ROB cover story, Oct. 30, 2009

Easy credit, soaring prices raise new housing fears

Toronto, Ottawa, Vancouver — Globe and Mail Update

Housing bubble (Marcelle Faucher)

Nick Burzese and his fiancée Di Pham recently realized the North American dream - they bought a house of their own.

And the couple's new home is not just anywhere. It's in Vancouver, one of the country's priciest markets. Having rented for years, the couple, who both work in the mortgage business, thought they'd never be able to afford a house in the city. They were doomed, they felt, to live in a distant suburb. As they house-hunted, they saw to their disappointment that the recession hadn't dampened the market much.

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"Everywhere we went, there were so many people there," says Mr. Burzese, 36, a broker at MPRO Mortgage Architects.

Eventually, they came across an old 11/2-storey "character" home on a leafy street of detached houses near the Pacific National Exhibition grounds, on the city's east side. "We immediately fell in love with it," Mr. Burzese says. "It's really an area that's starting to transform."

Ms. Pham, 28, and Mr. Burzese put $57,000 down on the $570,000 house early this year. The couple says they're comfortable with the debt. They make good money and are installing a basement apartment as a "mortgage helper." But they might not have been able to get into the market were it not for the intervention of the Bank of Canada and the federal government - in the form of a continued low interest rates and federal policies aimed at maintaining the flow of lending and spending.

The interest rate on the their mortgage? Just 1.5 per cent.

By taking advantage of ultracheap interest rates to buy something they couldn't previously afford, the couple are doing exactly what the government wants Canadians to do to restore growth to the economy. Mr. Burzese and Ms. Pham may well be able to handle the new debt. But mounting consumer debt loads across the country are worrying some economists -- and even the bankers who are profiting from it.

Canadians are in the midst of a mortgage binge, taking out home loans at a pace that's nearly 8 per cent faster than a year ago. The point of a record-low borrowing rate and new fiscal incentives, such as allowing first-time home buyers to use a bigger chunk of their registered retirement savings plans as down payments, was to stir the animal spirits of consumers spooked by the financial crisis. But now, as the recession eases, officials in Ottawa and the analysts who advise large institutional investors on where to put their money are suddenly paying closer attention to the effect of all this stimulus on the longer-term prospects of Canadian consumers.

The concern is that people are taking on too much debt on the assumption that interest rates will stay low for a very long time, making Canadian consumers far more sensitive to the effects of housing and other asset-price bubbles. There is a growing consensus among leading economists and policy makers that the financial crisis might have been less severe had they not bought into former Federal Reserve Board chairman Alan Greenspan's assertions that nothing can be done about bubbles.

In Canada, economists are worried about consumers' willingness to pile on debt so soon after an economic catastrophe that was triggered by Americans' willingness to do the very same thing. "We know that cheap money in the past caused some problems. This is a time to be prudent," says Benjamin Tal, an economist at Canadian Imperial Bank of Commerce in Toronto.

"Right now, the rates being what they are, people just say, 'I want that house,'" says Darin Bauer, a Toronto broker with Mortgage Intelligence Inc.

That attitude is lifting house prices faster than many economists expected, given the severity of the recession. Higher prices are creating wealth for the sellers, loosening the recession's grip on the economy and helping to explain why the Bank of Canada estimates that Canada's first recession since 1992 ended in the third quarter. In the fight against the worst global economic downturn since the Second World War, policy makers have effectively drafted Canadians en masse. It's working, but at a price.

Middle-age mortgagors

Canadian consumer debt loads were already heading in a worrisome direction before the crisis. The trend is now accelerating, driven by a large increase in mortgage balances among middle-aged people.

U.S. consumers, chastened by the destruction wrought by their profligacy, have lifted their savings rates to levels above 3 per cent, up from zero ahead of the crisis.

Canadians are going in the other direction. Household debt rose 3.4 per cent in the first half of the year, as personal disposable income fell 0.2 per cent, according to Mr. Tal. The debt-to-income ratio has risen to 140 per cent from 131 per cent in the past year.

