Floating high on a delicate housing bubble

Is the Canadian housing market in a bubble? It sure looks that way.

At a time when personal income is down about 1 per cent over the past year, we have seen nationwide average home prices soar 21 per cent to hit a record high, as did home sales. Even factoring in inflation, home price appreciation is now back to where it was in 1989. Back then, interest rates were far higher, but the economy was also in the late stages of a phenomenal expansion, not making a transition from deep recession to nascent recovery.

While the Canadian economy is recovering now, overall growth is still barely above zero as manufacturers grapple with excess inventories, a strong currency and soft demand south of the border. Employment conditions have improved but they are hardly healthy, as we saw in the November jobs report, where wages and the workweek were both down despite a constructive headline number. Even though home prices did come off a soft base from a year ago, so did most other economic indicators and they are still down from the depressed levels prevailing at this time in 2008.

As to the question of whether home prices are in a bubble, if it walks like a duck…

Looking at Canadian home prices in relation to personal incomes or residential rent, what we have found is that housing values are anywhere between 15 per cent and 35 per cent above levels we would label as being consistent with the fundamentals. If being 15-per-cent to 35-per-cent overvalued isn't a bubble, then it's the next closest thing.

Driving prices to new record highs here – at a time when home values are still down 30 per cent from the peaks in the U.S. – is a very tight supply backdrop (close to 4 months' supply in some major markets) and surging demand. Even though housing starts have hit 11-month highs in the single-family sector, we are 40 per cent below the overbuilt levels that touched off the home price slide in the early 1990s – back then, the unsold inventory broke well above 10 months' supply in the Toronto area.

This time around, there has not been a very aggressive response by the home building community to the spurt in demand, though construction permits will be a key variable to watch (note all the condominium cranes in Toronto). Keep an eye on the evil 'I', which is inventory. The shift toward an excess supply backdrop is what inevitably touched off the price decline in 2006, and as we saw south of the border, the more overvalued the market is, the harder the decline is likely to be.

You also can't have a home price bubble without a dramatic credit expansion. Over the past year, residential mortgage balances have risen 7 per cent, which does not sound like a lot, but, in the context of deflating personal incomes, it is huge. In fact, mortgage debt relative to Canadian household incomes just moved above 70 per cent for the very first time ever from just over 65 per cent a year ago.

What is fascinating is that mortgages on the books of the chartered banks have actually declined over the last 12 months, while the issuance of securitized mortgage products has ballooned by nearly 40 per cent and 100 per cent of them been insured by the government (over the past two years, 90 per cent were insured).

What happened here was the Canadian government's move to save the housing market from a collapse via the Insured Mortgage Purchase Program – currently, if you have only have a 5-per-cent down-payment for a home, you are eligible for an insured mortgage with a 35-year amortization to boot, which, along with record-low mortgage rates, has dramatically improved the financing costs in residential real estate. For current borrowers, carrying costs are very low, but here is the rub, rates have nowhere to go but up; only the timing is open for debate.

Moreover, based on anecdotal evidence, 40 per cent of the $60-billion of mortgages issued in 2009 were in very short-term maturities and vulnerable to any shift in central bank policy. Since house prices have risen so far and so fast, and because personal incomes are flat-to-down, housing affordability measures for new housing entrants are actually tied for being the most onerous ever. This may end up curbing demand, and if the surge in building permits morphs into an actual dramatic supply response in the coming year, a significant reversal in the housing market would rattle the nerves of even the most hardened market participants.

The banks in Canada have managed to get these high loan-to-value ratio loans off their books for the most part, but someone is going to be left holding the bag if the housing mania here pops at some point; and it is probably going to be the Canadian taxpayer.

So while a house price reversal would not likely turn into the financial event it did in the U.S., it certainly would be a fiscal and economic event. When asked what keeps us up at night, it is exactly this topic, because Canada right now is in the spotlight as being pristine and stable when it comes to government deficits and debt ratios, at least relative to its global peers.

(prepared by David Rosenberg , a chief strategist for Gluskin Sheff Associates Inc. and a guest columnist for Report on Business /Globe & Mail)