Where there's smoke, there's fire … except for those times when there's a production crew with dry ice, a wind-machine, and the soundtrack from the Fireplace channel.
Sensationalism in the market equals big dollars for media companies. I'll bet my life you are more likely to read a story titled "Market on Verge of Collapse!" than you are "market to remain relatively stable to foreseeable future." Sensational headlines tap into our carnal emotions, inspiring fear in many, anxiety in most, and excitement in nut-jobs like me always looking for a calamity to profit from.
Enter the worst kept secret in the economic universe these days: the Canadian housing bubble, an epic, titanic bubble 3,708 lbs in weight with 30 million cubic feet of air capacity stretching 55 stories high at its peak altitude. Sorry, that's the Red Bull Stratos high-altitude balloon … but you get the picture.
Many point to the marked similarities with the U.S. housing bubble, still so vividly entrenched in our memories, haunting us like the threat of another sequel to the Paranormal Activity movie series.
And the similarities are striking.
Outstanding Mortgage Loans
% Subprime Loans
150% - 160%
10-year Price Appreciation
Peak-to-Trough Price Decline
30% - 35%
*Estimates on outstanding non-prime Canadian mortgage loans range from $86 billion to $500 billion depending on the definition chosen and how much you want to scare people.
It seems that finally the air is being let out of the balloon, as prices began to stall during the summer of 2012 and declined substantially in the city of Vancouver.
Looks Can Be Deceiving
But if you can clear the fog from your glasses, you'll see there are some major differences between the two markets that expose the Canadian housing bubble as an imposter with dwarfism.
Low Interest Rates
A good friend told me people don't buy homes - they buy payments. The sticker price of the home is basically meaningless. What matters is how high their monthly payment is. Put another way: Household Debt-to-Income is much less important than Household Debt Service Requirements-to-Income.
And, of course, current Canadian interest rates are much lower than the equivalent American rates at the peak of the U.S. housing bubble.
Central Bank Rate
30-year Fixed (U.S.)
6.5% - 7%
6% - 7%
3% - 3.5%
For mortgagees, the increased principal portion has been offset by a declining interest portion, leaving payments relatively flat. And the evidence is in housing affordability as tracked by RBC.
Their measure tracks pre-tax household income required to service a standard home. Canada-wide, the index reached 43.4%, just 4% higher than its 30+ year average and still well below the peaks reached in 1992 when Canada suffered its worst housing-related recession since the Great Depression. This is hardly a sign of a distressed borrower.
Of course, there is a legitimate possibility that rates could increase quickly. The impact in the short term would be muted, however, given over 70% of Canada's outstanding mortgages are closed and have terms greater than 5 years. This shields borrowers from a dramatic increase in their payments, at least for a short while.
Better Lending Standards
Canada and the U.S. have two very different approaches to financial oversight and this has manifested itself in tighter lending standards north of the border. The Canadian federal government regulates financial institutions to such a degree it makes Barack Obama look like Ron Paul. Lending in Canada is a lot like being in high school detention. Lending in the U.S. is a lot like, well, this.
Suffice to say that the U.S. housing market went outright crazy in 2005 and 2006 … what with its 0% down payments, interest-only loans, no doc loans, liar loans, no hablo ingles loans, and no-income no-job no-asset loans. And when the borrower was so strapped for cash he couldn't even come up with the 0% down payment, they dreamed up negative equity loans.
In Canada, the maximum loan-to-value ever available was 95% and any down payment less than 10% had to be fully insured by CMHC (for Schedule 1 banks). So-called 'stated income' loans were available for self-employed individuals, but not for any less than 20% down and insured.
Also, the qualifying rate used is not the actual contracted rate, but a mythical, seemingly-produced-from-thin-air rate posted by the Bank of Canada. The required qualifying rate was 5.24% the week of 10Oct2012. On that date, essentially all the banks had 'Special Offer' rates in the 3.5% range.
What's more, the Canadian government has actually moved to tighten these standards in 2012 to reel in the "loose" lending years of 2010 and 2011.
Finally, we have financial regulatory proof that Canadians are boring.
One Bad Apple Spoils the Whole Bunch
Back to the RBC Affordability Index. RBC breaks down the index by major cities. Calgary, Edmonton, Toronto, Montreal, and Ottawa are all within 5 points of their long-term averages (plus or minus). Even in Toronto, where there are a record number of cranes erecting a record number of downtown condominiums, the Affordability index is only 5.5 points above average and still well below the nosebleed levels of the early 90s.
And then, there's Vancouver. In Vancouver, a standard 2-story home costs more than $850,000. At today's interest rates, payments eat up a stunning 93.8% of the average homebuyer's pre-tax income. That barely leaves enough money left over to support the average Vancouverite's specialty coffee addiction, never mind furnishings, a vehicle, a gym pass, and that extravagant luxury called 'food'.
There is surely some pain coming in Vancouver and, in fact, it's already here.
Remember September 29, 2008? The Dow collapsed 800 points after the U.S. House of Representatives voted down the Emergency Economic Stabilization Act. In hindsight, it was a fitting end for a month that saw the government takeover of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the $85 billion bailout of AIG, and the FDIC-sponsored fire sales of Washington Mutual and Wachovia.
It was a torturous and petrifying month for corporations, small business owners, employees, and others as the U.S. government grappled with an intractable dilemma. Should it bail out these gigantic financial institutions and effectively socialize the losses of incompetent, greedy financiers that deserved to suffer the consequences of their actions? Was it fiscally capable? Was it politically feasible? Was it morally justifiable?
While I can understand not wanting to bail out bankers that wouldn't pull a thread out of their Gucci suit to help clothe a homeless man, the 'No' vote that September was the economic equivalent of cutting off your nose to spite your face. Without the certainty of government backing of the financial system, businesses across the globe clammed up like a vampire on a sunny afternoon on South Beach.
By the time the act was tabled for a second vote, passed on October 3, 2008, and then switched from an asset purchase program to a recapitalization program, the damage had been done. The U.S. economy ground to a halt and bled millions of jobs. If the housing bubble was a tsunami, the uncertainty surrounding the U.S. government's role was the equivalent of a bad early warning system.
There will be no such uncertainty in Canada. The Canadian government has already nationalized the losses. No voting required, no politicking behind closed doors, no intensive economic and social debate. They skipped all that nonsense with what may be the first preemptive financial sector bailout in economic history.
The Canadian Mortgage and Housing Corporation (CMHC) is a federally owned and operated entity, which, among other functions, provides default insurance to banks and other finance companies that provide residential mortgages to personal borrowers. The guidelines for obtaining CMHC insurance are such that they insure some of the riskier loans in the market. After all, the banks don't need insurance for the strong loans.
As of 30 June 2012, CMHC has insured $576 billion worth of mortgage loans. That's more than 50% of all mortgages outstanding in the whole country! That's almost as much as TARP! That's almost as much as Jerome Kerviel owes Societe Generale! And it's enough to ensure the viability of Canada's financial system well into the future.
Coming Up Short
So, the Canadian housing market is unlikely to suffer a collapse similar to that of its southern neighbor and, even if it did, the Canadian government has guaranteed the safety of its financial system through CMHC insurance. But just because it is a little different this time doesn't mean there isn't a way to profit from what still could be a very real slowdown in housing prices and construction, just not necessarily in the way you think.
Stay tuned for part 2.