Back in the heady days of 2005, America looked like an awfully nice place to buy a house. Home prices were marching ever upwards. Home ownership was at record levels. Mortgage rates were at historic lows. Unemployment was falling while the economy was growing at a healthy clip.
Home sales had started showing their first signs of slowing that year, but that didn’t sway the National Association of Realtors from its persistently sunny view of the country’s housing market. “We’re confident that housing is landing softly,” David Lereah, the association’s chief economist, wrote in a November 2005 report just before house prices started a descent that would eventually wipe out nearly $30 trillion in global wealth.
Looking back, the signs of a country burying its head in the sand about a housing bubble seem obvious: the well-told tales of tricky teaser rates, of mortgage fraud and of gigantic home loans handed out to buyers with no income or assets. Household finances were even sketchier. In 2005, the average American owed $1.30 in debt for every dollar of income. Home equity was eroding as Americans pulled more than $900 billion out of their homes to buy cars, granite countertops and put their kids through college.
Then in 2008, the housewarming party was over as the country’s major banks teetered on the brink of collapse and took the economy with them.
Here in Canada, we patted our backs for not falling into the same trap, and basked in the spotlight as the world’s new beacon for financial stewardship. It’s a compelling narrative that has been promoted by the federal government and the Bank of Canada as they encouraged Canadians to spend their way through global economic turmoil.
But pry through the pocketbooks and bank accounts of the average Canadian and the country looks remarkably like the America of 2005—or even worse by some measures—complete with record house prices and unprecedented debt. “One of the really terrible narratives we’ve allowed to develop in the minds of Canadians is that somehow we are better than the U.S. and so that means we have nothing to be concerned about,” says Ben Rabidoux, who runs The Economic Analyst website and parlayed his obsession with watching the housing market into a job with a Wall Street firm that advises institutional investors on how not to get caught up in the Canadian miracle/disaster.
What Rabidoux and others have seen is just how much Canada’s economy has come to rely on the country’s housing boom—and how much consumers have been digging themselves into debt just to keep it going.
Since 2008, Canada’s ratio of debt to after-tax income has exploded. By the third quarter of 2011, Canadians owed an average of $1.53 for every dollar they brought in, up 40 per cent in the past 10 years and just below where the U.S. was before its housing crash. By the end of 2010, the average homeowner had just 34.3 per cent equity in their home, the lowest level in two decades and a 20 per cent drop in just four years.
“Everybody points out the differences in the U.S., about financial regulations and subprime mortgages,” said David Madani, a former Bank of Canada analyst now with Capital Economics. “But to me this is all a borderline attempt to misdirect the whole debate because we’re engaging in that type of discussion and only that discussion. It ignores the big elephants in the room.”
The elephants Madani sees include a sharp run-up in house prices compared to income: the average Canadian home now costs five times the average income, well above the multiple of three that is considered affordable. There’s also a sharp rise in home ownership rates, which at about 68 per cent of Canadians mirrors closely the 69 per cent at the top of the U.S. bubble. Madani also points to continued overbuilding and Canada’s still healthy construction industry. New building permits reached $6.8 billion in December, a 4.5-year high.
The biggest elephant of all is how much the boom has been fuelled by cheap and abundant credit thanks to a low interest rate policy pursued by the Bank of Canada, along with government-insured mortgages. “All the warning signs are there,” Madani says. “We just have to connect the dots.”
There is evidence the tide may already be turning in Canada’s housing market. The Canadian Real Estate Association reported home sales had fallen 4.5 per cent in January compared to December, the steepest decline since July 2010. Prices still rose, but by just two per cent, the slowest in the past year. Kelowna, B.C., a popular spot for retirees and vacation homes, reported a tenfold increase in foreclosures compared to three years ago. The hard landing might already be upon us.
In some major housing markets like Toronto, the signs of a bubble are as glaring as ever. Driven by a glut of condos that has made single-family homes a rarity, house prices have soared to nearly $500,000 on average. Even more proof that the city’s homebuyers have lost their heads: in January a west Toronto renovator’s dream went for $200,000 over asking price.
Nicole Austin, 31, and her boyfriend, Jim Varlas, know the mania all too well. The couple decided to sell their downtown Toronto condos and buy a house in Markham, a suburb north of the city. They moved in with Varlas’s parents and started shopping around for a house with a budget of $400,000. “Either the homes in our price range were really outdated and hadn’t been touched since the 1970s, or they would need to be renovated,” Austin says. They upped their budget to $500,000 and bid on three homes. They lost all three in bidding wars that pushed prices up as high as $575,000. “In some cases we knew what the house was worth and there was a certain point where we’d just walk away because it was getting ridiculous,” Austin says.
