As a country that earns its living exporting commodities, elevated prices have so far saved Canada from the kind of credit crunch experienced south of the border. In fact, for the last two years easy money has created a housing bubble. So, as the market begins to cool there’s growing speculation there’ll be a sharp correction – and one that would deepen if China’s rapid growth slows. This may be less of a concern for Canada’s banks, protected as they are by government guaranteed mortgage insurance, than its taxpayers.
For 20 years the average house cost $80,000 but between 2001-06 all the major markets in Canada doubled, as more lenient mortgages were introduced, culminating with zero-down, 40-year mortgages by late 2006. After a brief hiatus, Canadians have been lured by cheap money and have carried on buying houses they can’t really afford – detached as they have been from the economic reality facing other Western economies.
High earners in particular, whose incomes have been rising faster than everyone else, have been bidding up prices. By trying to keep up with these Joneses Canadians now have the highest consumer debt to financial asset ratio among 10 OECD countries, including the U.S., as they’ve taken advantage of low rates to maintain spending.
A sign of just how overextended Canadian homeowners are is that 375,000 mortgage holders in Canada are already challenged by their current payments and may not be able to handle higher rates, according to the Canadian Association of Accredited Mortgage Professionals
This is why the Canadian Centre for Policy Alternatives, in a study published last week, estimates house prices in Vancouver, Edmonton, Calgary, Ottawa, Toronto and Montreal will fall about 25% at best, and 35% at worst. Their view has been echoed in reports by CIBC and TD Bank economists, who agree that the appreciation in house prices has been quicker than justified by housing market fundamentals
This leaves home-owning taxpayers seriously exposed, because over half of Canadian mortgages are effectively guaranteed by the government – given that virtually all mortgages where the loan to value ratio is greater than 80% are guaranteed indirectly or directly by the Canadian Mortgage and Housing Corporation. Of course, the ability to pass on the risk to government agencies has not exactly encouraged the banks to be any more circumspect in their lending than Fannie Mae and Freddie Mac were in the U.S..
“With such ready access to taxpayer bailouts, Canadian banks need little capital. They naturally make large profit margins, and they can raise money even if they act badly,” write Peter Boone and Simon Johnson in an article titled ‘The Canadian Banking Fallacy.’
And if Canada’s banks have not been acting badly, they may have been acting irresponsibly, they suggest, given “the camaraderie between the regulators, the Bank of Canada, and the individual banks” – a supposed systemic strength of the Canadian system.
At the end of 2008 Canadian banks were actually significantly more leveraged – and therefore more risky – than well-run American commercial banks. Canada’s five largest banks averaged 19 times leveraged, with the largest bank, Royal Bank of Canada, 23 times leveraged. In comparison JP Morgan was 13 times leveraged, and Wells Fargo was 11 times leveraged. Similarly, JP Morgan’s tier one capital was 10.9% percent, while Royal Bank of Canada had just 9% percent. And U.S. banks also tended to have more tangible common equity than did Canadian banks.
The government clamped down on the loosest lending standards in 2006, when it forbade zero-per-cent-down mortgages with amortization periods longer than 35 years. But by then the housing market had slipped its leash, forcing it to tighten standards this year, by insisting buyers qualify for mortgages at the five-year rate instead of the lower variable rate, and insisting on higher down payments.
“The need to take the Canadian consumer away from the credit punchbowl remains a pressing one,” says Bank of America Merril Lynch, which is why the Bank of Canada will keep hiking rates for the time being. So far the Canadian economy has weathered the storm, but slowing home sales and wage growth that has been decelerating sharply since the start of 2009 are signs that the risk for the Canadian economy is weighted to the downside – especially with talk of a double-dip in the US, and OECD leading indicators rolling over.
A wave of defaults isn’t imminent, but Canadian banks balance sheets still have the potential to deteriorate rapidly, given that they have been “more than willing to collect on the sizable net interest margin” by increasing lending throughout the financial crisis. We all know now what reigning in a credit bubble means. Rising taxes to cover losses on mortgage insurance could be a double-whammy for Canadian consumers when the housing bubble eventually deflates.