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The ratio of home prices-to-household incomes surged to historical extremes last year, underscoring how expensive housing has become. The Bank of Canada’s housing affordability index has also deteriorated markedly because of both sky-high home prices and the recent surge in mortgage rates.Fred Lum/The Globe and Mail

Phillip Colmar is managing partner and global strategist at MRB Partners.

Canada is facing a massive housing bubble after more than two decades of cheap money and lax lending standards. And with a widespread affordability crisis, the country is now at an escalating risk of a housing bust. Many Canadians maintain hope for a soft landing, but higher mortgage rates and softening employment conditions are a lethal combination.

The rise in home prices to nosebleed levels began in the early 2000s when Canada experienced tremendous wealth gains from the commodity boom. That had the effect of propping up the Canadian dollar, which would weaken exports by making them relatively more expensive. The Bank of Canada therefore kept policy too easy during this period to deter additional currency appreciation.

This aversion to currency strength was amplified after the U.S. housing bust in 2008 when the Bank of Canada largely followed the Federal Reserve, despite the substantial economic differences at the time. Canadian consumer price inflation remained relatively subdued until more recently, so there was little impetus for tight monetary policy at the time. In that environment, persistently low interest rates drove home prices ever higher.

Housing is now unattainable for new Canadian homebuyers. The ratio of home prices-to-household incomes surged to historical extremes last year, underscoring how expensive housing has become. The Bank of Canada’s housing affordability index has also deteriorated markedly because of both sky-high home prices and the recent surge in mortgage rates.

Is this the most unaffordable time ever to buy a house?

Excessive home prices are worrying, but mounting household debt burdens is where the outlook becomes ugly. Canadian mortgage debt is now almost 140 per cent of disposable income and total debt is a whopping 180 per cent, which is about 50 percentage points above the U.S. prior to the 2008 financial crisis. This amplifies the risks of eventual forced selling, defaults and financial system strains.

Mortgage payments have already become unmanageable for many homeowners. The Canadian mortgage debt service ratio has surged to shocking levels, well above those experienced by Americans at the peak of their housing bubble. And Canadian homebuyers do not have the same ability to lock in a long-term fixed rate mortgage to protect against rising interest rates.

Lenders are reporting an alarming increase in the number of homeowners unable to fulfill their mortgage obligations once their interest rates were reset higher. Several major Canadian banks have reported that roughly one-fifth of their outstanding mortgages now have negative amortization, which occurs when payments no longer cover interest obligations, forcing lenders to increase the principle and extend the mortgage term. About one-quarter now have amortization periods greater than 30 years – rarely offered by lenders.

Unless mortgage rates fall substantially, Canadian banks and other lending institutions will be forced to deal with a continuing wave of mortgage resets and homeowners who are unable to meet their mortgage obligations. This will intensify if there is a downturn in the labour market.

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Despite hopes that the housing market will experience a soft landing, history shows that bear markets often “slide down a slippery slope of hope,” as described by the analyst Martin Weiss. The constructive outcome now hinges on a sharp decline in mortgage rates and a long runway before the next recession when employment conditions will weaken markedly. The new inflationary economic environment makes this considerably harder to achieve.

Many also suggest that low inventories will put a floor under home prices, although there is little support for this argument. The construction of new housing units has significantly outpaced the increase in household formation over the past few decades. It would not be long before the impact of this is visible in the markets. Meanwhile, the number of completed homes that are unsold is low, but this will rise as investment demand cools. And much more housing supply is coming, with a record number of housing units currently under construction.

Others hope that increased immigration will create ample housing demand. But the crisis of affordability will still play a crucial role in keeping a ceiling on this demand. Is Canada planning to attract only wealthy immigrants, or able and willing to offer them jobs that pay far more than existing Canadians currently earn? If neither is the case, then new immigrants will also struggle to buy homes. When prices soar so much that they outstrip demand, a bust is coming.

The potential for a housing bust raises the question of whether it will be like the painful and prolonged deleveraging adjustment experience of the U.S. economy after 2008. The U.S. example provides a useful road map. The key difference is that the world economy is now on a much stronger footing, so significant Canadian dollar depreciation and a boost to exports will be crucial in offsetting weak household demand. Also, higher inflation may allow for more of the home price adjustment to occur in real rather than nominal terms.

Regardless, Canada will face a difficult decade ahead once the housing bubble begins to deflate. Policy makers will have their work cut out for them, as the day of reckoning is now fast approaching.

Editor’s note: This article has been updated to clarify that about one-quarter of homeowners with mortgages now have amortization periods of greater than 30 years.

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