Canada's Housing Bubble

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Tighter regulations needed against overheating real estate, household debt: TD Print E-mail

Mar 19 2012 Eric Lam business.financialpost.com

Canada’s real estate market and consumer debt levels have risen to unsustainable levels, and unless new mortgage regulations are introduced a sharp correction in both would be disastrous for the economy, Craig Alexander, chief economist with TD Bank, said in a report Friday.

“The greater risk from the high level of consumer indebtedness and real estate overvaluation is to the overall economy,” Mr. Alexander said, citing the IMF’s annual report on Canada that warned of significant job losses, housing price declines and protracted weak household consumption as a result of such economic shocks. “Make no mistake, such a combination of forces would likely cause a recession.”

Mr. Alexander advocates measured changes to lending rules as the best choice to address these risks without rocking Canada’s economic boat too roughly.

Possible measures include shortening the maximum amortization on mortgages to 25 years from 30, introducing a minimum interest rate floor on income tests to ensure borrowers can handle a higher rate environment, and a modest increase in the minimum down payment to 7% from 5%.

“A steady and incremental leaning against the further accumulation of household debt and the appreciation of real estate prices seems prudent,” he said.

The key is that the overheating real estate market, which Mr. Alexander figures is between 10% and 15% overvalued nationally, and rapidly climbing household debt ratio are interconnected.

“We need to acknowledge that a significant imbalance has developed and it poses a clear and present danger to Canada’s medium-term economic outlook. It also suggests that further actions to constrain lending growth may be prudent,” he said. “If the overvaluation was fully unwound rapidly, it would be three times the correction in the early 1990s.”

While Canadians usually think of their credit cards first whenever the Bank of Canada sounds off again on household debt, the root cause of the debt problem has been growing home purchases in an exceedingly low interest rate environment keeping markets attractive, he said.

One feeds into the other, leading to imbalances in both at least since the 2008 financial crisis, including a record high debt-income ratio of more than 150% in the past year.

Canadians have heeded the debt warning to some degree, with personal debt growth in 2011, but the overall trend remains upward.

“The outlook is for mild employment and income growth in the coming year, implying that households will gradually become more leveraged over time,” he said.

Of course, the man at the helm of this particular ship is Mark Carney, governor of the Bank of Canada, who has had ample opportunity to raise interest rates by now if he really wanted to, but has been on hold since the summer of 2010.

Problem is, he can’t.

“The Bank of Canada is in a bind,” Mr. Alexander said.

The U.S. Federal Reserve has stated it will keep interest rates at close to zero until late 2014. If Mr. Carney raised rates in contrast, it would make Canadian cash and bonds look even more attractive to investors, pushing the loonie even further above par and further constraining Canada’s tentative economic recovery.

And when interest rates return to more normal levels, about two to three percentage points higher than they are now, it will be an inevitable shock to Canadians. More than one million households will have to devote 40% or more of their income to monthly debt payments, which the Bank of Canada deems unacceptable.

As well, it is illegal for financial institutions to collectively agree to lend less. And with many of the major banks introducing rock-bottom mortgage rates at 2.99% in recent months, it is instead indicative of a very competitive marketplace and of the financial health of Canada’s lenders.

 
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