Why Canada isn’t immune to a U.S.-style housing crash
A new report warns that Canadian home prices could fall 30 per cent in
the next five years
July 10, 2014
Investors should stay away from the Canadian housing market, warns a
new report from Chicago-based investment firm Morningstar. A house
price correction is “inevitable” within the next five years and could
send house prices falling as much as 30 per cent.
The report’s author, equity analyst Dan Werner, also takes aim at some
of the more popular arguments on this side of the border for why
Canada’s housing market is fundamentally different from the U.S.
housing bubble. “Many investors believe that financial crises are
things that happen to other people in other countries at other times;
crises do not happen to us, here and now,” he writes. “History has
shown, time and again, that ‘this time’ is not different. We believe
the same is true for the future of Canadian residential real estate.”
Skeptical? Here are some of the myths Werner debunks for why Canada
isn’t immune to a U.S.-style housing crash:
Canadian banks are better protected because, unlike the U.S., Canada
doesn’t have no recourse mortgages (outside of Alberta). That means our
banks can seize homeowners’ other assets if they default on their
Roughly 80 per cent of U.S. states actually do have recourse laws that
allow banks to confiscate the assets of defaulting borrowers. They
include Florida and Arizona, two states particularly hard hit by the
housing bust. But, Werner writes, recourse laws don’t mean much, since
people who default on their mortgages don’t typically have many assets
for banks to seize, other than their house. “Short of reinstituting
vagrant prisons, the implementation of recourse does not have a
meaningful impact upon bank losses when a housing bubble bursts.”
Americans took on riskier mortgages because they could deduct their
mortgage interest from their income taxes while Canadians don’t have
Typically, only 20 per cent of American homeowners actually take the
mortgage interest deduction. Those that do tend to be wealthier, since
they’re the ones who pay the most income taxes. Among households
earning less than $50,000 a year fewer than 10 per cent deduct their
mortgage interest and they save an average of just $120 in taxes.
Canadians put down bigger down payments and have more equity in their
homes than Americans did before the housing crash.
The average Canadian homeowner has a mortgage worth 45 per cent of the
value of their home, meaning they have 55 per cent equity. It seems
like a lot, but 55 per cent home equity is exactly where the U.S.
average was in 2005. At the same time 23 per cent of Canadian mortgages
have a loan-to-value ratio above 80 per cent, which means those
borrowers have less than 20 per cent equity in their homes. The U.S.
looked nearly identical at the height of the bubble: 22 per cent of
mortgages had loan-to-value ratios above 80 per cent.
At the same time RRSPs have become a major source of cash for down
payments for first-time homebuyers. More than 2.5 million Canadians
have cashed in their RRSPs to buy a house. But in recent years nearly a
quarter of them have had trouble paying back the money, Werner writes.
They’ve either missed the deadline to repay or aren’t paying the
required annual minimums. That’s money that gets taxed as income,
hitting cash-strapped homeowners with an extra financial penalty. It’s
also evidence, Werner writes, that sizeable shares of homebuyers are
struggling to pay down their debt.
Immigration is driving Canadian residential construction.
There are an average of 1.8 people immigrating to Canada for every
house built. But the typical Canadian household has 2.5 people. This
year Werner says we’re on track to build around 20,000 more houses than
we’ll need — and, he writes, we’ve been overbuilding now for more than
The Canadian government has been steadily tightening the rules for
mortgages – requiring higher down payments, shorter amortization
periods, heftier insurance premiums and more proof of income. This will
ensure a “soft landing” for the housing market.
Canada is among a number of countries, including Israel and Norway,
that have dramatically tightened requirements for new mortgages since
2008. None of that has done anything to cool the housing markets in
those countries. Why? As long as mortgage interest rates keep going
down, governments are powerless to put the brakes on house price
growth. “For banks, it is easier to find a way around firmer regulation
than it is to evade higher interest rates.”
Canada Mortgage and Housing Corporation has more than enough money to
withstand a modest house price correction.
The report calculates that even a “modest” 20 per cent drop in house
prices could trigger as much as $12 billion in CMHC’s default insurance
claims – or 75 per cent of the agency’s $16-billion capitals reserves
—if the correction causes widespread defaults.
Interest rates have been going down for years and will keep going down
for some time.
Over the past 30 years Canadian homeowners have indeed had a pretty
good shot at seeing their interest rate go down every time they renewed
a five-year mortgage. Some might be tempted to think that a declining
interest rate is the norm. But in fact, Werner argues, over the
long-term it’s extraordinarily rare: “Getting a lower mortgage rate
five times in a row is essentially the same as flipping a coin and
getting heads five times in a row—a statistical probability of two per
cent,” he writes. Chances you’ll flip a coin for a sixth time and come
up with a lower mortgage rate? About one per cent.
In fact, Werner predicts that over the next five years mortgage rates
will return to their historic averages of around five per cent, up from
the three per cent that’s typical today. In that case, he calculates
that for housing costs could easily consume 75 per cent of the average
Canadian household’s take-home pay.
Think this time it’s different? Think again. Or take our quiz to see if
you can guess which quote about the housing market came from an
official in the U.S. in 2006 or Canada in 2014.