Why a housing crash is not imminent

History indicates overvaluation alone is not sufficient for a crash.

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(Photo: C.J. Burton)

It’s quite a sight to see the housing bears hail recent softness in the Canadian housing market as the beginning of a U.S.-style meltdown. But how can a crash be imminent when the catalyst is absent?

History indicates overvaluation alone is not a sufficient condition. Take the U.S. housing market in 2007: the overvaluation only turned into a bust after the Federal Reserve tightened monetary policy dramatically.

It drove up short-term interest above long-term rates in a concerted effort to cool off an overheated economic expansion. Such interventions historically trigger modest corrections in house prices, but a free fall got underway because of the rot in the U.S. subprime mortgage market and a financial panic arising from the collapse of major institutions.

In 2012, monetary policies in Canada, U.S., Europe, China and elsewhere around the world are nowhere close to tightening mode. In fact, the opposite situation holds in extreme form: interest rates are at historical lows and the printing presses are running overtime. This is an extremely accommodative setting and it is very supportive of housing markets.

As for excessive risk-taking in mortgage lending and a weakened banking system, that scenario is even more remote in Canada. The subprime mortgage market remains relatively small and the banking system is still very strong.

As it stands, Canada is being dragged into monetary easing by the pump-priming polices of other countries: rock-bottom rates around the world are causing capital to flow into Canada and push up the value of the Canadian dollar. If the Bank of Canada were to raise rates at this juncture, it would increase overvaluation of the loonie and potentially tip Canada into recession.

Meanwhile, there are signs that the unprecedented amount of stimulus administered in some of the harder hit countries is finally filtering through. Notably, the inventory of unsold houses in the U.S. has attenuated enough to allow six consecutive monthly increases in U.S. house prices (based on the S&P/Case-Shiller Home Price Indexes).

This turnaround in U.S. housing is quite significant. Recoveries in the housing sector are what lead broader recoveries in the economy, so the U.S. appears at last headed toward a vigorous and self-sustaining upturn. There will be spill-over effects for Canada that will drive national income and job growth higher, which, in turn, will further support housing demand and valuations.

One side issue worth mentioning is differences across regions. While overheated pockets such as Vancouver are at risk of substantial correction, other parts of Canada are far less frothy. On balance, price statistics at the national level don’t seem likely to confirm the Great Crash scenario.

A second side issue is the tightening of mortgage rules by Finance Minister Jim Flaherty. I don’t think it poses a serious threat to Canadian housing; I offered reasons why in “Housing bears make more unsubstantiated claims.”

A third side issue is the proper measurement of price changes. Comparisons of average house prices are misleading because of distortions caused by changes in the mix of houses sold. Better indicators are the Teranet-National Bank indexes and MLS Home Price indexes since they control for this factor.

The differences can sometimes be startling. For example, a comparison of average prices in Vancouver shows tumbles greater than 10% in recent months. By contrast, the Teranet-National Bank and MLS Home Price Indexes recorded drops of less than 1%.

Over the quarters to come there will be dips in the housing market that the housing bears will seize upon as confirmation of their thesis. But they are fighting central bankers around the world and the tide coming in to lift all boats. I can’t see how they will win this battle.

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