Canadian housing: Bursting bubble or gentle landing ?

A Brewing Canadian Crisis, and What Americans Learned About Bubbles

Americans don’t like admitting failure. But after the 2008 global recession, something became unavoidably clear: The Canadian economy fared better than the United States.

Your banking system didn’t crumble like ours. Your unemployment rate didn’t rise as much as ours. Your budget deficit didn’t balloon like ours. When the headline, “For the First Time, Canadians Are Richer Than Americans,” appeared last summer, we cringed. Americans did something wrong. Canadians did something right.

But what?

In short, Canada avoided a housing bust. History makes clear that as goes housing, so goes the overall economy. And as American home prices took a bath from 2007 to 2012, Canada’s housing market marched higher. This alone explains most of why America suffered while Canada prospered.

But things are starting to turn.

American home prices are growing again. Canadian home prices are beginning to dip. A new theory is emerging: Canada didn’t avoid a housing bust. It’s just late to the party. As Robert Shiller, the brilliant Yale economist who predicted America’s housing bubble, put it: “I worry that what is happening in Canada is kind of a slow-motion version of what happened in the U.S.”

A reckoning by the numbers

Investor Marty Whitman once said that “Rarely do more than three or four variables really count. Everything else is noise.”

One variable that “really counts” in real estate is home prices in relation to average incomes. People have to pay for their homes over time, and that money has to come from income. While the short run is dominated by changes in interest rates and supply, there is little historical precedent for home prices growing faster than incomes over time.

Measure average home prices against average incomes, and you get this:

USACanPriceIncome

During America’s bubble, we made all kinds of excuses for home prices growing faster than incomes. We said housing was special. We said mortgage rates would stay low.  We said we could always sell our home to someone else. And we were wrong about all three. By 2010 the price-to-income ratio of American homes plunged back to historic average levels, where the humble laws of financial arithmetic said they belonged.

Another useful metric is home prices measured against average rents. It shows more of the same:

USACanPriceRent

Americans once tried to justify home prices rising faster than rents. We said there was pride in owning a home. We said renting was throwing your money away. We said owning a home provided freedom. But we ignored that rents are to homes what earnings are to stocks — a symbol of valuation that, over time, act as an anchor on prices. The price-to-rent ratio in Canada has risen by 70% since 2000. One Canadian commenter told a personal story atThe Daily Beast recently: “Buyers in Toronto are paying $1,958 a month to buy a place they could rent for $1,104.” That is neither sustainable nor rational over time.

Canada, you have a problem.

Economists at TD Economics forecast a decade of flat Canadian real estate prices after inflation. Others predict a plunge of up to 25%. Moody’s is contemplating a 44% crash.

Could they be wrong? Of course. There are a few arguments for why Canadian home prices won’t crash like America’s. None, however, are watertight.

Canada has more sensible rules regarding a borrower’s ability to walk away from a home even when they can afford the mortgage — although some say that law actually helped America’s housing bust end sooner. Chinese investors have provided outside demand to Canadian markets. But that may be just as big a bubble. Canada’s banking and mortgage system is often seen as more resilient than America’s was last decade. But that’s now being questioned, too. Morningstar analyst Dan Werner recently showed that the loan-to-value ratio in the Canadian market is similar American circa 2007. He wrote:

If 20% of the uninsured underwater residential loans are losses, the impact on tangible capital levels becomes meaningful with a 30%-40% reduction in pricing. In a worst-case scenario, if all of the uninsured loans were losses and residential prices fell 30%, we think nearly half of most banks’ tangible equity would be affected.

Werner singled out National Bank of Canada (TSX:NA) and CIBC (TSX:CIBC) as particularly vulnerable, according to CNBC’s John Carney. Toronto-Dominion Bank(TSX:TD) and Bank of Montreal (TSX:BMO) appear the strongest. But America learned that picking winners and losers is a tough game before a crash takes hold. “It’s only when the tide goes out that you learn who’s been swimming naked” Warren Buffett says.

What now?

We can’t predict when slowly falling home prices might turn into a crash. But let me share a few lessons America learned from our housing bust.

1. Housing markets are regional. Attitudes toward housing aren’t.

Canadian market watchers often say a housing bust will be contained to a few regional markets. Vancouver and Toronto come up most often.

Americans had faith in a similar theory. In 2005, Federal Reserve chairman Alan Greenspan said that while “we don’t perceive that there is a national bubble … it’s hard not to see that there are a lot of local bubbles.”

