Capital Economics report suggests that rising interest rates could trigger housing collapse

Rate hikes could trigger Canadian housing collapse

At least that’s the conclusion of a new report from Capital Economics who have calculated that home prices could fall 25-35% as the overnight interest rate from the Bank of Canada rises from its current level of 1% to closer to 3.5% by the end of 2012.

Unfortunately, the actual report is available only to paying clients.  I’ve requested a trial subscription to hopefully be able to get my hands on it.  In the meantime, the story was picked up by Canadian Business, Yahoo Canada, Financial Post, and the Globe and Mail.

Some key quotes from these articles:

“Even small rises in official interest rates have been shown to have a big effect on homeowner confidence in other countries under similar circumstances,” (Capital Economics Chief Economist David) Madani said Thursday. “If the Bank of Canada does resume its monetary tightening this year, this could easily prove to be a tipping point for a house price collapse.”

”If prices fall 35 per cent, the Canadian Mortgage and Housing Corp. that insures higher risk mortgages could suffer losses of $10 billion as about 10 per cent of mortgages default.”

”Madani believes the confidence (that the housing market will experience a soft landing) is misplaced, however. He says not only have prices risen as quickly as the U.S. before the collapse there, but Canadian prices are way out of whack with traditional markers, such as incomes and the cost of renting.”

If prices do fall as far as Mr. Madani predicts, “the knock-on effects to consumer spending and housing investment could be significant and perhaps even strong enough to push the economy into another recession,”

Of course you already knew that

Will recourse mortgages save the market?

Merrill Lynch ‘s current chief economist Sheryl King disagrees with her predecessor, and the Capital Economics analysis….”You need a rise in the unemployment rate and you need a wave of defaults from speculators,” she said. “But defaulting is not an option in Canada, and we have an unemployment rate that is headed lower, so I disagree.”

Two points for Ms King to consider:

1)  Many of the hardest hit states were recourse states.  Many economists who suggest that Canada’s real estate laws don’t allow you to walk away from a mortgage conveniently forget that neither did Florida, Nevada, Michigan, or Illinois, yet home prices have fallen by 50% in some of those jurisdictions.

In fact, states that have an element of lender recourse outnumber those that are non-recourse.

This is not to suggest that having an element of recourse has no impact on default rate.  In fact, the same Fed paper referenced above also suggests that recourse reduces defaults by 20%.  Not insignificant, but it certainly does not reduce them completely as seems to be often suggested, and it no doubt provides little comfort to those living in some recourse states like Florida and Nevada where the delinquency rate is hovering around an astonishing 20%.

2)  Falling home prices CAUSE unemployment, not the other way around.  Demand for new and existing homes falls as prices fall.  As Bob Farrel reminds us, people overwhelmingly buy at the top and very few buy at the bottom in any market.  Psychology being what it is, falling prices are viewed as a negative when it comes to purchasing assets.  In a cruel twist of fate, as prices fall, buyers become scarce.  The fear of catching a falling knife keeps on the sideline those who only months earlier may have been caught up in a bidding war and speculative frenzy.

As all of this unfolds, wealth effect spending in the broader economy dries up as home equity extraction is highly correlated with house price increase.  The net result is that unemployment is inversely correlated with house prices, but with a 12 month lag.  This is the US experience:

Parallels to Dean Baker’s and Stephen Jarislowsky’s warnings

While a couple of the articles referenced above described the Capital Economist report as the ‘most harsh’ warning for Canadian real estate, it’s not remarkably different from some other warnings from prominent economists.  You may recall that Dean Baker of the Centre for Economic and Policy Research warned that Canadian home prices are unsustainable and should be ringing alarm bells:

“Noting that average incomes in Canada are lower than those in the U.S. and land values are not appreciably higher, the fundamentals don’t justify the price premium, Baker said in an interview.”

“It looks me like you have some real problems,” he said.

“There’s a lot of things that look ominous. Debt to income ratios in Canada are close to what they were in the U.S. at the peak of the bubble, so there could be some pretty serious fallout.”

Canada could see house prices collapse by 25 to 30 per cent if interest rates rise by about two percentage points, he said.”

Similarly, famed Canadian investor Stephen Jarislowsky calculated that house prices were 20-30 percent above normal levels and set for a correction.

Bank employed economists muzzled?

One has to wonder why the divergence between the warnings of prominent money managers/economists and the predictions of bank-employed economists.  Certainly our big banks would be in for a world of hurt if these predictions were realized.  I’ve discussed this in several previous posts:

Are the big banks really concerned about the consumer or are there ulterior motives?

Canada’s banking system: Solid as a rock?

Could they even speak their mind if they did see a housing bubble.  Certainly there are other mainstream economists who have called for a soft landing, but it is an interesting thought.

Bad news in good news clothing

While the predictions of the report hinge on a small increase in the lending rate by the Bank of Canada, I would suggest that this is unlikely.  Those who do not understand credit deflation might think this would be a good thing.  I would direct your attention to the Japan and US experience where real estate has gone bust amid record low interest rates.  This is the inevitable result of a society that has reached peak credit.

It’s not the threat of inflation that keeps central bankers up at night.  Rather, deflationary spiral are the fabric of nightmares for Ben Bernanke, Mark Carney, and their cronies.  And while commodity prices which are set in global markets may wreak havoc, it is not the monetary inflation caused by an expanding money supply.  Thus, as deflation will pull on wages and employment, any commodity price inflation (which I am still unconvinced is more than pure speculation at this point) will sap living standards.  Not a pretty sight.

