NEW YORK (MarketWatch) — Rising home prices over the past decade, combined with mounting household debts, have fed concerns that Canada’s housing market has formed a bubble that’s about to burst.
“We call it a tug of war,” said Sonya Gulati, economist in regional economies, housing and government finance at TD Economics, an affiliate of Toronto-Dominion Bank. “Low interest rates make people want to participate in the housing market, but with modest growth, not strong job creation, we can see a negative repercussion on the horizon.”
A crash, or even sharp retreat, in home prices would contrast to the resilience of Canada’s housing market during the economic downturn, particularly compared to its U.S. counterpart.
Average American home prices have plunged 34% from their peak in April 2006 as of the most recent reading in December. In Canada, national average house prices fell 9% from their peak in August 2008 before they bottomed in April 2009, separate indexes from Teranet-National Bank of Canada and S&P/Case-Shiller show.
The U.S. housing market has recently started to improve, but it’s still far from prerecession levels. Sales of U.S. existing homes rose 4.3% in January, reaching the highest pace since May 2010, the National Association of Realtors said. However, American home prices in December fell to their lowest level since the housing crisis.Read more on U.S. home sales.
Relaxed lending standards in the U.S. and a Federal Reserve policy that kept interest rates at 1% for a full year before the central bank started to gradually raise them were blamed for the rapid gains in U.S. home prices until their peak in 2006, pushing values to unsustainable highs.
Canada discouraged overborrowing and limited its banks’ exposure to subprime lending with more conservative regulations and lending standards. Borrowers had to show employment and income records to take loans, while Canadian mortgage rates were kept higher than the U.S. rates over the same period to avoid boom-time price increases.
Canadians pile on debt
Canadian homeowners weren’t immune from the global financial crisis. But after home prices started to recover three years ago, Canadians have seen a sharp run-up in house prices relative to income, as well as excess real-estate inventories. Their bank accounts show a historic high debt-to-income ratio, spurred by ultralow interest rates.
The Bank of Canada announced on Thursday it would maintain its interest rate at 1%, which the central bank has kept steady since September 2010.
House prices in Canada have doubled in the past decade, with double-digit growth in the past few years. In British Columbia and Ontario, for instance, prices grew by 41% and 29% since their crisis troughs in the past few years, according to a 2011 country report on Canada by the International Monetary Fund.
The Fed cleared the way for many of the nation's largest banks to raise dividends and buy back shares as it released the results of its latest round of "stress tests." Photo: Getty Images
Alongside these gains, Canadian homeowners have become more debt-strapped. The level of household debt relative to disposable income has accelerated to 153% in 2011, versus 110% in 1999, Statistics Canada said.
These levels bear an eerie similarity to U.S. households’ debt burden before the financial crisis. The U.S. debt-to-income ratio climbed to its peak at 130% in the third quarter of 2007, according to the Federal Reserve’s Flow of Funds report. Much of the sluggish U.S. economic recovery has been blamed on a massive deleveraging by these debt-strapped consumers.
Though not a perfect metric, the rising trend in the debt-to-income ratio “flags the fact that Canadians are becoming more leveraged and are more vulnerable to an economic shock than they were heading into to 2008/2009 recession,” Craig Alexander, chief economist at TD Bank, said in a report.
“Housing contributed positively to the boom years and it will have a negative impact on broader economy when the market unwinds,” said David Madani, Canada economist at Capital Economics.
Immigration and population growth in Canada, which has grown 5.9% from 2006 to 2011, help drive housing demands. But the population growth in some cities can no longer keep up with real-estate inventories.
The greater Toronto area has experienced a boom in high-rise condominiums in recent years. Housing starts are approximately 40,000 per year, exceeding the demographic need of about 18,000 to 25,000 units, Gulati, of TD Economics, said.
“The number is not going to be sustained,” Gulati said. “There’s going to be a gradual unwinding of excess in the next few years. The competition between new and resale markets will lead to a negative repercussion in terms of price.”
