Canada's Housing Plays On As World Warns Of Risk

By Andrea Hopkins

TORONTO (Reuters) - Jeff Lowry and his family left a sedate housing market in Tennessee last year and moved to Canada in the midst of a housing boom, where bidding wars and soaring prices were an unpleasant reminder of his American roots.

Trading in his suburban home outside Nashville for a smaller $600,000 house in Waterdown, Ontario, about 40 miles outside of Toronto, the 39-year-old regional manager wonders if he's just bought into another bubble.

"Obviously it is risky, and we're concerned," said Lowry. "The housing market is skyrocketing and we wonder, are we paying the top price? Will what happened in the United States happen here? I don't know. I guess it's a gamble."

Experts ranging from Fitch Ratings and Morningstar to the International Monetary Fund and economist Paul Krugman have warned about the risks of the housing boom in Canada, where the average home price has doubled in 11 years. They point to record high household debt, cheap mortgages, and overbuilding as harbingers of the kind of doom seen in the U.S. housing collapse five years ago.

"Think of me as the designated driver at a party," said Dan Werner, an equity analyst at Chicago-based investment firm Morningstar. He warned in July that a house price correction is inevitable in the next five years that could send values tumbling by as much as 30 percent.

"There is this euphoria when you are within an up housing market,” Werner said. “We fell into it that here. I don't want to say Canadians are in a party mode, but they are thinking, 'What can possibly go wrong if prices keep going up?' It's going to end badly."

Werner said the reason why a collapse is inevitable include: home prices are rising faster than personal income; low mortgage rates are unsustainable; household debt levels are at historic highs; and builders have erected so many houses that there will soon be oversupply.

Fitch said in July that Canada's housing market was about 20 percent overvalued and warned that the country's debt-to-income ratio, which at about 163 percent echoes levels seen in the United States just before its crash, will be a liability when interest rates rise.

While the pace of homebuilding has slowed slightly from a 2012 peak, prices have kept rising, with the average home price up 5.0 percent in the last year to C$401,585 ($365,243).

But Canadians, from policymakers to bank economists to homebuyers, are confident that a solid banking system, more conservative borrowing and steady demand will provide a soft landing for a market that is already slowing.

"I really think that what we're observing is a high level of self-responsibility through this," Bank of Canada Governor Stephen Poloz said in late April. "I'm comfortable that this risk is not outsized."

THIS TIME IT'S DIFFERENT?

Canada's housing market is similar to the U.S. market before the crash in some ways: From the heady price gains and consumer indebtedness to the view of housing as an investment rather than just a place to live.

But defenders also point to the differences. Canada has tighter lending standards and healthier banks, a small subprime market, and high fees which discourage the buying and flipping of housing for profit.

The Bank of Canada estimated that Canada's non-prime loans represented about 7 percent of outstanding mortgages in Canada in 2012, compared with an estimated pre-crisis level of about 20 percent in the United States, citing data from the Canadian Imperial Bank of Commerce. Moreover, some of the mortgage products sold in the U.S. before the housing crash, such as negative amortization and interest-only mortgages, aren’t available or are very limited in Canada.

So a Canadian housing crash would look different than what was seen south of the border, but it still wouldn't be pretty.

Mark Zandi, chief economist at Moody's Analytics, said a crash might begin with indebted consumers who default on their mortgages, spread to the banks facing loan losses, and then hit the federal government as its mortgage insurance agency faces huge payouts and a housing-related employment slump.

"If you're in a full-blown housing downturn, with house prices falling, high debt loads, other credit problems developing - consumer loans, auto loans - that affects consumer spending more broadly," Zandi said. "The Canadian economy is so driven by housing that if housing goes down, it is hard to see the Canadian economy growing, so it would probably be fodder for a recession."

As in the 2008 financial crisis, banks wounded by bad mortgages would rein in other lending.

"If the banks are hobbled, then they are not going to be able to lend to keep the economy moving forward," said Zandi. "Credit is the mother's milk of economic growth. Without credit, you don't get growth."

With some 7 percent of Canadian growth coming from construction, a housing slump would also exacerbate unemployment, fueling a vicious cycle of more mortgage defaults.

