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Monday, April 23, 2012

Who is to blame for Canada's housing bubble?

Its so easy to point fingers.

Banks. The government. Local politicians / mayors. The real estate industry. The housing industry. Greedy sellers.

Canada’s housing market has been relatively stable for over a decade, with the notable exception of Toronto and Vancouver which are the country’s hottest real estate markets. As Canada’s largest city Torono's home prices have risen 10.5% over the past year alone. The condo industry in Toronto is so hot that there is now three times as many cranes dotting Toronto’s skyline as there are in New York City.

Many real estate analysts are becoming increasingly worried that Toronto, Vancouver and Calgary are in an American-style housing bubble which could lead to an implosion of prices and a recession.

The analysts are not alone. Bank of Canada Governor Mark Carney is sounding the alarm over the growing level of household debt, while maintaining the overnight lending interest rate at a near-record low level of 1%. Mark Carney's hands are a bit tied in this matter. He can't raise interest rates without risking being the needle which bursts the bubble.

What is bizarre is the economy in Toronto and Vancouver are both stagnant and yet the prices are rising unusually fast. In contrast cities like Edmonton and Saskatoon where the economy is booming but home prices are stable.

Some people argue that the Canada Mortgage and Housing Corporation’s (CMHC) policies are to blame because they encourage overseas investment in Canadian real estate. They claim that investors from overseas have corrupted the system and is creating an artificial and potentially dangerous real estate bubble that will ultimately lead to a recession in Canada.

There is of course a quick and easy solution to this. Ban overseas investors from buying homes and condos in Canada.

The CMHC controls the majority of Canada's mortgage insurance and securitization markets and guarantees all (100%) of the principle balances and interest rates on insured residential mortgages.

The problem is that the Bank of Canada has such low interest rates that in combination foreign investment and low interest rates in causing the bubble to grow at an exponential rate. Investors are particularly attracted to Toronto and Vancouver's markets because of the recent history of rising housing prices.

Another problem is Canada's artificially low interest rates have been kept low for since 2008.

The longer interest rates remain low and investors keep flooding the real estate bubble the worst it will be when the bubble bursts and a market correction takes place.

Trying to prevent a correction however might make foreign investors skittish and cause them to withdraw from the Canadian real estate market in a hurry. Thus a preventive measure could even kickstart the market correction.

Foreign investors are not wholly responsible for creating Canada's housing bubble. Investors are sheep. They go where they see a financial opportunity with little risk.

Foreign investment is normally a good thing. It creates jobs and adds to the local economy. More condos and homes being built means more money for developers and construction works. More rental properties become available. The problem however is that investors have a tendency to flood markets. The home prices and rental prices go up, people get into household debts they cannot afford due to outrageous mortgages... and when the fit hits the shan everyone with a mortgage loses their shirts.

While its true that in Canada we crave foreign investment, that is only true so long as the investors stay the course and don't all back out at the same time. We need to avoid an artificially inflated housing market that will bring the whole economy crumbling down when the bubble bursts (see the USA, circa 2007-09).

So who does the bulk of the blame lay with then? The answer is the blame can be placed squarely on government policy.

By guaranteeing 100% of CMHC-insured mortgages and 90% of privately insured loans, the government removes the risk from banks and investors, making it much easier to get loans whether you are a foreigner or a Canadian. A foreigner with a good credit rating can invest in Canadian real estate, borrow money from the Canadian government to invest in our own housing market... and if anything goes wrong they're not Canadian and don't have to face any financial responsibility here. If everything goes smoothly for the duration they eventually withdraw their money (with a decent profit) and put it to use elsewhere.

Having such weak policies and lending standards is Canada's Achilles heel.

A report from the Reason Foundation in the USA found that government guarantees always underprice risk, drive mortgage investment into unsafe markets and inflate housing prices by distorting the allocation of capital. Governments simply cannot price risk accurately while banks and private lenders have every incentive to price risk appropriately because its their money on the line. If the government loses money its the taxpayer that ends up with burdened and governments are far too willing to take unnecessary risks when there is no incentive to insure success.

If we were to try to prevent an American-style housing bubble bursting we should not have the Canadian government guaranteeing mortgages. Let the banking industry put the money up themselves and take on the risk.

After all why should taxpayers be asked to take on the risks of bankers and foreign investors? If people want to invest in Canada, fine, but they should do so without using government money as collateral.

The USA is already starting down that path. People looking to get a home purchase loan are now looking at companies which guarantee their own mortgages. ie. Mortgage Solutions of Colorado and similar companies are reducing (or removing entirely) their dependence on government guarantees.

Part of it may be because companies have realized that the American government isn't going to guarantee mortgages willy-nilly any more. Another part of it is Americans have become much more scared of mortgage contracts signed during a bubble and they think it is less risky to deal with a company which has its own money and isn't borrowing against itself to prop up its business.

Sadly I don't think Canada will learn from the USA's mistakes. We are just going to repeat the problem.

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