Cooling Canada's housing market

How Ottawa plans to make mortgages more expensive and drive down housing prices—without hiking interest rates.

(Photo: C.J. Burton)

There are many tricks to herding cattle. You’ve got to know how they move and think, the limits to their peripheral vision, and how to manipulate their comfort zone to your advantage. Do it right and they’ll saunter pretty much wherever you want them to. Do it wrong and you might provoke a stampede, making an ass of yourself in the process.

Federal Finance Minister Jim Flaherty could be forgiven for failing to grasp the finer points of bovine psychology. But perhaps he should brush up on it. For the past several years, he’s been trying to steer Canadians from accumulating too much debt. He and other officials watched with growing alarm as homebuyers took on ever-larger mortgages, particularly in major urban centres like Vancouver and Toronto. This has left households vulnerable to any number of possible misfortunes, the most obvious being sudden spikes in unemployment or interest rates. Over several years, Flaherty has gently prodded them to back off, with mixed results. Although he hasn’t sparked a panic, the herd has strayed further into dangerous pastures.

The orthodox view among economists and policy-makers is that excessive household debt poses a serious threat to the Canadian economy. The debate now revolves around the threat’s magnitude. A recent forecast by the Conference Board of Canada suggests that indebted households will restrain spending over the next few years, contributing to slow economic growth. The darker perspective is that they are now so vulnerable that even a relatively mild shock might catapult the whole country into recession. “We need to acknowledge that a significant imbalance has developed and it poses a clear and present danger to Canada’s medium-term economic outlook,” wrote Craig Alexander TD’s chief economist, in a recent commentary. “It also suggests,” he added, “that further actions to constrain lending growth may be prudent.”

The problem is that the lure of bountiful, cheap credit remains too strong for many Canadians. And bankers can’t be counted on to close the barn door. They can’t meet at a Bay Street steakhouse and strike a gentlemen’s agreement to tighten the credit taps—that would be illegal collusion. And they’re locked in a perpetual, no-holds-barred rodeo for market share. This year the Bank of Montreal upped the ante by offering five-year mortgages at an interest rate of 2.99%—leading some to wonder whether its risk management department had been ravaged by bovine spongiform encephalopathy. In February, Flaherty accused some financial institutions (he didn’t identify which) as having unduly relaxed their lending standards. Julie Dickson, superintendent of Canada’s chief banking regulator (the Office of the Superintendent of Financial Institutions, or OSFI), said in a recent speech that although most banks already have real estate underwriting policies, “we had noticed cases where board approved policies were not being followed.” It’s tough to say how serious the problem is; most observers regard Canadian lending practices as generally sound. Even so, some senior bankers now appear to welcome federal intervention.

Flaherty can count on his trusty herding pooch, Bank of Canada governor Mark Carney, to issue regular warnings about the hazards of reckless borrowing. But virtually nobody is suggesting Carney raise the overnight rate to make borrowing more expensive. U.S. Federal Reserve chairman Ben Bernanke has signalled he won’t raise American rates until late 2014 at the earliest. Should Carney move earlier, he could injure Canada’s exporters by driving the loonie up. Unsurprisingly, on April 17 the Bank of Canada again held the overnight rate at an anemic 1%. So the cheap loans continue.

That leaves Flaherty. He has already clamped down on some risky lending practices. But this year he has quietly introduced less obvious—some might even say devious—methods of making credit more expensive to access. If successful, these tactics should gracefully redirect consumers from their secular path toward financial oblivion, cooling Canada’s overheated housing market in the process. But there’s a risk the herd has already gained too much momentum. Flaherty could find himself blamed for a housing correction, even a recession, if he misjudges.

Flaherty and other policy-makers struck a Faustian bargain during the financial crisis. Canada was a rare example of a developed country where residential real estate recovered quickly and, indeed, surpassed pre-crisis heights. This was a tremendous boon to the economy, likely sparing many Canadians pink slips they might otherwise have received. The government willed this to be so, by encouraging and facilitating more investment in housing. The cost was that Canada passed up the opportunity to restrain household credit growth, which means our next recession might well be nastier.

One key measure of our current distress is the household-debt-to-disposable-income ratio. Economists sometimes lament the shortcomings of this oft-cited statistic. Among other things, it reveals nothing about the distribution of debt, which is crucial for understanding who has done the borrowing, why, and whether we should worry about it. But it tells an important story nonetheless: since the late 1980s, that ratio has more than doubled, and now stands at 153%. Americans and British households ran into serious trouble when their ratios exceeded 160%, and spent the past few years suffering the consequences.

