the near term,” reads a report by Roubini Global Economics, the research firm headed by NYU’s Nouriel Roubini, who rose to fame as “Dr. Doom” for predicting the U.S. housing bust and the worldwide recession that ensued.

Canadian banks, for one, won’t be able to rely heavily on the CMHC to absorb mortgage risk for much longer. The housing agency is approaching its $600 billion federally-imposed liability cap. Finance Minister Jim Flaherty also recently hinted the government might soon privatize it.

In any case, mortgage insurance doesn’t offer 100% protection. “In the event of a significant housing downturn,” continues the RGE report, “banks could still face legal risk should there be claim disputes between banks and mortgage insurers, as had happened in the case of U.S. banks.”

Comment: But a minor downturn is not even coming, never mind a “significant housing downturn”.

Even if Canadian banks are relatively sheltered in terms of mortgage debt, they could still suffer a major hit if dropping housing prices force Canadians to dramatically rein in borrowing or fall behind on their consumer debt. Rabidoux pointed out that, according to OSFI data, chartered financial institutions in Canada hold proportionally significant more HELOC debt than their U.S. counterparts. Outstanding HELOC debt in Canada is $206 billion, or roughly 12% of GDP. That compares to an estimated $649 billion of equivalent outstanding debt in the U.S. in 2010, according to consumer reporting agency Equifax, or roughly four% of U.S. GDP.

Comment: But house prices are not dropping, so it is a moot point. Even with Vancouver falling, the overall national average is up 1% over last year. Take Vancouver out and the country is up nicely. Toronto is up 6% last month.

4. Could all this trigger a recession?

According to the BOC, the ratio of residential investment to GDP has risen from 4.3% in 2001 to a whopping 7% in 2012. If the housing market falters, will the economy at large follow?

Comment: But that is because prices have risen significantly in that time. And there have been more sales. Of course that value has risen. And why is this a bad thing? The housing market is not going to falter, it just isn’t. Read everything above, it is all outline pretty well.

Despite his moniker, Roubini has been sounding a positive note about Canada’s economy and its sputtering housing market. RGE is still predicting that the real estate downturn will be relatively gentle and the economy will slow, but not shift into the reverse gear. Even in the event of a sharper-than-expected housing bust, the research firm forecasts only a mild recession in 2013, with GDP contracting by a modest one%.

Comment: Our housing is not “sputtering”, stop saying that. And Dr. Doom thinks we are in fine shape, predicting the same as me, a slowing of the current hectic pace. If we have a recession in 2013 I will buy you all lunch!

Sure, a rise in interest rates – which, sooner or later, must go back up – could be just the kind of spark that sets the house on fire. But, as economist Larry MacDonald notes, “interest rates normally trend upward when there is growth in incomes and jobs, factors that add to housing demand and offset the rate rises.”

Comment: Yes, rates will rise, but only once Europe has its house in order. And even then, so what if rates rise 60%? That means our current 3% rates go to 5%. Big whoop. We just aren’t going to see rates shoot into the double digits. And if, in the impossible event that it does happen, it means the economy is going gangbusters. Rates follow the economy. The better the economy, the higher the interest rates. Rates are low now because of 2008, the Euro crisis and the US stalling economically. Rates will not rise until economies rise. And with better economies comes more money – and people can then afford the higher rates.

Housing bubbles gone bust have plunged economies into recession – including right here in Canada, remember? – well before sub-prime mortgages and complex derivatives came around.

Comment: But that bubble saw a 127% price jump in 15 months in Toronto – not quite the same as the 6% annual growth we are seeing now. Which is actually only 4% after inflation. Whoa Nelly, 4% a year!

According to Capital Economics, there is “a good chance” that the housing market will become “a significant drag on overall GDP growth in both 2013 and 2014.”

Comment: But they are insane and say stupid things that no one else agrees with.

Moody’s, for its part, puts the chance of a recession at between 20 and 25%.

Comment: Speaking of… never mind…

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Contact the Jeffrey Team for more information – 416-388-1960

Laurin & Natalie Jeffrey are Toronto Realtors with Century 21 Regal Realty.
They did not write these articles, they just reproduce them here for people
who are interested in Toronto real estate. They do not work for any builders.
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Will Canada’s housing hit a brick

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