Much of the new borrowing is mortgages, which have grown even as Canada's broader economy was contracting. Adjusted for inflation, mortgage growth in the recessions of 1991 and 2001 was virtually non-existent. It currently tops 7 per cent, adjusted for inflation. Thanks to Mr. Flaherty's January budget, many first-time buyers can now take as much as $25,000 from their RRSPs to use as a down payment, compared with $20,000 previously. Novice buyers are jumping into surging real estate markets in Vancouver, Calgary and Toronto with little understanding that the value of the asset they covet can disintegrate.

Housing prices don't typically survive recessions. In April, 1989, the value of an average existing home in Toronto was $261,650. This was the peak of the 1980's boom, with prices 267 per cent higher than at the beginning of decade. The bust that followed was nearly as dramatic: The trough didn't come until August, 1993, when the average price sunk to $189,620. The average price didn't top the 1980's peak until January 2002. Whether they're first-time buyers or trading up, consumers are using low rates to take on a bigger loan than they would in normal times.

Customers of MortgageBrokers.com took out mortgages worth an average $196,599.49 between June and September, compared with an average of $150,840.44 during the same period a year ago, according to the company. From the height of the crisis in October, 2008, and last month, the five-year mortgage rate declined 1.75 percentage points.

But the decision to take on bigger mortgages isn't the result of bigger paycheques. In 2004, mortgage credit amounted to about 74 per cent of personal disposable income. Now it's 96 per cent.

The hurt of higher rates

The crux of the concern in Ottawa and on Bay Street is the impact that rising rates will eventually have on highly leveraged homeowners.

"We know that interest rates will rise - the only question is when," Mr. Tal says. "Even if you lock in a five-year mortgage rate, you have to realize that five years from now, they will be significantly higher than they are now. Clearly people have to be much more prudent in this kind of environment."

Bank of Canada Governor Mark Carney reiterated this week that his overnight target likely will remain at 0.25 per cent until next June. But central banks in Israel, Australia and Norway have begun reversing their extraordinary easing cycles amid signs of incipient inflation and some concern that asset prices, including real estate, are getting a little too hot.

Central bankers in the U.S. and elsewhere have also indicated in recent months that once they decide it's time to begin raising interest rates, they may do so at a faster pace than consumers and investors are used to.

While heftier debt loads obviously make all borrowers more vulnerable to higher interest rates, consumers' increased exposure to real estate also means that they have become more susceptible to changes in the housing market.

Broker Darin Bauer says most of his current customers are making down payments of only 5 or 10 per cent, and "not too many" come forward with the 20 per cent down payment that is the minimum to avoid the federal government's otherwise mandatory mortgage insurance.

"Generally, when they're doing the 5 per cent down, they're close to the maximum of affordability ratios," Mr. Bauer said. "If rates went up significantly, it could be a problem come renewal time."

Consumers with fixed-rate mortgages might feel secure. But with many mortgages now having a 35-year amortization, they are bound to feel the pinch of higher interest rates at some point.

"Consumers have to think very carefully about what they're going to do in five years when interest rates are higher," says Peter Aceto, the CEO of ING Direct Canada. The financial crisis crimped property markets around the world, but Canada's eight-month housing correction is now a distant memory.

'Irrational behaviour'

Sales of existing homes slumped in October, 2008, but by May, they had returned to pre-recession heights.

Home purchases are now back up to the "lofty" volumes of 2007, according to economists at Toronto-Dominion Bank, even though the country's gross domestic product contracted in August, according to report by Statistics Canada yesterday.

The pace of price increases in September was almost the fastest it's been in 20 years, according to Bank of Montreal economist Douglas Porter. Prices have gone up in 20 of the 25 largest cities in the past year, and in all 10 provinces.

"There has been no price reduction at all here," says Elena Levin, a real estate agent with Royal LePage in Ottawa. "Yesterday I worked on two deals with multiple offers."

In Halifax, Re/Max agent John Linders says house prices have increased 4 per cent this year and he expects the escalation to continue. Moreover, the stock of houses for sale is becoming tighter. "There's actually fewer properties coming on the market compared to more sales," he says. "I'm starting to see that for the first time just now."

