Canada's Northern Tiger looks very like a bubble


SERIOUS MONEY:THE CANADIAN economy has been the envy of the developed world in the recent past, as North America’s largest country weathered the global recession far better than most. The subsequent recovery has been sufficiently robust to allow both output and employment return to their pre-recession levels by the middle of 2010.

However, sharply rising housing prices, alongside a rapid increase in household debt, have raised concerns that the so-called “Northern Tiger” is simply an accident waiting to happen.

It is clear the Northern Tiger entered the downturn with critically important advantages that allowed policymakers cushion the blow and jump-start a recovery by means of aggressive monetary easing and extraordinary fiscal stimulus. These advantages included a strong fiscal position, credible monetary policy, a well-functioning financial system and private sector balance sheets that were not as stretched as those in much of the Western world.

The Bank of Canada reduced its policy rate to near zero at the height of the global financial crisis and, because the monetary transmission mechanism was not impaired, consumers were able to take advantage of generational lows in borrowing costs.

Households took full advantage of the extraordinarily easy monetary policy, which allowed consumption to regain its pre-recession level by the third quarter of 2009, while the boost to housing demand enabled residential investment to recover its previous peak in just 18 months.

The monetary stimulus, alongside other policy measures designed to insulate the housing market, precipitated a marked turnaround in house prices.

The decline in prices from the autumn of 2008 to the spring of the following year was contained to just 10 per cent. The subsequent rebound in the market has seen prices jump almost 15 per cent above their previous peak.

The Canadian experience stands in sharp contrast to its southern neighbour, the United States, where house prices continue to languish some 30 per cent below their peak with few signs of an imminent turnaround.

Canadian house prices had already enjoyed a marked increase from 2003 until the global crisis struck, such that valuations today cannot be described as anything but elevated.

The average priced home in Canada today is valued at more than five times median family income, as against just three times a decade ago, when valuations were close to their historic average. The situation is even more alarming in Vancouver, where the average price exceeds 11 times family income, more than double the national average and the figure that prevailed at the start of the new millennium.

In spite of the disturbing valuations, Canadians appears to have been seduced by the rise in prices: a recent survey conducted by the Canadian Association of Accredited Mortgage Professionals revealed that “almost 60 per cent of respondents thought that now was a good time to buy”.

The rise in house prices alone is not sufficient to pose a systemic threat but, when combined with high levels of debt, the cocktail could prove explosive. Household debt has expanded at twice the rate of personal disposable income since the recovery began during the summer of 2009 and, by the end of last year, the ratio of debt to income had increased to more than 148 per cent – a level that eclipsed US household indebtedness for the first time in more than a decade.

The additional borrowing, primarily in the form of mortgage loans and home-equity lines of credit, means a Canadian with a two-storey home spends almost half of his household income on mortgage servicing, with the share closer to 70 per cent in Vancouver.

Furthermore, the Bank of Canada estimates that “the proportion of Canadian households that would be highly vulnerable to an adverse economic shock has risen to its highest level in nine years, despite the improving economic conditions and the ongoing low level of interest rates”.

The central bank adds that “this partly reflects the fact that the increase in aggregate household debt over the past decade has been driven by households with the highest debt levels”.

Bulls on the Canadian housing market dismiss such facts and argue that a US-style meltdown is unlikely, given the tightly regulated mortgage insurance market. The banking sector is not permitted to hold uninsured high loan-to-value mortgages – currently, greater than 80 per cent.

Because the government not only owns the Canadian Mortgage and Housing Corporation (CMHC), which accounts for more than two-thirds of the mortgage insurance in force, but also provides a 90 per cent guarantee on private mortgage insurance obligations, policymakers play a major role in the evolution of underwriting standards and can thus contain potential excesses.

The government may well exert a strong influence on underwriting standards on paper but, in reality, the government-backed guarantees have introduced moral hazard through the transfer of default risk from bank shareholders to taxpayers.

Bank managements are incentivised to play hard and fast with the written rules and, should a negative shock arise, the CHMC has little room to absorb the losses. The government-owned company currently insures $536 billion in mortgages and has just $11 billion in equity: just 2 per cent equity against its total exposure. It’s easy to envisage a scenario in which the taxpayer is left holding the bag.

The Northern Tiger has attracted plenty of admirers in the recent past but, upon close examination, an accident may well be in the making. Will it happen? Time will tell.