We learned the hard way that he was wrong, because the theory is wrong. The worst of America’s housing bubble was concentrated in a few cities — Las Vegas, Miami, Sacramento, Phoenix — and they were hit the hardest when the bubble burst. But the crash changed the way all Americans thought about housing. Home prices lost value from coast to coast once Americans realized that a home isn’t a safe investment, but just a place to live and a potential liability. It was a paradigm shift in attitudes across the country.

2. Pain in the housing market spreads quickly.

A home is most people’s largest asset, and it’s usually leveraged. A small decline can be devastating on household wealth. Rebuilding that lost wealth after a housing crash takes time, and the increased saving diverts spending that would have otherwise gone toward going out to the movies, buying a new car, or taking a vacation. A housing bust is almost never contained to the housing market. It affects the entire economy.

3. There is never one cockroach in the kitchen.

We originally called our housing problems the “subprime crisis” because we thought the whole problem was centered on low-quality mortgages. We were wrong. As the tide went out we learned that Americans were addicted to all forms of debt — credit cards, auto loans, and anything else we could finance.

Canada appears to be in a similar situation. Debt among Canadian households as a share of disposable income is now at a similar level that prevailed in America in 2007, and double the level seen in the 1980s. A good portion of that debt is consumer credit, not just mortgages. It’s not so much the housing bubble but the debt bubble in general that poses a risk.

It gets better

The most important lesson America learned from our housing crash is: This too will pass. And then it gets better. Our housing burst caused Americans to live within their means again. It forced us to think more rationally about our future. For those prepared with gumption and a level head, it was an outstanding time to be an investor, as panic caused a once-in-a-lifetime buying opportunity. Warren Buffett says the key to investing success is to “be greedy when others are fearful, and fearful when others are greedy.” Many investors who know that saying miss the subtle lesson: When things look the scariest is when the future is actually the brightest.

America endured. So will Canada.

This post was authored by Fool.com contributor Morgan Housel.

Canadian housing: Bursting bubble or gentle landing ?

It’s looking like an unsettling spring in Canadian housing, a market that has proven far more even-keeled and less scary for investors in recent years than in the United States.

In what is traditionally the best season of the year for real estate agents, Toronto agent Ecko Jay says the industry is seeing far fewer buyers, a result of tighter lending rules, high prices and fear of a bubble. In Toronto alone, sales dropped 40% in the first quarter from a year earlier, making homeowners and investors jumpy.

You can’t get any more conservative than this, when it comes to the housing market.

You want lock in that mortgage? How about knowing what your rate will be for the next 25 years? Such a product actually exists at the Royal Bank of Canada, and it comes with a hefty interest rate of 8.75%.

“Some people want to cash in and pull out now,” said Jay, a 26-year veteran of the Toronto housing market, noting some are spooked by worst-case predictions of a 20 percent drop in prices from current levels.

“They say, ‘Before it gets low, let’s sell,’” Jay added. “And some of my clients want to sell and rent, hoping that when it goes down they will pick up something at a better price. Nobody has a crystal ball.”

But then there are Canadian policymakers, economists and market watchers who have the next best thing to a crystal ball. Their data and analysis point not to a bursting of the bubble like in the United States in 2007-08, when prices from peak to trough dropped 35$, but rather a gentle easing in Canadian housing prices, or perhaps just a momentary pause.

Naysayers believe Canada may be too optimistic and relying heavily on that old saw that Canada is not nearly as reckless as the United States. After all, the debt-to-income ratio of Canadians is at a record high, close to the levels experienced in the United States before its market crashed, and home ownership is at nearly 70$, also a record and five points more than its neighbours to the south.

But Canada does have some things going for it, most notably a move by the government to tighten mortgage lending rules four times in five years, most recently in July 2012, which has taken some buyers out of the market, dampening demand.

“If you look at the developments over the last year in Canada and compare them to the situation in the U.S. before the crisis, there is a clear difference,” said Julien Reynaud, an economist at the International Monetary Fund who follows Canada.

“It is not just a question of housing supply and demand; it is rather a difference in the system of mortgage finance.”

Canadians have more equity in their homes than Americans did, the default rate is lower, the sub-prime market is tiny, and mortgage interest is not tax-deductible, so there’s no incentive to build up debt.

Finally, mortgages are structured as recourse loans in which assets other than the house are held as collateral. That makes Canadian homeowners less likely to walk away than their American cousins.

“What makes Canadian housing different makes it stronger,” says Tom Lewandowski, who analyses Canadian banks for Edward Jones in St. Louis.

LEARNING FROM THE NEIGHBOURS

Lewandowski believes Canada will not suffer a U.S.-style housing crash simply because policymakers had the benefit of watching it happen next door.