This indebtedness is actually more alarming than that number suggests. An aging population like ours should have a dampening effect on debt growth because, generally, people borrow more in their youth, and pay down those debts and save more as they near retirement. What we’ve seen instead is rising indebtedness in all age cohorts. It’s now common to retire with sizable amounts of it.

There’s no magical ratio beyond which households cannot venture. But evidence from around the globe loudly demonstrates the hazards of debt-fuelled real estate bubbles. A recent paper by the International Monetary Fund warned that “housing busts and recessions preceded by larger run-ups in household debt tend to be more severe and protracted.” It noted that in the five years leading up to 2007, the ratio of household debt to income rose by an average of 39% across advanced economies, to 138%. “When house prices declined, ushering in the global financial crisis, many households saw their wealth shrink relative to their debt,” its authors observed, “and with less income and more unemployment, found it harder to meet mortgage payments.”

When consumers reach the breaking point, one expects to see rising numbers of mortgages in arrears. Then the personal bankruptcy rate would rise. Neither of those statistics is showing any alarming movement. Also, most of the concerns about the housing market revolve around Vancouver and Toronto. In the former, foreign buyers are blamed for driving home prices through the roof. In Toronto, condo developers stand accused of building far too many units for the market to absorb. In other words, households have not yet hit the natural limits of how much credit they can accumulate. We can’t know precisely where that limit lies until it’s too late.

If Carney’s and Flaherty’s regular, repetitive warnings are any indication, such dark thoughts have occurred to policy-makers. They must feel like members of an aging rock band, condemned to belt out worn tunes they’ve secretly come to despise. Such pronouncements represent not only tacit acknowledgement of the problem but also a tactic for dealing with it. It’s called “moral suasion.” It’s tough to gauge how consumers have responded. “The power of moral suasion is greater than we might think,” says Brenda Lum, managing director of Canadian financial institutions with bond-rating agency DBRS. But whereas older Canadians still buy Rolling Stones tickets, it’s unclear how many enjoy listening to monotonous official warnings. And since outstanding credit continues to rise, one might conclude Carney and Flaherty can’t get no satisfaction.

Ottawa has not confined itself to talk, however. The Canada Mortgage and Housing Corp., a Crown corporation, is a crucial cog in Canada’s housing market. Its primary activity is providing mortgage insurance to financial institutions. The Bank Act dictates that any mortgage for which the downpayment is less than 20% must have this coverage, and CMHC is far and away the largest provider. Simply put, CMHC helps many Canadians get mortgages banks otherwise wouldn’t provide.

By virtue of its ability to determine which mortgages are insurable and which ones aren’t, CMHC offers Ottawa a powerful tool to manipulate the level of real estate activity. For years, CMHC insured mortgages amortizing over no more than 25 years. In 2006, CMHC began allowing amortizations as long as 40 years, which drastically reduced monthly payments for some borrowers. CMHC also began accepting smaller minimum downpayments, as low as nothing whatsoever. Many consumers lapped up the resulting loans with enthusiasm.

Over the past five years, Ottawa has made tentative steps to rein in CMHC. First, Flaherty lowered the maximum permissible amortization to 35 years. Last year, he lowered it again, to 30 years. And CMHC also stopped insuring home-equity lines of credit (HELOCs), a popular method of borrowing money. “The government should receive an awful lot of credit,” says TD’s Alexander. “Three times they’ve tightened up the mortgage insurance rules, and when you do that, that changes the way banks lend to anyone who comes in.”

Flaherty now appears to be prodding CMHC again. The amount of mortgage insurance it’s allowed to have outstanding is capped by legislation. Traditionally, Ottawa has raised the ceiling anytime CMHC approached it, a practice that has allowed the institution to grow exponentially over the past decade. Most recently, in 2008 the limit was elevated to its current $600 billion. But recently, Flaherty signalled he’s unwilling to raise it further, at least for now. This creates a situation not unlike last year’s debt-ceiling showdown in the United States. During the 2000s, CMHC’s portfolio grew by an average of more than $30 billion a year. At last report (that is, as of Sept. 30, 2011), it stood at $541 billion, 8% higher than a year earlier. At that rate, CMHC would hit its cap around the end of this year and would no longer be able to insure any mortgages whatsoever.

CMHC plans to avoid that. To understand how, you have to understand the two varieties of mortgage insurance. The first is the familiar variety issued on a high-ratio mortgage (that is, those with downpayments of less than 20%). But CMHC also insures portfolios of conventional mortgages for banks. It’s called “portfolio” or “bulk” insurance. Banks want it because it helps them sell off mortgages on their balance sheet to raise capital. (More on this later.)

