What Canada can learn from the U.S. Housing Crisis
Many Canadian real estate analysts have erred by using defaults to predict a housing correction. It’s the other way around! Lessons from the U.S. show a housing slowdown in 2007 caused the rise in defaults and defaults didn’t peak until 2010. The housing crisis in the U.S. accelerated toward the end of 2007 so let’s look closely at what was happening around that time.
In 2001 when the US economy was in recession, the U.S. Federal Reserve reduced interest rates to boost the economy. Lower interest rates made it easier for households to carry larger amounts of mortgage debt, and so the demand for US housing increased. A contributing factor behind the surge in housing investment and aggressive price increases was a massive inflow of foreign investment into the United States, notably from China.
US household debt grew dramatically between 2000 and 2007 to allow people to buy ever more expensive homes and incomes did not keep pace.
A 2007 Time Magazine article said, “Since early 2000, economists have been sounding the housing bubble alarm with increasing urgency. And while many markets around the country have seen prices drop in the last year, the dire, across-the-board correction that many predicted has yet to materialize.” Time notes that a “bubble seems not to be a major concern.”
The Miami real estate market peaked in late 2006 and by May 2007 there were reports of condo buyers in Miami walking away from pre-sale contracts while the buildings where under construction.
In summary: interest rates are rising, households have record debt, experts are warning of a bubble, delinquency rates are at historical lows, and the housing market is slowing with some cities showing price drops.
What happened next?
Real estate is an interest rate sensitive asset and researchers at the Bank of International Settlements believe the cause of the initial drop in home prices was caused by rising rates rather than defaults of sub-prime mortgages. As well their research shows that:
House price trends have more inertia than other assets like stocks and bonds and are slow to adjust to economic changes.
Changes in short-term interest rates from up to five years in the past have a significant impact on current house prices.
So the initial 2007 drop in house prices was caused by interest rate rises that began in 2004 after the recession cause by the dotcom bust.
The subsequent housing price crash from 2008 to 2009 is believed to have been caused by homeowners with negative equity walking away from their house or rental property because they figured the short-term inconvenience of a bad credit score was less painful than making monthly mortgage payments on a house with a negative net value. Mortgage delinquencies didn’t peak until the last holdouts threw in the towel in 2010.
In October 2007, Hank Paulson the U.S. Treasury Secretary said, “despite strong economic fundamentals, the housing decline is still unfolding, and I view it as the most significant current risk to our economy.” He then railed “against the rampant speculation” and said he has no interest in bailing out “reckless lenders and speculators”. By September 2008 Lehman Brothers had declared bankruptcy.
The U.S. housing crisis only resulted in a 20% home price correction, but some local markets, like Miami, saw homes halve in value.
Why wasn’t Canada’s housing market hit as hard?
Home prices in Canada lagged the U.S. and dropped briefly in 2008 and Canada had a smaller recession than the U.S. The key negative economic impacts to Canada were a slowing US economy which imports 20% of Canadian exports and the credit squeeze in global financial markets. Keep in mind home prices all over the world were impacted and Europe was also hit particularly hard. Here are some possible explanations:
20% of Canadian workers are employed by the public sector and are not at risk of layoffs. This provides a buffer or cushion in an economic downturn. Canada’s public sector employment is 25% higher than that of the U.S.
Strong Oil, Gas, and Gold prices for export to Asia propped up the Canadian economy and absorbed people who lost jobs in other industries.
Canada didn’t have subprime mortgages like the U.S. however this argument is a little weaker since Canada did have programs that were “near subprime” and allowed people to buy million-dollar homes with a down payment as little 5% and repay the mortgage over 40 years. Additionally, Europe was hit quite hard by the financial crisis and they didn’t have mortgages that would be described as subprime.
Canada lowered interest rates before house prices began to drop, whereas the U.S. had lowered rates 6 months after a real estate slowdown.
Potentially, as U.S. home prices began to drop, investment capital flowing from Asia diverted from U.S. homes to Canadian homes which hadn’t yet shown weakness.
In the end there are many factors at play and we may never know exactly why Canada was spared and Europe was not.
What can we learn?
Early warning of a potential housing downturn 2019:
Global analysts have flagged several global cities as having high risk of a real estate bubble. Top of that list are Hong Kong, Munich, Toronto, Vancouver, Amsterdam, and London. Places like New York, Stockholm, San Francisco, and Sydney are considered overvalued but not as great a risk of a house price collapse. Although the U.S. is seeing a slowdown in home sales, they have less debt than Canadians and their real estate is less overvalued.
Interest rates in Canada have been rising since 2016 in response to a strong economy and house prices generally drop as interest rates rise, albeit with a lag of up to 5 years. House prices have already begun to drop in Vancouver with further interest rate rises scheduled for 2019 and 2020.
Canada has seen a rise in the use of private lenders who do not require income confirmation. A CIBC study from 2018 found that 10% of condos bought in Toronto involved financing from private lenders who charge more than double the borrowing costs of regular banks and require a new mortgage approval annually.
Although prices in Toronto are still rising, they’re rising on a foundation of 20% to 10% fewer sales (weaker demand) and if interest rate increases continue to reduce home buying budgets, prices will likely drop in 2019.
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