Canada: The land of hockey, socialized health care, and maple syrup. That’s the stereotype, anyways. But people who actually live in this country know that this gross over-simplification of our culture misses a very important piece: Complaining about real estate prices.
Seriously. Canadians love complaining about real estate prices. It’s our national past-time. We’re somehow simultaneously obsessed with owning houses, while complaining bitterly about how much they cost. In fact, in the last federal election, the number one issue that mattered the most to Canadian voters was reining in housing prices. Not dealing with the pandemic that was still going, but housing prices.
Well, as they say, be careful what you wish for.
In March, the Bank of Canada, started raising their key benchmark rate in order to deal with rapidly rising inflation. This in turn caused mortgage rates to go up. And this, in turn, caused housing prices to go down.
In some areas, quite dramatically. While the downtown cores of the major cities are only starting to see their prices slip, the suburbs where people flocked to during the pandemic thinking that they’d never have to commute to work again are seeing the steepest price drops.
In the Maritimes, for example, prices in Nova Scotia and New Brunswick are expected to fall 20 per cent over that timeframe. Ontario and Prince Edward Island could see drops of 18 per cent, with British Columbia giving back as much as 15 per cent.How much will home prices drop as interest rates rise? Depends where you live. GlobalNews.com
So here we are. The long awaited housing correction has finally arrived. And interestingly, the same people who were complaining that housing was too expensive are now panicking as they see their home values plummet. After just two rate hikes, nearly half of Canadians think that the central bank has gone too far and want the rate hikes to stop right the Hell now.
Well, too bad. The genie’s out of the bottle, and there’s no putting it back in. Tiff Macklem, the Bank of Canada governor has said in no uncertain terms that the rate hikes will continue until inflation is tamed, and if it means tanking the housing market in the process, then so be it.
At the news conference, Mr. Macklem repeatedly stressed that the central bank’s priority is getting consumer price growth under control, even if that meant a cooldown in the housing market.Bank of Canada warns high household debt and elevated home prices pose top risks to economy. TheGlobeAndMail.com
So this begs the question: Is it possible for the falling housing market in Canada to turn into a US-style Great Financial Crisis?
Let’s find out, shall we?
Why We Might Be Screwed
I’m generally not the alarmist type, but as I was conducting my research for this article, quite a few troubling parallels started to appear with our housing market and the US housing market circa 2007/2008.
As Canadians, we love comparing ourselves to Americans and feeling smug about ourselves (another often-overlooked part of Canadian culture). Whether it’s health care, gun control, or just about anything else Fox News screams about on a nightly basis, we love convincing ourselves that we would never be dumb enough to make the same mistakes that the Americans made.
Canadians Are In Epic Amounts of Debt
In the run-up to the Great Financial Crisis, Americans famously bought waaaay too much housing, and a Bush-era government that systematically deregulated the real estate market made it worse. Right before the crash, Americans famously had a household debt-to-income ratio of 120%, meaning that for every dollar they earned, they had $1.20 they owed. It doesn’t take an economist to tell you that’s a recipe for disaster.
Bad news. Canada is even worse.
Despite all the warnings from our government, despite our supposed risk aversion, and despite the giant cautionary tale south of our border, Canadians borrowed money like never before during the pandemic.
As central banks around the world dropped interest rates to keep the economy from falling over a cliff during the pandemic, we went shopping.
Canadians bought more real estate and got into more debt than ever before in our nation’s history, and we are now sitting on a national debt-to-income ratio even worse than the Americans.
Source: Household Debt To Gross Income in Canada, Tradingeconomics.com
That’s right. We took America’s 120% debt-to-income ratio that sank their economy and raised it all the way to 180%.
We’re number one! We’re number one!
We Have Rate-Reset Rate Loans
Another off-cited reason about why Canada is “so much smarter than the US” is the fact that the Americans had these weirdo mortgages that somehow reset higher after a few months of low teaser rates. What a stupid idea! Good thing we don’t have those up here!
Except we sorta do.
While it’s true that our normal fixed rate loans don’t change with interest rates (except at renewal), and it’s also true that our variable-rate mortgages tend to react to higher interest rates by lengthening their duration rather than increasing their payment, there is a type of loan that’s been gaining popularity that does reset their payments.
Home Equity Lines of Credit used to be a relatively esoteric financial instrument that most people didn’t know about, and even fewer people had, like reverse mortgages, but over the past few years they’ve exploded in popularity.
The reason? You guessed it, high real estate prices.
As housing became more and more unaffordable, millennials started doing what millennials did best. No, not make TikTok videos about avocado toast.
They whined to their parents.
Unable to scrounge up the cash to meet even the minimum down payment requirements, their parents took out HELOCs from their paid off, price-appreciated homes to gift to their kids so that they too could experience the joys (?) of home ownership.
HELOCs, by the way, are floating rate loans. And because HELOCs don’t have an amortization that can be extended, their monthly payments simply adjust upwards with rising interest rates. So as the Bank of Canada hikes their benchmark, anyone with a HELOC in this country are seeing their payments go up…and up…
We Have No-Recourse Loans Too!
The final piece of the puzzle that made the US housing crash so terrible was the fact that many states allowed something called no-recourse loans. Basically, a no-recourse loan meant that if a homeowner defaulted on their mortgage, the bank can foreclose on their house as normal, but if that house was worth less than the mortgage, the bank couldn’t go after the mortgage holder’s other assets.
