Why a Severe Downturn in the Canadian Housing Market is Likely

By Davide Pavone

The sustainability of the current boom in Canadian residential real estate has been questioned by several economists. The nonexistence of a Canadian housing bust is said to be attributable to the stringent lending standards of Canadian banks. The role of the Canada Mortgage and Housing Corporation in the mortgage market is often disregarded when analyzing the residential housing sector. A closer look reveals that the risk-externalizing policies of the Canada Mortgage and Housing Corporation, as well as loose monetary policy, have created an unsustainable rise in home prices.

The Role of the Canada Mortgage and Housing Corporation in the Mortgage Market

The Canada Mortgage and Housing Corporation (CMHC) is wholly-owned by the Government of Canada, and provides mortgage insurance to National Housing Act Approved Lenders. The CMHC protects the lender from borrower default by guaranteeing the complete loan amount, as well as accrued interest. Mortgage loan insurance is mandatory if a down payment is less than 20% of the home’s purchase price, however a lender may purchase mortgage insurance if the loan-to-value ratio is less than 80%. Only insured mortgages are eligible for the National Housing Act mortgage-backed security program (NHA MBS).

A portfolio of insured mortgages may be securitized by the lending institution, and sold to the Canada Housing Trust (CHT). The CHT is managed by the CMHC, and sells securitized portfolios of insured mortgages to investors as Canada Mortgage Bonds (CMBs). Given that the CHT and CMHC are agencies of the federal government, the CMBs are deemed to be high quality obligations as they are backed by the full faith and credit of the Government of Canada. In June, the stock of NHA MBS amounted to approximately $300 billion (all figures are in Canadian dollars).

Given that the market interest rate is composed of time, inflation, and risk components, CMHC mortgage loan insurance artificially lowers the risk premium, and permits the riskier borrower (the borrower whose down payment is less than 20% of the home purchase price) to obtain a lower mortgage rate. From the viewpoint of the lender, risk is externalized as the CMHC guarantees the complete loan amount, as well as accrued interest. It is also important to note that a “Canadian TARP” is integrated into the mortgage market as the federal government, through the CMHC, is required to bailout a lender in the event of borrower default. Ultimately, CMHC mortgage loan insurance transfers the risk of borrower default from the lending institution to the Government of Canada, as well as promotes moral hazard and excessive risk-taking in the residential real estate market.

The Residential Real Estate Market: 2007 to Present

In the fourth quarter of 2007, the Bank of Canada (BoC) initiated an expansive monetary policy to (supposedly) prevent an economic recession. The year-over-year change in M2+ attained a bottom of 7.2% in November, while the BoC lowered the bank rate from 4.75% to 4.50% in December. In the same month, the 5-year conventional mortgage rate reached a high of 7.54% (the 5 year term is the most popular) (see Figure 1), and the stock of NHA MBS amounted to approximately 19% of total residential mortgage credit.

In 2008, the Government of Canada implemented the Insured Mortgage Purchase Program (IMPP), and announced key amendments to the Mortgage Insurance Guarantee Framework. Through the IMPP, the federal government purchased roughly $75 billion in insured mortgages from October 2008 to March 2010. The important changes to the Mortgage Insurance Guarantee Framework took effect in October 2008. In order to qualify for CMHC mortgage loan insurance, the borrower’s down payment would have to be a minimum of 5% of the home purchase price, and the amortization period could not be longer than 35 years (see here for the CMHC mortgage loan insurance requirements). Prior to October 2008, a 40-year residential housing mortgage, despite no down payment, qualified for mortgage loan insurance (provided that the borrower passed certain debt service tests). The Teranet – National Bank National House Price Composite Index, the Canadian equivalent of the Case-Shiller index, attained a high of 130.79 in August 2008, a rise of approximately 92% since the beginning of the decade.

In 2009, monetary policy was considerably expansive as the bank rate was lowered to 0.50% in April. Accordingly, the year-over-year change in M2+ attained a high of 13.3% in the first quarter of 2009, and the 5-year conventional mortgage rate reached a low of 5.25% in April and May. In the same time period, the Teranet – National Bank index fell roughly 9% from its pre-recession high to a recession low of 119.19. From December 2008 to November 2009, the year-over-year change in the stock of private sector mortgage credit was negative, while the stock of NHA MBS rose at a considerably rate (see Figure 2). Arguably, the CMHC’s promotion of risky lending, as well as considrably loose monetary policy, prevented a further fall in home prices, and contributed to the rise in prices beginning in the fourth quarter of 2009.

Home prices have staged an impressive rebound as the Teranet - National Bank index has risen 13% from its recession low. In addition to loose monetary policy, the rebound in home prices is due to the rise in the stock of NHA MBS as it currently amounts to approximately 30% of total residential mortgage credit. Moreover, economists have noted that the harmonization of provincial sales taxes and the federal goods and services tax, which took effect July 1st and increases the cost of purchasing a home, artificially spurred home buying activity. A rebound in the supply of housing (see Figure 3) may also impede, if not reverse, the rise in home prices in the near future. Monetary policy is also likely to prevent a further significant rise in house prices.

The BoC initiated a tight monetary policy in June as the bank rate was raised to 0.75%, and again in July to 1.00%, and higher interest rates are largely expected. Accordingly, the year-over-year change in M2+ has fallen to a little less than 4%. The rise in interest rates does not bode well for mortgaged homeowners as approximately 27% of all mortgages are classified as floating rate. Roughly 15% of mortgage holders have indicated that they are currently having difficulty respecting their payments, and/or were to have difficulty respecting their payments should their mortgage rate rise to 5.25% (the average mortgage rate was 4.09% at the time the survey was published) (see Figure 4 for a historical comparison of mortgage debt service ratio and mortgages in arrears). However, economists have remarked that the correlation between the number of mortgages in arrears and unemployment (r = 0.73) is stronger than that between mortgages in arrears and interest rates (r = 0.13). Given the decline in the rate of change of M2+, a slowdown in economic activity is increasingly likely, and would cause the number of mortgages in arrears to rise.

Conclusion

The role of the Canada Mortgage and Housing Corporation in the mortgage market is to artificially reduce the risk premium of the riskier borrower, and transfer the risk of borrower default from the lending institution to the Government of Canada. Recently, a rise in the stock of National Housing Act mortgage-backed securities from 17% of total residential mortgage credit to 30%, as well as loose monetary policy, prevented a considerable decline in home prices, and caused prices to rise from their recession low. A further significant rise in house prices is unlikely given that (i) the year-over-year change in the stock of National Housing Act mortgage-backed securities is declining considerably, and (ii) the Bank of Canada has initiated a tight monetary policy.

David Pavone is an undergraduate finance student enrolled in the Desautel Faculty of Management ( McGill University)