Strong medicine urged for a fevered real estate market

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"Canadians ought to put themselves in risk management mode," urges Queen's University finance professor Louis Gagnon.

The professor is adding his voice to the chorus urging the federal government to make it tougher for marginal buyers to get into the Canadian housing market.

At the same time, people across the country should be lightening their heavy debt loads to avoid a shock when interest rates rise.

"Canadians are collectively growing more vulnerable," he says.

Prof. Gagnon, who specializes in risk management, points out that it's pretty common knowledge now that Canadians, on average, have a higher level of indebtedness than their U.S. counterparts had at the height of their housing boom. While U.S. households have been paying down debt in the past few years, consumers in this country have added more.

"Collectively, our risk exposure is on the rise with no sign of abatement."

Prof. Gagnon is calling on the government to tighten the rules further in order to relieve the upward pressure on real estate prices and prevent a bubble. Which is not to say we're not already in a bubble – it's just that nobody knows how the current market dynamics will play out.

"It may be at some point we will all conclude that this was a bubble."

Prof. Gagnon would like to see the maximum mortgage amortization period knocked back to 25 years from the current 30. The minimum down payment, he suggests, should be 10 per cent instead of five.

Doing so would prevent the most vulnerable Canadians from entering the real estate market at inflated prices. He recommends that people who have not saved enough for a healthy down payment stay on the sidelines for a while until they can save enough to build up some equity.

"I think the key is equity," he says. "When interest rates go up, those people who have a low level of equity in their homes will have their equity wiped out."

Stricter rules could help marginal borrowers avoid the temptation of the historically low interest rates on offer.

"We have to dissuade Canadians from thinking that this is a good deal."

Prof. Gagnon adds that the economies and financial markets around the world are steeped in uncertainty.

"Everything is shifting all around us. That makes leverage all that much more risky."

While interest rates seem quite sticky at the moment, he says, the U.S. economy will firm up and that will lead to an increase in economic activity on this side of the border too. As economies become more robust, interest rates will rise.

"There is no imminent threat, but it will happen," says Prof. Gagnon. "It's inevitable."

His best-case scenario is a soft landing for the Canadian housing market engineered by some timely government intervention.

The worst-case scenario could occur if interest rates rise so sharply that home and condo owners can't make their mortgage payments. That in turn could lead to panic in the housing market as everyone tries to unload the property they can no longer afford.

"It would be a classic case of everybody dropping their asset at the same time just to make ends meet."

The feds should also forge ahead with their plan to make it less costly for Canadians to pay down their fixed-rate mortgage debt faster, he adds.

Just as Prof. Gagnon is calling for more sanity, the big banks have been engaging in another round of mortgage rate price cuts.

The last time the banks dangled such enticing rates – in the depths of winter – real estate agents instantly felt their BlackBerrys buzzing.

That action was reflected in the latest report from the Toronto Real Estate Board, which says sales in the Greater Toronto Area jumped 16 per cent in February compared with the same month last year. New listings were also up year-over-year, but only 11 per cent.

It's important to note that this year is a leap year, with one extra day in February, points out TREB president Richard Silver. Turns out Feb. 29 was a big day in the market: Without it, sales were up 10 per cent and six per cent respectively.

And Mr. Silver agrees with the other voices urging caution: He thinks Canadians should pay down some debt.

He believes first-time buyers in particular can be too susceptible to "HGTV syndrome". They pass by the houses they can realistically afford – those with knob-and-tube wiring and lead plumbing – to buy the properties with stone countertops.

He recommends considering houses that can be improved over time. Sometimes they turn out to be a better investment and allow buyers to move into a neighbourhood they couldn't otherwise afford.

Prof. Gagnon says that the run-up in Canadian real estate has created a mentality among many that they must get on the property ladder or forever miss out.

And while he believes that real estate is generally a good long-term investment, he remembers a similar prevailing optimism just before the market slide that began in 1989 and lasted into the nineties.

If a sell-off does come, it may only be a small one – who knows? What the professor does know is that Canadians were lucky to avoid the credit crisis that gripped other countries in 2008. Meanwhile, we may have manufactured our own. A meltdown would have consequences not only for rapacious borrowers but for the entire economy, he warns.

"Eventually the mood will sour."