Flaherty bombs on housing bomb

Think of Canada's housing market as a ticking time bomb. Think of Jim Flaherty, the Minister of Finance, as the unlucky bomb-disposal expert called in to deal with the problem.

Flaherty is moving slowly -- oh, so slowly -- to snip a wire here and there in an attempt to defuse the mess. Problem is, the ticking is getting louder by the minute.

If the bomb explodes, home prices could plunge. In the worst case, plunging prices could bring on an economic downfall such as the United States, Ireland and Spain suffered after their real-estate markets collapsed.

But to make Flaherty's challenge even more difficult, he still has to convince most people the bomb even exists. At the moment, he's being cautious in how he describes the problem. He's being even more cautious in how he deals with it. Perhaps too cautious.

Flaherty told Canwest News Service last week that he's monitoring the real-estate market and is ready to intervene if it reaches "irrational" levels. The Finance Minister says he may require homebuyers to put down higher down payments. He may also force them to amortize their mortgages over shorter periods.

No doubt these are excellent ideas. But Flaherty has already tried them.

In July 2008, he made his first tentative move to defuse the housing sector by requiring homebuyers to put down at least 5% of the purchase price of a home.

At the same time, Flaherty reduced the maximum amortization period on home mortgages to 35 years from the previous limit of 40 years.

His cautious strategy accomplished absolutely nothing. The Canadian Real Estate Association reported the resale price of an average Canadian home hit $337,231 in November, up a stunning 19% from a year earlier.

If a red-hot real estate market during the brutal recession of the past year doesn't meet Flaherty's definition of an "irrational" market, it's difficult to know what would.

Yes, interest rates are historically low, but any rational homebuyer has to realize interest rates will inevitably rise. When that happens, many homeowners will face much larger mortgage payments.

Canadians appear unshaken by the risk of higher rates, perhaps because home prices have doubled over the past decade and many buyers assume more gains lie ahead.

It is difficult, though, to come up with a rational explanation of why home prices should climb from here.

Canada's population growth has been nothing extraordinary. Wage increases have crawled. The supply of new homes has surged and the level of home ownership stands at a four-decade high. Meanwhile, Canadians are aging, which suggests the pace of household formation should be slowing down.

So why are homes still being bid higher? It seems to come down to the widespread conviction that a house is a great investment.

History suggests this is true only sporadically. Robert Shiller, the Yale economist who warned of both the dot-com bubble and the U.S. housing bubble, has accumulated a mountain of data to demonstrate that the price of a home in the United States over the past century has barely beaten the rate of inflation.


Piet Eichholtz, a professor of real estate finance at Maastricht University in the Netherlands, came to a similar conclusion when he studied real estate prices in an Amsterdam neighbourhood from 1628 to 1973. He found that home prices required 350 years to double in real terms.

If you assume home prices should rise in line with inflation, you come to a dire outlook for Canadian real estate.

Taking figures from 1990, 1995 and 2000, and boosting them by inflation during the intervening years, suggests the national average home price should check in around $200,000 -- a third less than the current figure.

More sophisticated calculations arrive at similar estimates. David Rosenberg, chief economist at the money manager Gluskin Sheff in Toronto, examined home prices in relation to personal incomes and residential rents. He concluded that prices are between 15% and 35% above levels that are consistent with fundamentals.

"If being 15% to 35% overvalued isn't a bubble, then it's the next closest thing," he writes.

So what can Flaherty do? He's already missed the opportunity to defuse the real estate bomb at an early stage. He's understandably reluctant to raise interest rates when the recovery is still tentative.

He should follow through on his vows to increase downpayment requirements and shorten amortization periods. Most important, though, he should loudly caution Canadians on the dangers of taking on more mortgage debt when home prices seem unsustainably high. After all, when a bomb-disposal expert can't do anything else, he can at least warn people to run for cover.

(prepared by Ian McGugan/Financial Post/National Post)