Faceoff: Bubble trouble

Benjamin Tal, managing director and deputy chief economist, CIBC World Markets Inc.

Stance: Slowdown, not slump

Every time there’s news about a dip in Canadian housing activity it fuels frenzied speculation about an impending U.S.-style crash. While home prices in Canada are headed for a correction in the coming year or two, it would be an overstatement to liken it to the U.S. market of 2006. Canada today is very different from a pre-recession America, especially as far as borrower profiles go.

Cautious optimism

The extremely low mortgage delinquency rate in Canada can be considered a measure of our stability.

But our southern neighbour has taught us that this sea of tranquility can turn cataclysmic overnight. In just a short 18-month period in 2007-08, the mortgage arrears rate in the U.S. surged by more than 300%.

The same holds true for the claim that the debt-to-asset ratio in Canada has been relatively stable. The U.S. basked in the same stability in the years leading to the recession, but that did little to prevent the crash.

Many housing experts may also argue that unlike the U.S., Canada (with the exception of Alberta) provides a more foolproof buffer by being a recourse country—lenders can go after borrowers’ other assets to pay down a mortgage.

Housing market performance

But research shows there’s no significant difference in housing market performance between recourse and non-recourse states. Besides, only 12 U.S. states are non-recourse states (see “Housing market performance,” right).

Also, mortgage interest payments south of the border are tax-deductible, thereby igniting a ravenous appetite for ownership. But research suggests mortgage interest deductibility (MID) played only a minor role in elevating U.S. homeownership. Just over one-fifth of American taxpayers claim MID, and only 15% of them earn less than $50,000 per year. And for those 15%, the average tax savings are less than $175 per year.

Advantage Canada

Not all of Canada’s perceived advantages rest on shaky ground. Yes, the debt-to-income ratio in Canada just broke the American record set in 2006, but this ratio compares the stock of debt to the flow of income, and the latter also includes income of households with no debt whatsoever. A bunch of countries with higher debt-to-income ratios have not experienced anything resembling the recent U.S. debacle.

While we can’t ignore the level of that ratio, the speed at which it grows is more important. Here the picture is better. Comparing the three years heading into the U.S. crash to the past three years in Canada reveals the debt-to-income ratio in Canada has been rising at half the speed seen in the pre-crash U.S. market.

And on average, over the past decade, housing starts in Canada exceeded household formation by only 10%—with most of the excess relegated to cities such as Toronto and Vancouver.

In the U.S., the gap during the decade leading to the crash was almost 80%.

Subprime saga

Even more paramount than the quantity of debt is its quality. In the U.S., the proportion of debt in the risky category rose by 10 percentage points and accounted for 22% of the market just before the recession. That’s not the case in Canada.

In 2006, non-conforming mortgages (subprime + Alt A) accounted for 33% of originations and close to 20% of outstanding mortgages in the U.S. What’s more, an astonishing one-third of mortgages taken out in 2005 and 2006, before the drop in prices, were in negative equity position, and more than half had less than 5% equity, making them highly exposed to even a modest decline in prices.

In Canada, the negative equity position is nil, and only 15% to 20% of new originations have an equity position of less than 15%. Furthermore, we estimate the non-conforming market is currently at around 7% of mortgage outstanding, up from 5% in 2005 but dramatically below the level seen in the U.S. before the crash.

At its core, the U.S. meltdown was a story of subprime souring. Average house prices in cities with above-average non-conforming exposure fell by 40% from the June 2006 peak — double the decline in cities with below-average exposure. Eradicate subprime from the U.S. housing market and, instead of the most severe house price meltdown since the Great Depression, you get a soft landing.

A typical U.S. mortgage is for 30 years compared to a typical 5-year term in Canada, which makes Canadian borrowers more sensitive to the impact of interest-rate hikes. Borrowers here are already curbing their rate sensitivity by reducing the share of variable rate mortgages in new originations to a multi-year low (mainly among more risky mortgages). It was just the opposite in the pre-crash U.S. The share of adjustable-rate mortgages (ARM) remained elevated until the end, with 80% of non-conforming originations being ARMs.

