Friday, 6 January 2012

2012: the Year the Canadian Housing Bubble Will Burst

January 6, 2012

This is the time of year when all economists (and some political economists) are called upon to make their forecasts for the year which is beginning. From the recent data it appears that the USA will have a very modest increase in economic growth, not enough to significantly reduce the number of people who are unemployed, working part time while wanting full time work, or who have given up looking for a job and have left the work force. The European Union has an enormous pile of debt to deleverage, is already in a double dip recession, and all forecasts are for an overall negative growth rate for the year. This can only be bad news for the economies of the USA and Canada.

The housing issue
However, it does seem likely that the average price of a house in the USA will finally reach the bottom of the collapse of their housing bubble. As I write this prices have fallen back to where they were in 2000, the beginning of the formation of the bubble. We can see this in the graph of the trends in house prices tracked by the most respected sources of data, reported here by Calculated Risk.

As most people know by now, the housing market in the USA took off when the government deregulated the finance industry, drastically reduced the interest rates on mortgages, lifted the requirement for buyers to have 20% equity when buying a house, and instructed the federal chartered housing corporations (Fannie May, Freddy Mac, Federal Housing Authority, etc.) to insure all the marginal mortgages. This created what became known as the “sub-prime” mortgage market.

These very risky mortgages were then bundled together into mortgage backed securities (MSBs) which were then sold on the bond markets around the world as top rated investments. This  Ponzi scheme collapsed when many of the new homeowners could not keep up the payments. There are still over four million houses in the USA in some phase of the foreclosure process.

Canada: “The housing market is different here.” 
But as we are told over and over by our political leaders, the spokesmen for the housing industry, the banks, the mainstream economists and the mass media, Canada is fortunate that this did not happen here! There is no housing bubble in Canada! But is this really true? 

Since the end of World War II the price of a house purchased in Canada (and the USA) has averaged between two and three times annual household income. When it rises higher than this ratio, owners become “house poor;” they cannot keep up with all the costs of owning a home and have enough income left over to lead a normal middle class life style.

Furthermore, our economy cannot function as it should when the average price of a house rises so high that the average family cannot afford to buy. In North America around 65% of families and individuals prefer to make monthly payments to bankers rather than landlords. This ratio rose to over 70% in the USA during the housing boom and has now dropped back to the 65% level. In Canada the option of ownership is still at the 70% level.

So where are we now? The average price of a house in the USA is $175,000, and the median family income is $50,000. In Canada the average price of a house today is $362,000 and the median family income is $65,000. So the average price of a house today in Canada is over five times the median family income. But all the powers that be in Canada insist that there is no housing bubble.

Government policy and the Canadian housing bubble

To a very large extent it has been government policy which has promoted the housing bubble. In the 1990s most of the advanced industrialized countries sought to boost their economies by expanding the private housing market. It was hoped that the expansion of the housing industry  would help to offset the decline of the manufacturing industry.

In Canada in December 2006 Stephen Harper’s government introduced 40 year mortgages with no money down. These policies were directly aimed at first time buyers. Interest rates were reduced, and the cost of carrying a mortgages fell significantly. A five year fixed mortgage can be purchased today with an interest rate cost of only 5%. Since World War II mortgage interest rates have averaged a bit over 8%. 

As part of the change in policy, those who bought a house with less than the traditional 20% down payment were required to get mortgage insurance. This was the task of the Central Mortgage and Housing Corporation (CMHC). The risk of default on these mortgages was shifted from the banks and other lenders to the Canadian taxpayers, who own and bankroll CMHC. In 2011 the average first home buyer had only a 7% equity in the purchased home.

Today first home buyers can still purchase a home with 5% down and a 35 year amortization. Furthermore, banks have allowed some first time buyers to borrow the 5% down payment. The results have been as expected. In the United States, the federal agencies holds mortgages worth around $1.3 trillion. In Canada, CMHC has acquired and insured $600 billion of our “sub prime” mortgages. CMHC bundles up these mortgages into mortgage backed securities (MSBs) and sells them as bonds on the international market, 100% guaranteed by the Canadian government. Canada is different,  Eh?

There are signs that the housing bubble in Canada is starting to break, even in some of the key markets like Vancouver and Toronto. Canadian households seem to have finally become concerned over their very high ratio of debt to income. So it is my projection that this is finally the year when our housing market will begin its path down to the normal level. But not in Regina, due to the influx of population. This would change if the oil and potash industries were to follow the general decline now evident in world commodity prices.


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