Fallout from a housing crash would hit Canada’s biggest banks hard.
Some economists said the housing concerns, though warranted, are slightly overblown for the near term. Gradual moderation and correction in housing market are likely.
In a forecast released in February, Canada Mortgage and Housing Corporation, the government-owned housing corporation, said it expected the housing market to remain “steady” for 2012 and 2013.
“We see housing market slowing down, but we don’t believe there’s a bubble in Canadian market right now,” said Benoit Durocher, senior economist at Desjardins.
Durocher noted that the main risk for housing market is Canada’s economic condition. An increase in mortgage rates, modest job creation, and external shocks from weak economic recovery are possible triggers.
Canada’s economy is set to grow at modest pace. Gross domestic product fell to an annualized rate of 1.8% for the final quarter last year, from 4.2% in the third quarter. The U.S. economy grew at an annual rate of 3% in the final quarter 2011.
Bank of Canada estimates that Canada’s economy will grow at 2% in 2012, down from 2.5% in 2011, and at 2.8% in 2013.
Canada economy lost 2,800 jobs in February, putting the job gain total to around zero in 2012. However, the exit of 38,000 people from the work force helped push the unemployment rate down to 7.4%, from 7.6% in January, Statistics Canada reported.
Much of Canada’s economic strength in recent years has derived from its strong natural-resource exports, which have benefited from China’s surging demand. That’s also its vulnerability.
“A decline in foreign demand for Canadian exports and weaker commodity prices in the context of increased global risk aversion could lead to higher unemployment in Canada and a downturn in house prices,” Canada report by the IMF said.
Fewer mortgage perks
But compared to the U.S., Canada still has some structural supports that should help its housing market, said Mazen Issa, Canada macro economist at TD Securities.
Unlike in the U.S., mortgage interest is not tax deductible in Canada, reducing an incentive to take out mortgages.
Defaulting Canadian borrowers continue to be responsible for repaying the full amount of the loan even in the case of foreclosure. In the U.S., lenders cannot recoup money from the homeowner beyond the property if borrowers decide to walk away from their home and mortgage loan.
Home affordability, supported by low interest rates, could be another buffer to a housing collapse.
Sales of existing homes are predicted to rise 0.3% this year but the average home price is expected to fall 1.1%, the Canadian Real Estate Association said in its quarterly forecast this month.
“Low interest rates should hold affordability in check for some time, allowing incomes to catch up with higher prices and restore proper valuations,” Sherry Cooper and Sal Guatieri, economists at the Bank of Montreal, said in a special housing report in January.
Madani, economist at Capital Economics, counters it is a “wishful thinking” that income growth will close the gap between house prices and income. Focusing on house affordability ignores borrowers’ abilities to commit to repay their loans over decades.
“If you buy a home today, that’s one thing,” Madani said. “But you have to be able to pay in 25 to 30 years; it’s more than just the ability to buy a house in today’s market.”
A five-year fixed rate mortgage with a 25-year or 30-year amortization period is the most common mortgage product in Canada, as opposed to the 30-year fixed mortgage mainstay in the U.S. This means that by the end of the five-year term when Canadian borrowers have to renew their rates, they may not realize what an increase in mortgage rates will mean for their personal income and monthly payments, Madani said.
Canadian policy makers, mindful of the destruction wreaked on the U.S. economy by its housing market collapse, have been introducing new measures to prevent borrowers from overstretching.
Finance Minister Jim Flaherty has tightened mortgage lending rules three times since October 2008, recently reducing the maximum term of publicly insured mortgages to 30 years from 35 years.
Banks also started enforcing lending policies on the self-employed and new immigrants.
Nonetheless, mortgage rates that remain exceptionally low risk fostering further, possibly precarious rise in home prices.
“In the last 10-20 years, we see bubbles in commodities, in housing, in the markets,” Madani said. “Is there any great surprise? Canada is not different from other country.”