Earlier this month, the couple settled on a new build, paying “in the mid-to-high 500s.” But Austin says taking on a larger mortgage than expected was a fair tradeoff for finding a house in their chosen city. The couple say they expect prices to crash, but that doesn’t matter much since they plan to be in their home for at least 10 years.
With an average price topping $348,000 in January, Canadian homes are now worth a total of $3 trillion, nearly twice the country’s GDP. Home prices have doubled since 2002 and risen 13 per cent since the global recession hit in 2008.
When home prices rise, so does consumer confidence. Canadians, believing that their bricks and mortar are a gold mine, have become ever more willing to open their wallets. In less than 10 years, consumer spending has gone from 58 per cent of Canada’s GDP to 65 per cent.
The housing boom has helped prop up Canada’s construction industry, which now represents 7.4 per cent of the labour force, higher than it was in the U.S. at the height of its boom. Add in other housing-related industries, such as real estate agents, mortgage brokers and insurance companies, and the sector represents a staggering 27 per cent of the Canadian workforce. In the U.S., those same numbers peaked at 23.5 per cent. “We are far more dependent directly and indirectly on this current housing boom than they were in the U.S.,” says Rabidoux. “How in the world are you going to orchestrate a soft landing?”
More worrisome is where consumers have been getting their spending money. As wages stagnate and credit card use levels off, Canadian consumers have increasingly turned to their homes as a source of cash. As of last year, Canadians had pulled roughly $220 billion from their houses in revolving home equity lines of credit, a per capita amount three times larger than the U.S. at its peak.
Home equity lines of credit, known in the industry as HELOCs, have increased 170 per cent in the past decade, twice as fast as new mortgages. The federal government recognized just how risky HELOCs had become last April, when it announced it would no longer allow the Canada Mortgage and Housing Corporation to insure them.
Such home equity withdrawals were a large factor in fuelling the economic recovery. In 2007, Rabidoux says, home equity withdrawals in B.C. alone reached 4.5 per cent of the province’s GDP. “This is the real story of the Canadian economic miracle,” he says. “There’s nothing else that did such a ﬁne job of pulling the country out of a recession than inviting people to take three per cent worth of GDP out of their homes.”
Of course, so long as home prices keep rising as fast as they have—averaging five per cent a quarter through 2011—the risk of all this debt seems minimal. It’s when the prices start to slide, as they have recently, that household debt becomes a problem.
Madani thinks the Canadian housing market has already hit a wall. “Overconfidence is what’s driving the market. It’s been fuelled by cheap credit. That just can’t keep going on forever,” he says. “I think it’s going to end badly.”
It’s hard to blame consumers for taking on huge mortgages when banks are offering five-year rates as low as 2.99 per cent. “Low interest rates are like a drug,” says TD Economics chief economist Craig Alexander. “The low interest rates are encouraging people to buy houses and take on debt. When they’re unhooked from that drug, they’re going to have to be unhooked very gradually because going cold turkey is going to hurt them.”
Banks themselves can only be blamed so much for offering consumers mortgages for next to nothing. The Bank of Canada has held its key interest rate at one per cent since September 2010, and most economists expect the bank to keep it there until well into next year.
It’s a dangerous game. Low interest rates might sound great for anyone looking to take out a loan, but they can have a perverse effect on an economy when they stay low for years.
Low interest rates had as much to do with the U.S. housing bubble as subprime mortgages, even working to make such lending more popular, says Stanford University economist John Taylor. He argues there never would have been a housing boom or a bust at all if the U.S. Federal Reserve and its chairman, Alan Greenspan, hadn’t slashed interest rates in the wake of the 2000 dot-com bust and then held them low until 2005. Not only did low rates encourage Americans to take on larger mortgages, but they pushed banks to make more aggressive loans in search of profits and increased demand for higher-yielding—and therefore riskier—debt.
Given what happened in the U.S., many question why the Bank of Canada is sticking to the same strategy. The bank is well aware that its monetary policy has encouraged Canadians to pile on the debt. Governor Mark Carney has taken to sounding the alarm bells about household finances every chance he gets, telling the CBC in December, “The greatest risk to the domestic economy is household debt.”
