Revolutionary Moderation

Danger

So, Mrs. RevMod and I have been doing some househunting, and we were both shocked at the size of mortgage we've been pre-approved for. We've also been wondering why the housing market in Canada hasn't suffered the massive deflation of the American market. Even as we've gotten closer to buying, we've been researching the answers to these questions, and we've reached the point of stepping back from the precipice. Allow me to share what I've discovered.

Former Tory and eventual independent MP Garth Turner is the author of Going Rouge Greater Fool, a book and weblog dedicated to tracking the Canadian housing market as we rush toward what he sees as its inevitable decline. Now, my politics certainly don't match his, but he's spent a lot of time thinknig about the housing market, so he can't be ignored. Further, unlike almost every one of the real estate "experts" that are quoted in the newspaper (presidents of local real estate marketing organizations, bankers, CMHC or government representatives), he doesn't have any particular self-interest (beyond what I expect are investments that reflect his view of the future). He, and others I've found through reading him, have pointed out some problems on the horizon for Canadian real estate:

- Wages have been stagnant through the entire rise of the housing market since the turn of the century, significantly raising the ratio that measures affordability (median house price divided by the median household income) People have been assuming greater amounts of debt to buy these homes, because debt has been cheap and easy throughout the period. They're willing to take on that greater debt because they believed through the boom that geometrically increasing prices on real estate would continue in perpetuity (a falsehood made obvious in the last couple of years), and they believe now that there's something unique about the Canadian market that shelters us from the real estate devaluation that's happened so sharply in the United States and elsewhere (resource-based economy, conservative banking practices, magical Canadian pixie dust).

- Far from being conservative, our banks are lending out absurd amounts of money to most anyone who asks, and then securitizing the debt. Those of you who have paid any attention at all to the American real estate meltdown will recognize this practice - banks would issue mortgages to people at attractive teaser rates, with absolutely no concern about the ability of the borrower to pay it back. They then would repapckage the loans into mortgage-backed securities, to sell to investors who were more than happy to buy a security that was backed by the solid Fannie Mae and Freddie Mac. The banks would then have to issue more mortgages to continue to have debt to package into securities.

The reputation was that these loans were only issued to people on the edge, people who shouldn't have been issued credit cards, much less mortgages, but as we've since discovered, many many people in all sorts of income classes were issued too much debt, and the availability of this seemingly easy money had a rapid inflationary effect on housing prices. That led to the speculative market in housing, which led to overconstruction, and all of this continued to feed prices, so long as no one got off the merry-go-round. But of course, perpetual motion machines don't exist in nature, and neither do they exist in a real economy.

Let me say this again, because it's important. Your bank will lend you money - more than you think, because they'll sell the debt to someone else. The debt is guaranteed by CMHC, an arm of the government, which means when the housing bubble deflates, we're all going to be on the hook as taxpayers to make sure the investors continue to get paid. The bank, therefore has no interest in screening you to make sure you can pay back the loan - they have no skin in the game. This is the very recipe that cooked up a huge bubble in the American housing market.

- The government may see the bubble coming, but it has vey few good choices. If they make outward noises that it's a bubble, they ignite the selling that'll pop it. That goes for more subtle signs that they know it's a bubble, like tightening the CMHC qualifications. They could raise the prime interest rate, but that can also be seen as a warning about the housing market, and it comes with a second problem - a higher interest rate slows growth, which would be a good policy to deal with housing, but a lousy idea in the rest of the economy. The point is that beyond a certain threshold, there's no good way to slowly let air out of the bubble. Really, the government can only leave it be and attempt to quietly prepare and even hedge for the worst (buying up the mortgage-backed securities now might be cheaper than paying them out later, for example), or they can try to keep the bubble inflating in the hopes of passing the problem on to the next government. That's obviously an irresponsible choice, but knowing how Prime Minister Prorougey McAutocrat has behaved thus far, it's the most likely choice.

So, to conclude, Mrs. RevMod and I have decided that this may be the wrong time to buy, that Canada's real estate market isn't immune to the trouble that incinerated the American market, and that it'll do no harm to rent a while longer while we watch from the sidelines and perhaps get other debts out of our way while the interest rate is still so low.

As a postscript, I want to link to the Edmonton Real Estate blog as well. The authors are Edmonton realtors, and don't have the same pessimistic view I have of the long term prospects, but they also don't seem to have the same starry-eyed optimism I've heard from every other realtor or sales centre associate I've spoken to over the last few months. It's worth a read on occasion if you're interested in more detail and in the perspective of thoughtful people deeply involved in this market.

Update, Sunday evening: The Globe and Mail's cover story this weekend uses the dreaded word "bubble", but only to deny one exists. The alarm bells started going off for me reading the sidebar:

Residential mortgage debt as a percentage of personal disposable income has been rising since the early 1980s.

But thanks to lower mortgage rates, the debt service ratio - a measure of how well Canadians can afford their monthly interest payments - was trending downwards until a couple years ago.

And since the banks losses on mortgages in Canada are so small as to be insignificant, they have steadily continued to dole out more in mortgages each and every year.

To recap this with a slightly different spin, for the last couple of years Canadians have taken on decreasingly affordable mortgages, even while interest rates are at historic lows. The government's default insurance exposure is likewise increasing. And, to do the math, on a half-million dollar home, the 5% down payment is $25,000, but a 3.15% CMHC insurance premium is added to the mortgage, making the debt nearly $490,000. It will take very little downward pressure to leave these homeowners with more debt than house, which encourages defaults, which begins the dominos tumbling. I say again, we're headed for a very uncertain and scary time, and Jim Flaherty can try to cool the market come budget time by raising the bar for entry, or he can stay on the sidelines while an entirely predictable crash takes a lot of Canadian futures with it.