To avoid hitting its ceiling, last year CMHC told banks it would ration bulk insurance to remain within the legislated cap. Ottawa’s intent, it seems, is that by forcing CMHC to curtail bulk insurance, it has nudged up the cost of capital for the bank. The bank, in turn, will pass on those costs to households in the form of higher interest rates. That would tend to moderate or lower housing prices over time. “I think it is quite a clever approach,” says Eric Lascelles, chief economist at RBC Global Asset Management. “It’s almost a bit of ju-jitsu.”

CMHC’s current projections show it will not hit its cap until at least 2016. Unfortunately, it has a poor record when it comes to long-term forecasting. In 2007, for example, it predicted that by the end of this year it would have less than $350 billion in insurance outstanding. Just how long Flaherty will keep the cap in place is unclear, but pressure will mount as CMHC approaches the limit. There’s also a wild card. CMHC has two private-sector competitors, the larger of which is Genworth Financial. Genworth has a cap, too, but it still has plenty of room to issue mortgage insurance. “I can’t imagine they will be able to completely replace the role CMHC played,” Lascelles says, “but I don’t know how this plays out.” Flaherty likely doesn’t, either.

It’s difficult to calculate the impact of Ottawa’s moves. TD’s Alexander guesses that in their absence the debt-to-income ratio would have risen above 160%. But the herd is untamed still.

Flaherty’s job gets harder, and more dangerous, as Canadian households become more leveraged. Several sources interviewed by Canadian Business stressed the delicacy of the situation. “You want to have a controlled, managed improvement in consumer indebtedness as opposed to doing anything radical,” advised Lum of DBRS. TD’s Alexancer, citing what he perceives as modest (10-15%) overpricing of housing nationally, warned against “heavy-handed” tactics. “The challenge is that you don’t know how the real estate market will react to changes in the lending environment when you have a degree of overvaluation,” he said.

Currently, the Ministry of Finance is working on new rules that might make it more expensive for banks to raise capital. Since 2007, Canada’s largest banks have enthusiastically issued something called covered bonds, which are backed by residential mortgages. Many of these mortgages carry bulk insurance from CMHC, so they’ve contributed to the rapid growth of CMHC’s portfolio. Covered bonds offer a cheap way to raise capital, and banks are thought to have used much of the proceeds for new lending.

Ottawa has been working for some time on a new legislation governing covered bonds. It’s unclear what the new rules might be, although there are several rumours. “It’s widely anticipated that the legislation will limit or prohibit banks from using insured mortgages in their covered bond pools,” says Finn Poschmann, vice-president at the C.D. Howe Institute, a think-tank. “This arguably would raise a bank’s cost of borrowing slightly.” Banks might pass some of that along to consumers in the form of higher interest rates. Whether that’s Flaherty’s intention is anyone’s guess.

In March, OSFI unveiled a series of proposed new rules governing mortgage loan underwriting. Home-equity lines of credit are another instrument of debt Armageddon. They’re a way of extracting home equity, and they have proven massively popular, growing from $8 billion in 2001 to $64 billion in 2010. Many consumers use HELOCs to refinance higher-rate debt, or simply to help them spend more. But there’s a logical limit to how long that can go on. Among other things, OSFI’s new guidelines (if implemented) would limit HELOCs to 65% or less of the value of the underlying home. Since the current limit is 80%, this could significantly reduce consumers’ ability to borrow.

There are other options for further action. One would be raising the minimum downpayment on mortgages from its current 5%. Raising it to, say, 10%, would add a potent barrier for first-time buyers. Alexander, for his part, suggests reducing the maximum amortization for CMHC-insured mortgages to 25 years. “For a long time, we had 25 years being the maximum,” he says. “The country was well-served by that policy.”

Some warn Ottawa against intervening too much in the private sector. “It’s not really the Department of Finance’s job to make sure lenders don’t lend too much money,” says Poschmann. “That’s something lenders and borrowers really ought to be able to figure out on their own.” Such edicts probably mesh well with prevailing Tory ideology. Yet a glimpse at American and European banks is enough to cause some to lose faith in the wisdom of the herd. If Flaherty manages to coax Canadians back from the pastures of indebtedness, it will be an achievement without equal across the G7. We might even grant him the affectation of wearing a larger belt buckle in Parliament. If he doesn’t … well, try to avoid getting trampled.