In a falling real estate market, this encouraged people who were in an underwater mortgage situation to simply abandon their homes knowing that the bank couldn’t do squat to them, which caused banks to start haemorrhage money and turning a housing crash into a full-on financial catastrophe.
What a stupid idea, right? Who’s the idiot who let that happen? Clearly, we as Canadians would never allow something like that to proliferate here, right?
Alberta allows no-recourse mortgage.
Jingle mail — the act of walking away from an underwater mortgage by mailing your keys back to the bank — is a peculiarity of the Alberta residential market.Jingle mail rears its ugly head in Alberta, CBC.ca
I know, I know. I was just as surprised as you presumably are when I found that out.
So let me get this straight. We knew no-recourse loans were a bad idea, we saw what they did to our southern neighbour, and we still didn’t get rid of them?
Why We Might Be OK
Now, I admit, the above reasons sound pretty bad. I don’t always know which direction an article goes as I write it, but I also found some pretty encouraging silver linings that might indicate that we may not head down the path of a US-style recession. Wanna hear them? Yeah, you do.
Alberta Already Had Their Housing Crash
So, first, the Alberta thing.
I admit that I was pretty shocked and disappointed to learn that one of our provinces learned nothing from the debacle in the US and had set up a situation where something similar could happen here. And as we know, once a housing crash transforms into a financial contagion, that contagion can metastasize everywhere.
With the right conditions in Alberta and aggressive rate hiking from the feds, there’s really no reason why a housing collapse can’t start there. Except for one thing.
Alberta already experienced a housing crash.
It was back in 2015, when the Saudis decided that the whole “US drilling for their own oil” thing wasn’t funny anymore and tried to knock the frackers out of the market with a good old fashioned price war. They pumped like crazy, flooding the energy markets with cheap oil, and drove its price down from above $100 all the way down to $40 a barrel.
Alberta, unfortunately, got caught in the crosshairs.
The Alberta oil sands have always been trickier to extract from than a normal well, so when oil prices plunged below their cost of extraction, mass layoffs resulted, which then caused housing prices to crash.
Oil prices have since recovered, but that psychological damage persists to this day. Albertans learned real fast that housing doesn’t always go up, and real estate in Calgary and Edmonton are still way cheaper than other similarly sized cities as a result.
But that also means that the housing bubble mania that has swept through most of the country doesn’t exist in Alberta to the same extent. That makes Alberta not the systemic risk that it could have been.
Banks Are Earning More Money
Here’s another major difference between us and the US. As real estate corrects, our banks are making more money, not less.
Unlike the US, where the housing crash was caused by a lot of bad lending habits all catching up with the lenders at once, ours is caused by rising interest rates. Higher interest rates mean higher mortgage rates, which might be bad news to current mortgage holders, but you know who loves higher mortgage rates? The banks.
Not only did every single of our major banks report stellar earnings this last quarter, but many of them also raised their dividends.
And just recently two of our biggest banks, CIBC and Scotiabank, announced that they were increasing the salaries of the majority of their workforce.
None of this paints a picture of a financial system in distress. Quite the opposite, actually. Banks don’t raise dividends and salaries when they’re worried about the future. They do that when they’re anticipating making so much money they don’t know what to do with it. Collectively, our banks are estimating that the increased interest rate will result in a net increase in profitability to the tune of over $1 billion.
Banks tend to earn higher interest income when interest rates rise. That is partly because they are able to charge wider spreads between deposits and loans, but also because they earn a better rate of return on financial assets they purchase with the deposits and other funds they hold.Canada’s big banks expect billions in added income following interest rates hike, TheGlobeAndMail.com
And they reason they’re so optimistic is because…
Jobs, Jobs Jobs
Our job market remains clicking hot.
That’s actually a major difference between Canada and the USA in 2008. Remember, the US housing crash only became a Great Financial Crisis when people started losing their jobs and defaulting on their mortgage payments. The wave of defaults overwhelmed the financial system, and that’s when the really bad stuff started happening.
But rising mortgage rates in and of themselves is not sufficient to cause a contagion. If the job market remains robust, then the effect of higher interest rates will result in more of each home owner’s paycheque going towards their mortgage. That’s going to suck for the home owner since it feels like they’re getting a pay cut, but as long as they don’t default, the banks don’t lose money.
Quite the opposite actually. They get to make more money from those poor suckers and then distribute those extra profits to shareholders in the form of increased dividend payments!
So as long as the job market doesn’t fall over and people can afford to keep paying their mortgages, it’s possible that a housing crash in Canada won’t result in a repeat of 2008.
Now all this being said, nobody has a crystal ball. Our ability to avoid a recession hinges entirely on the strength of our labour market. The biggest danger to what the Bank of Canada is doing is that if another unexpected world event impacts our job market and starts causing that unemployment rate to tick up before we’ve gotten inflation fully under control, we’re going to be in real trouble. Then the government will be forced to choose between stubbornly high inflation or mass unemployment.
However, right now that’s not the choice we have to make. Right now, the bank has to choose between tackling inflation or keeping the housing market inflated, and in that decision the bank has clearly decided to tackle inflation even it if means the housing market gets whacked.
This is the right decision. Increasing interest rates hurts recent homeowners, especially those that bought during the pandemic at inflated prices and are holding mountains of debt. But not increasing interest rates means inflation will continue to hurt everybody.
Basically, our central bank has chosen to sacrifice over-leveraged home owners and speculators into the jaws of inflation in order to save the rest of us.
Depending on which side of that equation you’re on, you might have very different opinions on whether this is fair, or the right thing to do, but either way, let’s hear what you think in the comments below!
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