Canada's armoured housing market has some big cracks

One of the enduring mysteries of the Great Recession is how Canada largely escaped the crushing home price correction that hit virtually every other Western country.

After a brief setback in 2008, Canadian prices resumed their upward climb. The average price of a house is up a remarkable 21 per cent in the past 12 months, reaching a new record of $341,079 in October.

Fresh numbers on home sales are due out today.

In the hottest markets, such as Vancouver, buying fever is back, marked by bidding wars and overnight campouts to buy condos.

Compare that with the United States, where housing prices are down roughly 30 per cent from their peak. Even in Europe, values are off an average of 6 per cent.

The contrast is startling, and quite frankly, defies logic.

It isn't as if Canada was immune to the worst recession since the Second World War. The economy contracted, stocks tumbled, unemployment jumped more than two percentage points to 8.5 per cent, 321,000 jobs were destroyed and personal income fell.

There are two possible explanations for the anomaly. One is that Canada has coated itself in armour, aided by brilliant monetary stewardship at the Bank of Canada, prudent lending by banks and just the right dose of stimulus from the Harper government.

Or, more probably, it's not a protective coating at all, but a real estate bubble that will eventually burst – two years after the rest of the world.

Arguing for the armour case in a new report for the Federal Reserve Bank of Cleveland, University of Western Ontario economist James MacGee says the main reason Canada's housing market hasn't gone bust is because of much sounder lending practices. An explosion of subprime and high-risk mortgages, rather than merely low interest rates, was the primary reason that U.S. prices boomed and then collapsed, according to Prof. MacGee.

The result is that Americans took on too much debt, relative to the both the value of their homes and their incomes. That left them highly vulnerable. They bought homes they couldn't afford, leading to an inevitable spike in delinquencies and tumbling prices.

In Canada, that didn't happen. Prof. MacGee said risky lending was held in check because banks did less securitization of mortgages. Also, stricter capital requirements and tighter mortgage insurance rules discouraged subprime lending.

The result is that mortgage delinquency rates in Canada and the United States, which had been comparable roughly up until 2006, began to diverge: They spiked in the U.S., but held steady in Canada.

Prof. MacGee acknowledges the possibility that he's wrong, and that Canada could face a correction some time in 2010. But he said that if it happens, it's likely to be more of a "housing market slowdown, rather than a bust."

There is another camp. A small, but growing minority of experts are now warning of a more severe real estate bust in Canada. Last week, Bank of Canada Governor Mark Carney said excessive household debt poses the biggest threat to the recovery.

And in a recent Globe and Mail column, economist David Rosenberg, chief strategist at Toronto-based Gluskin Sheff Associates Inc., raised the spectre of a Canadian housing bubble that is on the verge of collapse. He figures prices are 15 to 35 per cent overvalued, based on relative rental rates and incomes.

Canadians should pay attention. Mr. Rosenberg, a former Merrill Lynch economist, was among the first on Wall Street to warn of a housing-led recession in the United States. He knows what a housing correction looks like.

Homes are now less affordable in Canada than they've even been, relative to income.

So while it's true that Canada's banks are financially sound, it's less clear that homeowners are being similarly prudent.

Too many appear to be blindly following Americans down a path of excessive debt, enticed by low rates. The ratio of mortgage debt to household incomes in Canada recently hit a record 70 per cent, up from 65 per cent a year ago. And 40 per cent of home buyers are opting for short-term, variable-rate mortgages, which will eventually ratchet up, leaving some owners in deep financial trouble.

Canadian authorities have seen the U.S. movie; they helped fuel the hot market in Canada, and presumably they know how to cool it. The Bank of Canada would raise its key interest rate and Canada Mortgage and Housing Corp. would wind down its purchases of insured mortgages from commercial banks.

Brace yourself for a rough 2010.

(prepared by Barrie McKenna/Globe & Mail)