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Townhouses in Toronto. Yale economist John Geanakoplos argues that the size of down payments play a major role in determining home prices.

Ian Willms/The Globe and Mail

Among the contenders for this year's Nobel Prize in economics was a Yale University professor named John Geanakoplos, whose work focuses on what's known as "the leverage cycle." While he didn't win the prize – it was awarded Monday to a Finnish and British team – the fact that Mr. Geanakoplos attracts this level of critical acclaim should serve as a wake-up call to Canadian homeowners.

The Yale scholar's research, born out of the U.S. housing market meltdown and global financial crisis, shows that if Canada is in a housing bubble, the economy will take a pounding when it bursts. Mr. Geanakoplos's theory defies conventional wisdom, which dictates low interest rates are driving up home prices. The Yale professor argues interest rates are only part of the story. His thesis is collateral drives asset values. In the case of the housing market, that means the size of down payments play a major role in setting home prices.

The theory of a leverage cycle is clearly driving federal Finance Department policy on residential real estate, as Ottawa has consistently been trying to increase the down payments Canadians make when buying homes.

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The perverse behaviour that drove the recent U.S. housing bubble is evident in data that shows for six consecutive boom years, the price of homes soared while the average down payment fell.

In the American experience, Mr. Geanakoplos found buyers made down payments worth 13 per cent of the value of their homes in the year 2000, and that steadily decreased until the day U.S. house prices peaked in 2006, when the average down payment was just 2.7 per cent of the home's value. We all know what happened next.

"When leverage is loose, asset prices go up because buyers can get easy credit and spend more. Similarly, when leverage is highly constrained, that is, when credit is very difficult to obtain, prices plummet," wrote the Yale economist in a paper published by no less of an authority than the U.S. Federal Reserve Bank of New York. Working from decades of data, Mr. Geanakoplos concluded: "A leverage cycle swings up, sometimes to dizzying extremes, and then comes crashing down, often with devastating consequences."

In tracing who is to blame for "dizzying extremes" across the housing cycle, Mr. Geanakoplos said the problem does not start with "homeowners who take on loans that they could not really afford, but rather lenders … who failed to ask for enough collateral."

For evidence that the Finance Department is paying attention to Mr. Geanakoplos's theory, consider what Bill Morneau announced last December, just five weeks after taking office. The Liberal government tightened the rules on who gets government-backed mortgage insurance by hiking minimum down payments. With an eye toward taking some of the air out of soaring house prices in Vancouver and Toronto, Mr. Morneau said, "This is going to help create stability for the overall market by targeting pockets of risk."

Keep in mind that Ottawa didn't just start to pay attention to potential problems in the housing market. The Liberal's decision to increase the collateral required to buy a home followed on similar moves by the federal Conservatives, stretching back over four years.

There's a case to be made for further hikes in down payments on Canadian homes.

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First, the minimum down payment remains just 5 per cent for homes worth less than $500,000. The bar was set at 10 per cent until 1992, when the federal government loosened the rules to stimulate the economy. A number of the bank CEOs have come out publicly to endorse a return to a 10-per-cent minimum.

Secondly, the carnage that comes when a housing bubble bursts means that Ottawa is well advised to err on the side of caution. The impact of a sharp decline in prices is felt across the population, in everyone from new home buyers who suddenly find themselves underwater, with homes worth far less than their mortgages, to aging homeowners who counted on selling their residence to help fund retirement. Mr. Geanakoplos recorded a lengthy list of economic ills that come when the leverage cycle gets out of whack, roping in everything from curtailing consumer spending and destroying productivity to distorting the banking system and government spending.

Recall what happened to the U.S. economy and political system in 2008, when the housing market's woes spilled over into financial markets. That's an experience no one wants to revisit.

The Finance Department should take heed of Mr. Geanakoplos's theories by popping this real estate bubble with another targeted arrow of higher payments on homes.

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