“What we experienced here in the U.S. with housing markets and regulators goes directly to the attitude and changes the minister of finance has made in Canada. A regulator who is being proactive is taking Step One in making sure the housing market doesn’t find itself in a bubble,” Lewandowski said.

Both Bank of Canada Governor Mark Carney and Finance Minister Jim Flaherty have been on the march against a housing bubble for years, aware how low rates and loose lending standards in the United States ignited a boom and bust there.

The central bank has held rates low since the global financial crisis because growth remains tepid and global woes weigh on Canada’s export market, and Canadians can find a five-year mortgage rate below 3%.

But the government’s gradual tightening of rules for borrowers — a firm admission that the market was hotter than anyone was comfortable with — has taken some steam out of the market, and economists, like Carney, seem to believe a soft landing may be at hand.

“We’re encouraged by the fact the level of housing starts has come down to slightly below demographic demand, as we see right now, there’s still more adjustments to go,” he said in testimony to Parliament last week. “We’re encouraged by the evolution of house prices in a number of markets. We’re on the path to a balanced evolution of the household sector and we all have to continue to be vigilant.”

PATRIOTISM MASKS PROBLEMS?

Recent history shows, however, that even the top policymakers can make huge miscalculations on housing. The most notorious case might be that of Federal Reserve Chairman Alan Greenspan, who failed to see the U.S. housing catastrophe on the cards before he left in 2006.

Carney may be on to his next job in Europe before any hard downturn in the market proves him wrong. He leaves the Bank of Canada in June for a job heading the Bank of England.

Vancouver is no tamer than San Francisco, and San Francisco is one of our bubbliest cities

The latest figures suggest Canada’s housing market is slowing rather than collapsing. National sales of existing homes were down 15% in March from a year earlier, but they edged up from the prior month as spring buyers breathed a little life back into the market that had been cooling all winter.

Prices, which rose 84% in the last 10 years, are still rising, though they were up less than 3% from last year in March – a slowdown welcomed by everyone but sellers. But bidding wars remain commonplace in hot markets like Toronto, where immigration and low supply fire demand.

Glenn Lowson for National PostYale economist Robert Shiller, one of the few to predict the U.S. housing crash, sees the same thing happening in Canada — just in slow motion.

Interest rates are stuck at historic lows, so affordability is actually improving as the market cools, though it still takes about 42% of pre-tax income to cover the typical costs of owning a detached home. Canadians have $1.65 in debt for every dollar they earn, a ratio that makes policymakers shudder.

The notorious debt-to-income ratio, at a record high, has been cited time and again by Finance Minister Flaherty and Carney as a sign consumers have taken on too much debt.

But while many economists are reassured by the differences between the Canadian and U.S. housing markets, there are some who care more about the similarities.

Yale economist Robert Shiller, one of the few to predict the U.S. housing crash, sees the same thing happening in Canada — just in slow motion.

To Shiller, whose Case-Shiller Home Price Index is widely recognized as the best measure of U.S. house prices, the parallel between the U.S. bubble and Canada’s run-up in home prices measured by the Teranet index is obvious.

“I just plot. I plot the Vancouver Teranet index with my own San Francisco index. It looks the same. Vancouver is no tamer than San Francisco, and San Francisco is one of our bubbliest cities,” said Shiller, who looks at psychology as much as data to draw his pessimistic conclusions.

He’s an outlier. A February Reuters poll of 15 forecasters, including most of the major Canadian banks, predicted Canadian house prices will fall just 7.5% in the next few years. None believe the correction will result in the devastation seen in the United States five years ago.

“It’s not even this time that is different, it is that this place is different,” said David Onyett-Jeffries, an economist at Royal Bank of Canada, the nation’s largest lender.

But Shiller said the psychology and patriotism of bubbles — the idea that a national can’t spot the problems that an outsider can — are not represented by Canada’s low default rates and a system of mortgage insurance that protects banks from default.

“Patriotism needs to be researched more in economics,” said Shiller. “There are psychological and sociological factors as well. Maybe we need a sociologist here.”

Meanwhile,

New US housing bubble?

Record High New-Home Prices Have Room to Grow

Despite moderate moves higher in home sales, home prices are on a tear.

The median price of a newly built home soared to $271,600, the highest level on record dating back to 1963, according to a new report from the U.S. Census. Prices are now 15 percent higher than they were a year ago for new construction and around 10 percent higher for existing homes.

So, Canadian housing: Bursting bubble or gentle landing ?

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