Against this backdrop, I highly doubt we will see much by way of rate hikes for much of 2011.  I still believe that any rate hike will later be unwound as a stimulative measure as housing and the broader economy cools.



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11 Responses to Capital Economics report suggests that rising interest rates could trigger housing collapse

  1. debunking says:

    Dream on.
    Interest rates are not going to go up anytime soon. Get used to it.
    And if they do, they will lag inflation by at least 3% or more. This is how soft landing is manufactured and it seems to be working so far.

    • Re-read my post. You and I agree. But they aren’t going anywhere for the exact same reason they didn’t go up in Japan and more recently in the US. The only way the BoC keeps interest rates at these levels is if credit contracts, demand for credit falls, and deflationary pressure builds…..which are increasingly likely. If you think house prices will stay buoyant in the face of strong deflationary forces, you are dreaming my friend!

      • Vince says:

        Was wondering if you have looked into insider selling at the Canadian banks? They have been heavy sellers for quite a while. I’m astonished that they can get away with so much selling given govt assistance in the form of CMHC and during the financial turmoil of 2008.

  2. Out-Sider says:

    Thank you for all your posts Ben, I agree with almost all you say and mind you that I have been thru the most intensive Economics course since the fall of the Icelandic economy in the fall of 2008. Having lived it on my own skin I know you are right. Our house price has fallen 70% and still hasn’t reached the bottom (but hopefully close). Our unemployment rate followed the collapse on the housing market and is now somewhere in the range of 20% (official numbers 9% but real number is hidden a bit though as thousounds of families have moved over to Norway and other neighbouring countries. Since the WWII the unemployment rate has never been anywhere close to this, typically 3-4% and the years before the collaps it was 2-3%. Salories have gone down by 50% and all imported consumer goods have gone up in price due to the devalued local currency. Just like you guys, we all thought we were different 🙂 Whatta ride my friend. Keep on warning them.

  3. John in Ottawa says:

    I commented back in early December that a neighbor of mine received a call from his bank. They had “just noticed” that he hadn’t paid his mortgage for six months. Two weeks ago he declared bankruptcy and last weekend he moved out. Now the bank owns the house. The man is more than 50 years old.

    He is now a data point in the national average for defaults and bankruptcy.

    I don’t like averages. Canada is too big and diverse for averages to be useful. Even composites can be skewed significantly by large markets such as Vancouver Toronto. Averages can be alarmist or lulling and always misleading.

    However, averages come from real data and somewhere in Canada that data is hidden, festering. House prices in Chibougamau, QC or Tuktoyaktuk, NT will probably not fall 2 or 3% and not all houses in Vancouver will fall 25-30%.

    But that’s the problem with averages. If the average house price in Vancouver falls 25-30% a whole bunch of houses are going to drop 50 or 60 or 70%. That’s how we get averages and those houses that drop the most are going to be at the bottom of the price heap, not the top. That means that a whole lot of people are going to get hurt and hurt bad.

    Face it, wealthy people can take a hit. Wealthy people don’t have high LTV mortgages. Wealthy people aren’t about to waste the money on mortgage insurance. That stuff’s expensive.

    It’s the young, the stretched, the people who hope they can grow into their mortgage or hope that the value of the house will grow out of high LTV who are vulnerable and as can be deduced from this mad rush to get in on the last of the 5/35, there are a lot of them.

    Is CMHC likely to take a $10 billion hit? I would hesitate to call it unlikely. Is that a disaster? Hardly. It isn’t anywhere near as extreme as the trillions the US has had to pour into it’s banking system to keep it afloat, with no end in sight. Canada is a strong country with tons of natural resources to sell to the world. Canada will survive. Canada is, after all, just a symbol we assign to an another average.

    All those little real data points that make up the average. Ah, there is the rub. All those little real data points are people, most of them young and pretty naive. It reminds me of the military statistic that the “average life expectancy” of a second lieutenant in battle is 60 seconds. Hey, after the battle, you are either alive or you are dead. You are never average.

    The average Canadian is going to be fine. The banks are going to be fine. CMHC will weather the hit. When the housing market turns not every market will be a metaphorical battle ground, but where the market turns the hardest, a bunch of young people are going to end up financially “dead.” And like my neighbor, they’ll be added to an average.

  4. The Masked Haranguer says:

    A trial subscription?? Give me a break! With your inflated salary, you can buy one and contribute to keeping our recovery going!!

    Yes, we can go after those who default on their mortgages but there is usually no point. Lack of equity is the primary reason borrowers default. People do not default when they have something to loose. It’s very rare that people walk away from their home and still have significant outside assets that a lender could go after. The fact that a bank could take recourse is of no concern to someone who has had to leave their home. Recourse mortgages are a red herring!

    The Masked Haranguer

  5. Just stumbled upon your post by accident. Excellent write up. I completely agree with your final thoughts and I look forward to reading more from you.


  6. Pingback: Inside Capital Economics’ “Bleak” Housing Report |

  7. Mandelbrot says:

    What are your thoughts on CMHC’s official response to Mr Madani’s research? Letter is linked here:

  8. Pingback: Capital Economics on the Canadian economy: Housing downturn to hit hard | Financial Insights

  9. Pingback: David Madani on CBC’s “The Lang and O’Leary exchange” | Financial Insights

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