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:
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.