On Thursday morning, Mr. Linders' computer showed that there were 24 new listings and 19 houses conditionally sold. "These two numbers are closer together than I've ever previously seen."

Reports of such conditions in various markets are spurring talk of a bubble. "It's environments like these that breed bubbles," Mr. Aceto says. "There is what feels to be a little bit of irrational behaviour in the real estate market, and I do think it is in a large way fuelled by how low interest rates are."

If a bubble is in the works, it hasn't yet inflated to dangerous proportions.

Evridiki Tsounta, an economist at the Washington-based International Monetary Fund, published a working paper this week that concluded that "while house prices might be a bit overvalued in the West, over all they are close to equilibrium," considering fundamental factors such as incomes and commodity prices.

Mr. Carney doused talk of a house-price bubble during parliamentary and senate testimony this week, saying much of the current increase in home buying and prices is the work of buyers who put their plans on hold during the worst of the recession. Mr. Carney, who expects the real estate market to cool off by 2011, also pointed out that construction of new homes remains below year-ago levels, suggesting that purchases of existing homes in superhot markets such as Vancouver and Toronto is skewing the national picture.

All things being equal, higher prices should encourage more people to put their houses up for sale, which in turn should lower prices by increasing supply.

The problem is it's difficult to spot a bubble for sure until it bursts. "That was the point that Greenspan used to make about why this is a problem for central banks," says Craig Alexander, an economist at Toronto-Dominion Bank.

Mr. Greenspan's approach was to let bubbles burst, then attend to the damage by lowering interest rates. The Bank of Canada, like many of its counterparts, doesn't have the luxury of simply resorting to manipulating interest rates. If Mr. Carney became worried about a housing bubble, the economy remains too fragile to raise interest rates. Doing so would also carry the risk of driving up the value of the Canadian dollar, which already is at uncomfortable heights for the country's exporters.

'Monitoring the situation'

Canada's housing market is certainly not stained by the sort of excesses that characterized the U.S. market before the crash. Subprime lending in Canada is estimated to represent less than 5 per cent of the market, compared with more than 20 per cent in the U.S. prior to the crisis.

But an ironic scenario could still unfold. In an effort to combat a recession that had its origins in a U.S. housing bubble, Canadian policy makers have responded with low rates that might create a bubble here, giving the mortgage market too much of a kick-start through low interest rates and a program of buying billions in mortgages from the banks.

Federal Finance Minister Jim Flaherty says he is confident he has a handle it. He noted that in 2008, the government decided it would no longer insure mortgages with 40-year amortization periods, reducing the maximum acceptable term to 35 years. It also boosted the minimum down payment to 5 per cent. Both Mr. Flaherty and Mr. Carney said measures of that type could be taken again if Canadians get in over their heads in the mortgage market.

"We're monitoring that situation," Mr. Flaherty told reporters in Toronto yesterday. "Interest rates are very low, and that is no doubt contributing to some additional activity in the real estate market. We'll watch, and what we've done before we can do again if we need to."

The Bank of Canada is paying special attention to household debt, and it will include an analysis of the debt burden of all income classes when it releases its biannual review of the financial system in December.

For now, Mr. Carney says the situation is under control because the cost of paying for that growing debt is much lower than its historic average. While total household debt rose by $44-billion during the first six months of the year, interest payments on debt actually fell by $3-billion, according to economists at CIBC.

Still, Mr. Carney reminded members of Parliament and Senators this week that rock-bottom interest rates can only move in one direction. Accordingly, he encouraged both borrowers and lenders to act "prudently."

And even though he dismissed the idea of an imminent bubble, Mr. Carney still encouraged discussion of the subject. The reason: The more people talk about bubbles, the less chance they form. A key ingredient in the U.S. subprime mortgage crisis was the lack of attention that was being paid to the problem as it brewed.

"We welcome the discussion of this issue because it is anticipatory," Mr. Carney told the Senate banking committee. "People are anticipating a potential vulnerability as opposed to looking in the rear-view mirror and seeing a vulnerability that is already here. That is one of the ways that one prevents that."

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