Canada's Housing Boom - Too Good to be True?
Last week I received an email from Lombard Street Research, a very well-respected macro research outfit in London, UK to which we are paid-up customers. Noted commentator Leigh Skene had a note on Canada with the not-so-flattering title “Behind Canada’s Facade.” There has been a growing chorus of “Doubting Thomases” on Canada’s “too-good-to-be-true” economic performance during and after the 2008 credit crisis, with much of the criticism coming in the last 6 months or so. Given that we have many international clients as well as Canadian clients, it behoves us to wade into the debate!
The principal areas of concern are household debt, inflated real estate, rising government debt/deficits and a risk of a sharp slowdown in economic activity. Canadian household debt levels are highly elevated relative to our reputations as far more sober consumers than Americans.
Source: mrb partners
The high level of household debt is undoubtedly a function, in part, of extremely low interest rates, rising home prices and financial innovation – namely ‘Home Equity Lines of Credit’ (“HELOCs”).1 Household debt is at 153% of disposable income (Q3/2011) versus 146% in the U.S. Warnings from Finance Minister Flaherty, BoC Governor Carney and even Canadian bank CEOs on the need for consumers to reduce borrowings are evidence that debt levels are uncomfortably high. As shown in the chart below, the composition of household debt between consumer and mortgage credit is detailed. Mortgage debt has climbed to nearly 100% of disposable income from 50% in the past year.
Source: Statistics Canada
A recent CIBC report4 suggests that Canadians are now at the upper limit of what they can carry and service as evidenced by the recent slowing in the rate of debt growth. Indeed, they find that most of debt issued has been the 45+ year-olds who have simply piled on more debt as rates collapsed.
Source: Canada Financial Monitor, CIBC
This is not a good statistic from a demographic/future savings perspective. The delta on changes in interest/mortgage rates, even marginal increases, could substantially impact our economy (Click here to read more).
Of course, debt service would be easier if we had rising real wages/incomes. Unfortunately, Canada has not done well on this front with growth in real disposable income at a 15-year-low. Poor productivity is also a big issue.
Source: Statistics Canada
Given that the large increase in household debt is largely associated with HELOCs, of which roughly 40% was used for consumption (particularly in 08/09) and home renovations, government officials are right to be concerned. Only the virtuous cycle of rising debt, leading to rising home prices, leading to more HELOCs, etc., etc., has kept things above water. The following chart from Friday’s Bank of Canada release shows how closely HELOCs and home prices have been correlated from 2000 onwards.
Source: Bank of Canada, Teranet, CREA and authors calculations
Jim Murphy speaking on behalf of the Canadian mortgage industry stated that a “sizable minority of almost 650,000 people (who) would be challenged by rate rises of less than 1%”9. About 5.8 million Canadians have mortgages.
An important factor in this virtuous cycle has been the Canadian Mortgage and Housing Corp. (“CMHC”) which has provided “insurance” to our banks for purchasers who do not have the necessary 20% down payment banks typically require. Without CMHC insurance, people who would not have normally qualified can put down as little as 5% to obtain that mortgage. Some have compared this to U.S. subprime or ALT A loans, but this is nonsense. Canadian banks do not issue NINJA loans but they have been busy laying off a lot of risk on the CMHC. As a taxpayer-funded government institution, the CMHC has come under criticism from outside of Canada as nothing more than a Fannie/Freddie look alike. Given the fact that it has $500+billion of “in force” insurance with only $11 billion of equity (Q3/2011), taxpayers have a right to be concerned. However, I suspect most Canadians are unaware that they indirectly support a subsidized housing policy in Canada, especially since 1999. To date, over 90% of all mortgages are guaranteed by the CMHC. One of the direct consequences of the CMHC’s activity has been to inflate the rate of home ownership (versus renting). While this has positively impacted economic growth, it has also introduced risks. similar to those in the U.S. prior to its housing bust.
Today, the ratio of home prices to household income is approximately 5x – versus an average of 3.5x. That is simply too high, as many people are forced to stretch for home ownership. As they say, nothing cures high prices like high prices. The question is, how overvalued are Canadian home prices? The Economist, Capital Economics and others suggest that Canadian residential real estate is 25% overvalued while research from TD Bank and others suggests something closer to 10%. According to the CREA, Canadian home prices rose 30% between July 2006 and November 2011, while Case Shiller shows U.S. home prices declined by over 30% during the same period. The Economist has a neat interactive graphic (Click here to try) - I took the liberty of putting in Canada, Australia and the U.S.
Source: The Economist
Maybe the U.S. is just cheap?
As an alternative to price, one could examine the supply and demand dynamic. Economist George Athanassakos is predicting a sharp correction in home prices, given that residential real estate construction has hit his 7% of GDP threshold that usually signals a downturn
Anecdotally, Nicolas Johnson recently reported that there are now more condos under construction in Toronto (167) than in New York City!
Undoubtedly, a good deal of this growth is related to the massive build-up of condominium towers fueled by foreign and domestic speculation. We have seen this movie before in the early late 80s early and 90s in Canada.
Many pundits are suggesting that housing will undergo a mild correction – a soft landing of sorts – as supply and demand came back into balance. History, however, suggests that our current state of affairs is very susceptible to an exogenous shock (serious global slowdown, oil price spike, rise in interest rates, etc.), which would have a very deleterious effect on consumption and economic activity. When one looks at the U.S. prime mortgage market, it would have been previously inconceivable that some 12% of borrowers would be seriously delinquent on their payments, with over one-third of them underwater on their debt relative to their home price. While hard to imagine in Canada today, it is certainly not impossible. Without a doubt, the current under performance of Canadian equities and the Canadian dollar is partly due to these worries.
In a follow-up post, we will look at Canada’s economic performance from a fiscal and macro-economic perspective. In particular, we will look at government spending and debt levels.
1. Bank of Canada Review, Winter 2011-2012, Special Issue: Household Finances and Financial Stability
2. Annual State of the Residential Mortgage Maket in Canada; November 2011, Will Dunning, CAAMP Chief Economist
3. Capital Economics, Canada Economics Update, June 15, 2011 and Feb 3, 2011
4. CIBC World Markets, January 26, 2012 Beyond Debt-to-Income: New Light on How Canadians are Really Doing; Avery Shenfeld and Benjamin Tal
5. The Economist, “Castles Made of Sand”, November 24, 2011
6. Bloomberg, “Canada Housing Heads for Severe Correction on Investment”, February 17, 2012; Doug Alexander and Ilan Kolet
7. Lombard Street Research, “Behind Canada’s Façade”, February ,2012, Leigh Skene
8. Globe & Mail, “Toronto’s Moving up…and up”, February 19, 2012
9. Globe & Mail, “’Sizable Minority’ of Canadians at risk if mortgage rates rise report warns”; November 9,2011; Steve Ladurantaye
10. MRB Partners, Canada Country Report, February 24, 2012