With incomes declining, high consumer debt, a high debt to GDP ratio, an abundance of housing inventory and personal bankruptcies at record levels in Canada, some analysts believe it is only a matter of time before the Canadian housing market experiences a dramatic correction. A downturn in the Canadian housing market could negatively impact the country’s banks, currency, retailers, manufacturers and construction industry. See the following article from The Street for more on this.
It has been painful to watch the housing turmoil in the last few years play out in the U.S. I know friends who have been terribly affected by it. After seeing the devastating impacts on the entire economy from this housing downturn, many market observers have pointed to China as a frothy real estate bubble that will likely pop soon. However, you might be surprised to learn that — up until very recently — there were bidding wars going on for homes in Canada.
- Canada might be America’s neighbor to the north, but it has a bubbly real estate market, even as the U.S. market continues to limp along. Consider these eye-raising facts: Canada’s real estate prices have increased on average 40% in the last year while incomes have dropped.
- Canadian residential real estate is now worth more today than it was pre-Lehman.
- There are now more dwellings built in Canada (assuming, as the Canadian government does, that an average of 2.3 people live in each dwelling) than the population of Canada.
- Canadian consumers have racked up enormous debts while interest rates have been low over the past 20 months.
- Personal bankruptcies are at record levels now in Canada when interest rates are still at historical lows.
- In Vancouver, people now spend 68% of their disposable income on housing. In Toronto, people spend 44% of their disposable income on housing. (Keep in mind that the China bears were complaining that it was unsustainable that some Chinese in Beijing and Shanghai were spending more than 30% of their disposable income on housing.)
Canadians have been proud that their banks have done well post-Lehman, unlike so many of their global peers. The banks have actively originated mortgages demanded by Canadians over the last year, but — unlike U.S. banks during the housing boom — for the most part, they’ve elected not to hold on to these mortgages. As quickly as they can, they pass along the mortgages to the Canada Housing and Mortgage Corporation. This is a crown corporation, meaning it’s 100% owned by the federal Canadian government (i.e., the Canadian taxpayers).
Over the last five years, the CHMC’s liabilities — meaning the mortgages they hold on their books — have gone up five times from C$80 billion to C$400 billion. Any time you see a business increase its liabilities by that amount, it’s intriguing. When you consider the last two years has been the worst economic downturn since the Great Depression, it’s even more head-scratching.
However, Canada’s economy was going along okay pre-Lehman. When the stock market dropped, Canadian housing and real estate activity stopped and prices did drop. But, with most consumers and the Canadian banks in okay shape, and with Canadian job losses not as bad (relatively) as in the U.S., Canadian consumers had quicker confidence to spend thanks to the lower interest rates.
When famous bear David Rosenberg left Merrill Lynch to move back to Canada in 2008 and join Gluskin Sheff, he spoke in glowing terms about Canada’s position in the global economy. Yet, even he has begun to acknowledge the housing bubble that exists in Canada.
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If you talk to Canadians about the possibility of a real estate downturn, you get a swift and immediate response: “We don’t have subprime like in the U.S., so a downturn can’t happen here.” This is categorically untrue. If you can’t get approved for a mortgage from the traditional banks in Canada, there are alternative mortgage providers. Whether you call them subprime lenders or not is up to you but that’s what they’re doing.
The fact is that home prices can’t keep going up while incomes are going down. That’s an environment ripe for a correction. At some point, sellers will outnumber buyers, prices will flatten and then decline, people will feel poorer and list their homes, begetting more selling pressure.
The question is: Will there be a hard or soft landing in Canadian real estate and what are the implications?
Optimistically speaking, the Canadian government and Canadian homeowners hope for the following:
- Rich Hong Kong-Chinese keep buying condos in Vancouver supporting prices there;
- The U.S. economy continues to rebound, supporting Canadian manufacturers;
- Employment increases in Canada, making consumers more confident and willing to spend; and
- If the economy grows slower than expected, the Bank of Canada can always keep rates low.
However, what would happen if there was a correction in Canadian real estate prices? After all, LIBOR has increased over these last couple of weeks due to the events in Europe, affecting the cost of borrowing for mortgages and credit cards in the U.S. and in Canada. It’s not at all far-fetched to imagine more dominos falling in Europe or Japan, no matter what happens in North America.
And, it has happened before in Canada. Toronto experienced a mini-housing bubble in the late 1980s. Then, interest rates rose and prices crashed. On an inflation-adjusted basis, the average price of a home dropped 50% from 1989 to 1996.
We have seen what a 40% housing correction has done in the U.S., a big correction in Canadian real estate prices would hurt the following:
- Canadian retailers who have enjoyed consumers taking on more debt;
- Canadian constructions for new homes and renovations;
- Canadian banks like Royal Bank(RY), TD Bank(TD), CIBC(CM), and Bank of Montreal(BMO), who, although they have off-loaded the mortgages to CHMC, would still have to deal with consumer credit cards and lines of credit;
- The Canadian government, who would likely have to bail out the CHMC in some way, increasing Canada’s debt-to-GDP ratio (which some currently peg at 70% including all existing liabilities) and;
- The Canadian dollar.
Most traders view the Canadian dollar as a proxy for the cost of commodities in the global economy, assuming that Canada has a rich supply of many commodities (which is true). However, most don’t realize that 35% of the value of the Toronto Stock Exchange (a proxy for the Canadian economy) is related to the financial industry (in the U.S., only 11% of the stock market’s value is related to financials).
The bottom line is, when you give people free money, they’ll spend it, whether they’re American, Canadian or Chinese. At some point, however, that spending can’t continue and corrections happen.
At the time of publication, Jackson held a short position in the Canadian dollar.
This article has been republished from The Street. You can also view this article at The Street, an investment news and analysis site.