Neil Macdonald: Why a U.S.-style housing nightmare could hit Canada

An expatriate always thinks about going home. The longer the time abroad, the stranger the prospect of re-entry feels.

But if you're a Canadian living abroad these days, the idea of returning home has become downright frightening. Stories are now routinely surfacing in the Canadian media suggesting collective madness when it comes to affordable living.

Our biggest real estate markets — Toronto and Vancouver — seem to have decided they're really London and Manhattan. Several of our smaller cities are wildly optimistic, too, with year after year after year of six-, seven-, even 10-per-cent increases in property values.

Friends and colleagues who own homes in Canada are the very pictures of smug. They seem convinced the markets in which they happily reside will keep rising forever. Or at the very least, never drop.

And any discussion of the subject usually involves condescending lectures about how Americans, who are only beginning to recover from a six-year nightmare of foreclosures, could have used a dose of Canadian common sense and prudence.

Well, I watched America's nightmare unfold, and it appears pretty evident to me that a sequel of some sort is coming to Canada.

So I ran that thesis past Robert Shiller, of Yale University, probably the foremost authority on real estate in America. He co-founded the Case-Shiller Home Price Index and predicted the American collapse in 2005, a year before it happened.

"I worry," he told me, "that what is happening in Canada is kind of a slow-motion version of what happened in the U.S."

Nosebleed levels of debt

What Shiller was getting at — and what is most alarming to economists and to the Bank of Canada — is the debt Canadians are carrying.

As was the case in America when I arrived here nine years ago, Canadians have for years been so desperate to avoid being left behind by a surging housing market that they've been stretching themselves beyond reasonable financial limits to jump in, thus of course ensuring continued surges.

In the process, household debt has doubled, going from a manageable 75 per cent of household income in the early 1990s to 150 per cent today.

That's just about exactly the nosebleed level Americans were at when everything imploded here in 2006.

Worse, as the Bank of Canada has been pointing out, Canadian debt is disproportionately concentrated in the most vulnerable households, defined as those devoting 40 per cent or more of household income to paying interest charges.

That means those households are extremely sensitive to any sort of shock — be it a rise in interest rates, a drop in home prices, or, worst of all, job loss.

The central bank's analysis suggests that if interest rates rise to 4.25 by mid-2015, fully one fifth of all Canadian debt would be held by those households least able to finance it.

"That is rather scary," says Don Drummond, a former federal mandarin who also spent many years as the chief economist of the TD Bank.

Drummond says an interest rate of 4.25 by 2015 would not be out of the question, given the levels of economic stimulus in recent years. He also says the bubble in Canada is bursting right now.

"My base case expectation would be that most markets in Canada over the next two years would see a pullback of housing prices of 10 to 15 per cent."

A similar delusion

Now, both Shiller and Drummond are quick to say Canadians are not likely to experience the near-total meltdown Americans experienced.

For one thing, Canadian banks never joined in the subprime-lending lunacy that inflated the American bubble to such extremes.

For another, Canadian mortgages are insured by the federal government through Canadian Mortgage and Housing Corp.

But Shiller says Canadians do seem to be suffering from the same delusion that afflicted Americans: the notion that housing prices always rise.

He has studied data going back a century, and says that when you factor in inflation, and depreciation of the home's physical structure, "historically home prices haven't gone up. Real home prices were essentially unchanged over that interval."

There are bursts of growth, as in the past 10 years in Canada, but historically they are offset by retreats.

Shiller says real estate bubbles are nothing more than groupthink, and that they "always have their end built into them."

"People are investing in real estate that is tough for their budgets because they think it will make them rich, and that can continue only as long as [prices] keep increasing.

"When they stop increasing," he says, people back off, and the bubble then collapses. "So it has its own internal dynamic."

Exactly when this groupthink changes course, says Shiller, is hard to pinpoint, but one sign is a flurry of media stories. Such as this one, I suppose. Not to mention the attention we are giving this subject on The National.

Even though many of us in the media own homes ourselves — and have a self-interest in the market continuing to rise — there clearly comes a point when the subject begins to dominate public discussion.

Shiller also points out that it was not the financial crisis that burst the American housing bubble. Rather, when the groupthink that caused the bubble turned, the market collapsed, and that in turn triggered the financial meltdown and the crisis among lenders.

"The same sort of thing might well happen in Canada," Shiller told me.

Canadians seem to think that stricter government regulation in Canada protects them. But they are in some ways more vulnerable than Americans.

Americans at least have the option of lifetime payment stability. The gold standard here is the 25- or 30-year fixed mortgage. The interest rate can be locked in for the life of the loan.

In Canada, most mortgages "renew" every few months, or years, and payments can spike by hundreds of dollars a month if rates rise even slightly.

Americans also deduct interest payments from their taxable income. So many people get a big annual refund, which provides a financial cushion.

If you take that tax refund into consideration, prices in Ottawa are now approaching or equal to prices in Washington, DC., a city steeped in wealth and power.

Seen from this distance, by a longtime expat, that is just unmoored from reality.