From WinnipegREALTORS® Real Estate News Publication, November 2, 2012.

Canada is not poised for an American-style real estate meltdown, according to a new report from CIBC World Markets. 

While there are a number of factors that raise concerns about Canada’s housing market, according to the report, there are fundamental differences between the Canadian and U.S. markets that should see a soft landing and no American-style meltdown for the real estate market here.

“To be sure, house prices in Canada will probably fall in the coming year or two, but any comparison to the American market of 2006 reflects deep misunderstanding of the credit landscapes of the pre-crash environment in the U.S. and today’s Canadian market,” said CIBC deputy chief economist Benjamin Tal.

While the debt-to-income ratio in Canada just broke the American record set in 2006,  Tal said, “this ratio is more a headline grabber than a serious analytical tool. There is a list of countries with comparably higher debt-to-income ratios, which did not experience anything remotely resembling the recent U.S. experience.”

Tal said we should pay more attention to the speed at which the debt-to-income ratio is growing. 

“Here the picture looks a bit less alarming,” he commented. “Comparing the three years heading into the U.S. crash to the past three years in Canada reveals that the debt-to-income ratio in Canada has been rising at half the speed seen in the pre-crash U.S. market."

The strong growth in indebtedness south of the border was partially fueled by speculative activity in the housing market, which is something seen far less of in the Canadian market. In the decade leading to the crash, housing starts in the U.S. exceeded household formation by nearly 80 per cent. On average, over the past decade, the gap in Canada has been only 10 per cent — with most of the excess seen in cities such as Toronto and Vancouver.

Another key difference between Canada and the U.S. is in the quality of mortgages. The distribution of credit scores has not changed dramatically in the past four years in Canada, which is a very different story to what happened in the U.S. during the four years heading into the recession. Stateside, the proportion in the risky category rose by more than 10 percentage points and accounted for 22 per cent of the overall market.

But credit score does not tell the whole story, according to Tal, who said that many of the troubled mortgages in the U.S. were sold to borrowers with an acceptable credit score, but who did not satisfy the underwriting rules for prime loans because they were unable or unwilling to provide full documentation on their mortgage applications. In 2006, these non-prime mortgages accounted for no less than 33 per cent of originations and close to 20 per cent of outstanding mortgages.

“An astonishing one-third of mortgages taken out in 2005 and 2006, before the drop in prices, were in negative equity position, and no less than half had less than five per cent equity, making them highly exposed to even a modest decline in prices,” added Tal. 

“In Canada, the negative equity position is nil, and only 15 to 20 per cent of new originations have an equity position of less than 15 per cent. Furthermore, we estimate that the non-conforming market is currently at around seven per cent of mortgage outstanding, up from five per cent in 2005 but dramatically below the over 20 per cent seen in the U.S. at the eve of the crash.”

At its core, according to the report, the U.S. meltdown is a non-conforming story. Average house prices in cities with above-av erage non-conforming exposure fell by 40 per cent from the June 2006 peak — double the decline in cities with below average exposure. 

“Eradicate subprime from the U.S. housing market and, instead of the most severe house price meltdown since the great depression, you get a soft landing,” said Tal.

In the U.S., a mortgage was typically 30 years compared to a five-year term in Canada. Traditionally, this made Canadian borrowers more sensitive to the impact of interest rate hikes. 

In Canada today, borrowers are already curbing their rate sensitivity by reducing the share of variable rate mortgages in new originations to a multi-year low (mainly among more risky mortgages).

“In the pre-crash U.S., the opposite was the case with the share of adjustable rate mortgages (ARM) staying elevated until the bitter end, with no less than 80 per cent of non-conforming originations being ARMs,” Tal added. “And those mortgage gymnastics did not end here. The introduction of the teaser rate, a low introductory rate for a period of two or three years that would adjust upward at the end of the initial period, worked to effectively neutralize U.S. monetary policy.”

Tal said that between mid-2004 and mid-2006, the Fed Funds rate rose by more than 400 basis points, but in part due to the impact of the teaser rate, the effective mortgage rate rose by only 30 basis points. The practical implication of that was that when the teaser period expired, millions of Americans felt the full impact of two years’ worth of monetary tightening virtually overnight.

“The reset of no less than $2 trillion of mortgage debt in 2006 and 2007 was no doubt the trigger to the U.S. housing crash,” said Tal. “Such a potential trigger does not exist in Canada with mortgage rates likely to rise gradually, allowing borrowers to adjust over time.”

Tal did caution that not all is well in the Canadian housing market. Home prices are overshooting their fundamentals, mainly in large cities such as Toronto and Vancouver and the recent slowing in sales activity will probably be followed by price adjustments in many cities across the country.

“But the Canada of today is very different than a pre-recession U.S., namely as far as borrower profiles are concerned,” Tal added. “Therefore, when it comes to jitters regarding a U.S.-type meltdown here at home, the only thing we have to fear is fear itself."