David Carey, the senior economist on Canada at the Organisation for Economic Cooperation and Development, said Canada's big six banks are too well capitalized and their loan portfolios too sound for them to be at risk of a bank failure, though their profits would take a hit.

They are insulated as well because mortgage insurance is required whenever a homebuyer puts less than 20 percent down on a home - and a federal agency, the Canada Mortgage and Housing Corp, provides most of that insurance.

But in the event of a crash, the CMHC will suffer a big blow, which in turn will hurt sovereign debt and taxpayers.

"The federal budget is at risk because the CMHC is on the hook for loan losses," Carey said in an email. “These would reduce CMHC's profits and hence the dividends it pays to the federal government.”

The IMF in Washington and the Paris-based OECD both question Canada's government-backed mortgage insurance program. Typically, Canada's big private banks buy the insurance, charge the borrowers for the cost, and stand to get their money back if the homebuyer defaults on the mortgage.

While the cost of the mortgage insurance is an incentive for buyers to put more equity in their home, the bulk of the insurance is provided by the CMHC, which means taxpayers are on the hook for some C$600 billion in insured loans if the market collapses.

"The banks are able to make mortgage loans that if they go bad, the cost falls back to a government agency. When we talk about moral hazard, that's what we're referring to," said Carey. "This arrangement encourages more risk taking than would occur if there were no government involvement."

THE TIPPING POINT

Foreigners and Canadians alike agree on what could cause a housing collapse, namely a spike in interest rates from the record low levels that have dominated for five years, or a rise in unemployment, or both.

A Bank of Canada study has suggested that a return of real mortgage rates to the long-term average of 4 percent would cut mortgage payment affordability to the lowest level in 16 years. An interest rate hike of 2 percentage points would push 10 percent of indebted households into debt-service ratios over 40 percent, a threshold considered unaffordable.

Data on just how much mortgage debt exists - C$1.17 trillion as of April 2013 - and how much of it is vulnerable to rate increases shows that while Canadians have a lot of equity in their homes, many have borrowed against that equity and are relying on low rates to service the debt they've accumulated.

Some 59 percent, or 5.6 million, of Canadian homeowners have mortgages, and 2.2 million have home equity lines of credit, a phenomenon that echoes the habit of Americans to use their homes as cash machines in the run-up to the bust there.

Still, the average equity is estimated at 73 percent. Among the CMHC's insured portfolio - the mortgages that tend to have a higher risk profile - the average equity is 45 percent. Average home equity was about 60 percent during the U.S. housing boom, and it fell to about 38 percent by the third quarter of 2009 as the market crashed, according to the Federal Reserve Bank of San Francisco.

While equity is relatively high, official interest rates are historically low at about 1 percent, and policymakers from the Finance Department and the Bank of Canada have warned they won't stay that way. The average mortgage rate is 3.24 percent, according to the Canadian Association of Accredited Mortgage Professionals, a rate that has allowed consumers to get into debt very cheaply.

Though 65 percent of Canadian mortgages have fixed interest rates, the most popular fixed mortgage product gets renewed after only five years. Canadians are so used to falling interest rates they may have forgotten that their debt burden can get heavier. Among people who renewed a mortgage from the start of 2013 to April 2014, 54 percent saw their mortgage rate fall, according to CAAMP. That won't happen much longer.

For Morningstar's Werner, the biggest risk is not only in the numbers but in the mentality of buyers in a bull market.

"If you start looking at your house as an investment class -- as something else you should be investing in rather than the stock market -- you run into the danger of being exposed to some of the excesses going on in the system," he said.

Jeff Lowry is already counting his gains as the Canadian housing market marches ever higher.

"We've only lived here eight months and the values have even gone up since then," said Lowry, marveling at how much money his neighbors are getting as they sell.

"I think I will make money here. I purchased it at C$600,000 and they are now going for C$680, C$690. If that trend continues I'll be sitting pretty in two or three years."

(1 US dollar = 1.0908 Canadian dollar)

(Editing by Amran Abocar and John Pickering)

Banny Bar, Montreal Real Estate Broker