They mocked America’s banking system for failing in the realm of conservativism, pointing to Canada’s strong “big five” banks as experts in safe mortgage lending. Canada’s housing was perceived to be God’s gift to the world; something that could never go down in value, despite being just as overpriced as American housing.
For what it’s worth, Canadians are still in the lead in terms of wealth. According to a report, the net worth of the average Canadian household in 2011 was $363,202, compared to around $320,000 for Americans. What put Canada on top? Housing, of course!
Real estate held by Canadians is worth more than $140,000 more on average and they have almost four times as much equity in their real estate investments.
The Difference Between American and Canadian Housing
Go through all the rules and regulations on American housing and then those of Canadian housing. You’ll find small little differences like requirements for down payments, or the simple fact that Americans have access to 30 year fixed loans and Canadians do not. These tiny little things are just that…tiny little things.
America’s housing burst was propelled by the negative amortization loan, which once issued in mass and refinanced all at the same time, would result in tons of foreclosures all at the same time. The media often refers to negative amortization loans as adjustable-rate mortgages. Negative amortization loans are ARMs, but ARMs are not negative amortization loans. Squares are rectangles, but rectangles are not squares – you get the idea.
A negative amortization loan is one in which the principal goes up with each payment. When all the negative amortization loans were up for refinances at higher rates and higher principal amounts to people who could not afford an actual amortizing loan, the housing market collapsed as homes were quickly sold by those needing to escape. Those who couldn’t sell went into foreclosure. Then the housing market went into free fall.
Canadian Housing Lacks a Catalyst
The American housing bubble had a built-in needle, a catalyst in the form of negative amortization loans. Canadian housing does not have that catalyst. It doesn’t have a bunch of negative amortization loans outstanding. It doesn’t have a bunch of loans made to people with no jobs, no income, or no assets. Canada’s lenders, as any Canadian will happily tell an American, are far more conservative in their lending practices.
But just because Canadian banks lend only to people who “can afford their homes” doesn’t mean that home prices are justified. Sometimes people can “afford their homes” only because home prices are going up.
As I talked about on Monday, we all basically work for the housing sector. In the United States and at the height of the bubble, Americans withdrew home equity worth 8% of their annual income year after year. Therefore, a not so insignificant amount of all American spending from 2002 to 2008 was financed with home equity – home equity from overpriced homes.
The same article also says that while lines of credit are 85 times higher in Canada today than in 1980, personal incomes grew by a multiple of 3 during that period.
I could not find a source for home equity withdrawals in Canada, unfortunately, but these statistics reveal that Canadians are funding purchases with home equity. The Bank of Canada does say the following in a report about household debt:
In 1995, secured PLCs represented about 11 per cent of consumer credit; by the end of 2011, this share was close to 50 per cent. It is likely that the factors contributing to the growth in home-equity borrowing…led to stronger growth in total consumer credit than would otherwise have occurred.
I also found this chart, which shows the value of Canadian resales as a percentage of GDP:
If Canadians cannot get a loan from the bank against their home equity, they’re clearly quite capable of selling their home to someone and extracting the equity that way.
My point here is to simply demonstrate how easy it is for Canada’s home equity to flow into every other facet of the economy without aggressive lending practices. I think I’ve done that; Canadian consumption is propelled by the tailwinds of ever increasing home prices.
The loans we make are unimportant – a distraction. The extent to which we rely on housing for economic growth is important; it should be the focus. No matter the loan type, Canadians are using their home equity to spend just like Americans were.
Canada’s housing prices are entirely out of whack on the basis of price to rents. Right now, Canada’s price to rent ratio is 76% higher than the historical normal average. Just like we saw in the American housing bubble, the worst ratios are in the most densely populated parts of the country.
Here’s an index of prices relative to rents in Vancouver, for example:
Vancouver is the most overheated market. I want to stress the point that it is in the most densely populated areas (like Vancouver) that housing is the priciest. This is important.
In the most densely populated areas you find the priciest homes, and where you find the priciest homes, you find the areas that have the highest share of construction employment. Hence, you find the areas that will have the worst unemployment if housing prices dip. Alternatively, you find the most people who can afford to buy a home only because they are employed in the business of building homes.
Think about that for a second. Housing booms fuel themselves. People who make a living building homes can afford to buy a home only because they are employed in building homes because home prices are expensive. Infinite loop, engaged.
You can see a very clear relationship between sky-high housing prices and construction employment:
Construction employment is a derivative of housing prices, and interestingly, also a driver of housing prices. It’s a double whammy when construction slows – fewer people can afford their homes, economic growth dips, employment dips, and naturally this happens right about the time that housing prices take a dip, slowing everyone else’s ability to consume with money from home equity.
Just one Tremor
As I said before, Canadian housing lacks a visible catalyst necessary to send its home values to more reasonable levels. I really do believe that the Canadian bubble will burst; it is not a matter of “if,” but a matter of “when.” Given that Canadian economic growth is so levered to housing, it’ll take only a small shake of the housing market to kick off the correction. From there, I think we can expect construction employment, housing price ratios to rents, and GDP growth to turn downward – a chain reaction of economic contraction.
Yesterday the IMF did warn that it was worried about Canada’s future economic prospects citing slowing housing and record levels of household debt.
Canadian housing wasn’t picked as some anomoly in global economics. It just lacked a catalyst for correction. It still lacks that clear catalyst. The American boom was a ticking timebomb with negative amortization loans acting as the timer. We had something embedded in our housing bubble that made us realize how ridiculous our home prices were. Canada does not.
Just give it time. Canada’s sky-high household net worth and incredible ever-increasing real estate market has to return to the mean…eventually. Would I bet on a correction? Absolutely! I’m already looking for that bet.