The warnings have, predictably, fallen on deaf ears. Who, after all, can resist the lure of free money? The damage was done in 2009, when the Bank of Canada slashed interest rates to 0.25 per cent in April and promised to keep them there until the second quarter of 2010 on the condition that inflation didn’t spiral out of control. Inflation spent much of 2011 at three per cent, above the bank’s target rate of two per cent.
“You could argue that the Bank of Canada, by keeping interest rates so low for a long time, violated to a certain degree its mandate in terms of price stability,” says Thorsten Koeppl, the Queen’s University economist who spent much of 2011 advocating for higher interest rates to curb inflation.
So if Carney is partly to blame for inflating the bubble, could he have done anything differently? Most economists say Carney’s hands have been somewhat tied by the U.S. Federal Reserve, which is expected to keep its interest rate at near zero until 2014. Raising Canada’s rates too high by comparison would inflate the loonie, punishing exports and manufacturing.
But at some point the risks of a housing bubble begin to eclipse those of harming the export economy, and some economists have started calling on Carney to stop just scolding profligate consumers and start setting interest rates based not just on inflation, but on the stability of the financial system, including rising levels of household debt.
“I don’t know how effective his talks will be if we see lower and lower and lower rates,” Koeppl says. “The stakes are much higher, the imbalances are larger, the risks are larger and the moral suasion works less and less. The issue really here is when do we go back to a normal monetary policy regime?”
Getting back to normal interest rates of three to four per cent becomes increasingly difficult the longer rates stay low. Carney may be caught between trying to boost employment by getting business to spend their unused capital and trying to stop consumers from digging themselves into a hole. But he may also have backed himself into a corner if inflation or unemployment rises unexpectedly.
“One of the problems with getting out at the extremes of things like debt and financial crises is that all of your policy options get harder and harder and harder and you can’t fix one problem without another major side effect. And we’re in side effect city,” says University of Manitoba finance professor John McCallum.
TD’s Alexander believes an interest rate hike of two percentage points would push 10 per cent of Canadians into danger territory where they would be spending upwards of 40 per cent of their income on debt payments. “The economy is very sensitive to shocks,” he says. “Every quarter-point increase in the interest rate could have a far greater impact on the economy than a quarter-point increase could have had 10 years ago.”
Mortgage rates are especially vulnerable. Shorter-term variable rates, which are linked to the Bank of Canada’s overnight rate, have become increasingly popular, now making up about 40 per cent of the market. Nearly half a million homeowners swapped their fixed-rate mortgage for variable rates last year. “If you’ve got a very big variable rate mortgage and those rates moved up two to three per cent, I think a lot of families are right at the line in terms of spending and suddenly they’re looking at a very big jump,” McCallum says.
Where analysts say there is more room to move is in Canada’s housing policy, including reining in the growth of mortgages insured by the CMHC. This month, the government-backed insurance corporation warned that it was close to maxing out its $600-billion budget for insurance, driven in large part by banks insuring portfolios of low-risk mortgages, which are repackaged as bonds and sold to investors, primarily in the U.S.
Since they were first introduced in Canada in 2007, such investments, known as covered bonds, have grown from a $2-billion industry to $50 billion, with much of the growth coming in just the last year. The rise in mortgage bonds has also worked to drive mortgage rates down by freeing up banks’ money to make more loans.
The Conservative government has taken some steps to tighten mortgage rules, including lowering amortization periods to 30 years from 40, and raising the minimum down payment for CMHC insurance to five per cent from nothing. CMHC says it will limit the amount of portfolio insurance it offers to banks.
Rabidoux thinks the CMHC should reinstate a cap on the price of mortgages it will insure. Until 2003, the corporation would only insure mortgages up to $300,000 in markets like Vancouver and Toronto. After a decade of relatively flat growth, house prices rose steadily once the CMHC removed the cap. “The point of the CMHC is not really to get people into their dream house off the backs of taxpayers,” says Rabidoux.
But the debate has already morphed into one over whether the Canadian government should be in the mortgage insurance business at all, or whether the CHMC is the product of a bygone era when working stiffs had little opportunity to buy their first home without a huge down payment.
“It may be those times are past and we need to take another look at the whole of housing policy,” says economist David Laidler, a professor emeritus at the University of Western Ontario. “It’s something you need to think about as a major policy issue on the same level of health care.”
Of course, it may be too late for such a discussion. As the U.S. showed in 2005, no matter how loud the alarm bells and how long they’ve been ringing, a housing crash always comes as a surprise to the people paying the mortgage.
Or as John McCallum puts it: “The thing with household debt is it’s not a problem until it’s a problem. But when it becomes a problem, it’s usually a really big problem.”