Advice to investors

If you’re buying for the long haul, the market shouldn’t impact you all that much. But if you buy now, you’re probably buying at the peak. As far as investment properties and condos, you should hold up fine if rental income, not capital appreciation, is your goal. There continues to be more rental demand than supply in the market.

I have been optimistic about REITS for a while. They will continue to do well for the next year or two because interest rates will stay relatively low, and there is a huge demand in the market for high-dividend-yielding properties. Worry about REITs when interest rates start rising in earnest.

Barry Page, CRA, residential appraiser and former instructor, licensing program at the Ontario Real Estate Association

Stance: The bubble could burst

We’re overdue for a correction, particularly in Ontario. The market is still overheated with overly competitive offers—20 to 25 offers at times—on properties priced between $300,000 and $700,000.

Single-family units may seem unscathed, but the downturn has already hit the condo. Prices have not yet corrected, but activity is down 60% to 80%. Prices will eventually follow transaction volumes. In the housing slumps of ’74, ’80 and ’90, the condo market fell first; the rest followed.

Upper-end recreational properties in Ontario have also taken a beating—dropping 20% to 30%, depending on the area. There’s a glut of listings and no activity. For example, there were properties last year over the $800,000 mark in Simcoe, Ont., and just two sold. Rural areas have also witnessed a couple of months of significantly low activity, leading to surplus supply and shadow inventories.

All these signs indicate we might be perilously close to a downturn. All it might really take for the market to spiral are major newspapers claiming, “It’s over.”

Defying gravity

Historically, Canada has always reflected the U.S. market. But the 2008 housing downturn never really touched urban Ontario. Prices in Toronto fleetingly adjusted downward, but then immediately started to climb. Now Toronto and Vancouver are peaking as rural Canada corrects and the United States bottoms out.

The Canadian government succumbed to market pressures and loosened borrowing requirements, extended amortization, and lowered interest rates to boost economic activity. That led to conditions quite akin to the subprime market in the U.S. before it imploded. The government has since taken corrective measures by tightening home-lending rules, but the measures have come too late.

In its eagerness to stoke up the dying embers of economy, the federal government made another crucial mistake in 1996: exempting high-ratio properties from formal appraisals. For those houses, the Canadian Mortgage and Housing Corporation introduced Emili—an automated system that averages the value of recent sales of nearby homes to gauge property values.

However, inaccurate over-valuations by the database—when the market was peaking—posed significant problems for home buyers, sometimes forcing them to overpay or over-borrow for a home that hadn’t been individually appraised. New CMHC guidelines introduced in summer 2012 have since reversed that situation, but it may be too late.

Appraisals based on generalities have led valuations to be off by 10% to 15%. If the market were to drop 10% or 20%, you could be looking at situations where your home is worth 20% to 40% less right off the bat. There is a very real danger of that happening in Ontario. Some of these homes are essentially financed at 110% or 115% (if a buyer put no money down when CMHC was insuring them at 100% of the purchase price), and are now in negative equity. That means Canadian taxpayers could also be at risk if mortgage defaults spike and CMHC cannot liquidate properties at their anticipated prices.

I don’t think we’re going to see a repeat of the crisis of the ’90s. That was an anomaly. Historically a decline lasts seven to eight years. During that downturn, we didn’t get back to 1990 prices until 2004. The U.S. market has already started its arduous trudge back to pre-recession prices. Hopefully that uptick will halt our downward spiral, especially in the rural areas.

There’s an ugly possibility of a crash looming. Historically, if the employment situation goes sour, a crash becomes reality.

Advice to investors

If a client is considering a house worth more than what he’s selling, advise him against it. But if his property is worth a million today and he’s downsizing to something worth $500,000, go for it.

If clients are looking to buy a condo, it might be prudent to wait six months and watch where the wind blows. If I had cash, I’d be buying real estate in Vegas, Phoenix or somewhere in Florida.

Kanupriya Vashisht is a Toronto-based financial writer.