Canada won’t see U.S.-style housing meltdown

There are several factors that raise concerns about Canada’s housing market, including sky-high prices in some cities. However, Canada is still sheltered from a U.S.-style meltdown, finds a report from CIBC World Markets.

“House prices in Canada will probably fall in the coming year or two, but any comparison to the American market of 2006 reflects deep misunderstanding,” says CIBC deputy chief economist Benjamin Tal.

Read: Cdn housing headed for a soft landing: Scotiabank He adds while the debt-to-income ratio in Canada just broke the American record set in 2006, “this ratio is more a headline grabber than a serious analytical tool. There is a list of countries with comparably higher debt-to-income ratios, which did not experience anything remotely resembling the U.S.”

Tal says we should pay more attention to the speed at which the debt-to-income ratio is growing.

“Comparing the three years heading into the U.S. crash to the past three years in Canada reveals the debt-to-income ratio [here] has been rising at half the speed seen in the pre-crash U.S. market.”

Read: Housing: Will the bubble burst?

In the decade leading to the crash, housing starts in the U.S. exceeded household formation by nearly 80%. Over the past decade, the gap in Canada has been only 10%—with most of the excess seen in cities such as Toronto and Vancouver.

Another key difference between Canada and the U.S. is in the quality of mortgages. The distribution of credit scores hasn’t changed dramatically in the past four years in Canada. Stateside, the proportion in the risky category rose by more than ten percentage points and accounted for 22% of the overall market.

Read: Canadians confident about housing But credit score does not tell the whole story. Tal notes many of the troubled mortgages in the U.S. were sold to borrowers with an acceptable credit score. However, they didn’t satisfy the underwriting rules for prime loans because they were unable or unwilling to provide full documentation on their mortgage applications. In 2006, these non-prime mortgages accounted for 33% of originations and 20% of outstanding mortgages.

Read: Housing market cools: report

“In Canada, the negative equity position is nil, and only 15-20% of new originations have an equity position of less than 15%,” says Tal.

He adds, “We estimate the non-conforming market is currently around 7% of mortgage outstanding, up from 5% in 2005 but dramatically below the over 20% seen in the U.S. at the eve of the crash.”

Also, average U.S. 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.

Read: U.S. housing sector to grow at slower pace

And in the U.S., a mortgage was typically 30-years compared to a 5-year term in Canada. Traditionally, this made Canadian borrowers more sensitive to the impact of interest rate hikes. Today, Canadian borrowers 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).

“In the pre-crash U.S., the opposite was the case with the share of adjustable rate mortgages (ARM) staying elevated until the bitter end, with no less than 80% of non-conforming originations being ARMs,” he says.

He adds, “The introduction of the teaser rate, a low introductory rate for a period of two or three years that would adjust upward at the end of the initial period, worked to effectively neutralize U.S. monetary policy.”

Read: Housing crash? So what

Tal notes between mid-2004 and mid-2006, the Fed Funds rate rose by more than 400 basis points, but in part due to the impact of the teaser rate, the effective mortgage rate rose by only 30 basis points. The practical implication of that was when the teaser period expired, millions of Americans felt the full impact of two years’ worth of monetary tightening virtually overnight.

“The reset of no less than $2 trillion of mortgage debt in 2006, and 2007 was no doubt the trigger to the U.S. housing crash. Such a potential trigger does not exist in Canada with mortgage rates likely to rise gradually, allowing borrowers to adjust over time.”

However, not all is well in the Canadian housing market. Home prices are overshooting their fundamentals, mainly in large cities such as Toronto and Vancouver and the recent slowing in sales activity will probably be followed by price adjustments in many cities across the country.

Read: Housing prices up, sales down

“But the Canada of today is very different than a pre-recession U.S., namely as far as borrower profiles are concerned. When it comes to jitters regarding a U.S.-type meltdown, the only thing we have to fear is fear itself.”