Canada’s housing bubble is starting to burst

Canada escaped the global financial crisis in 2008 unscathed relative to much of the developed world, but after 15 years of virtually uninterrupted home price appreciation, America’s neighbor to the north might be cooking up a financial crisis of its own.

Loose lending has helped create a housing bubble to rival that of the U.S. in 2006, and with household debt in Canada being among the highest in the world, Canadians have little room in their budgets to absorb rising housing costs.

The next year will be telling because unlike in the U.S., the interest rates on most mortgages in Canada reset to the current rate every five years, and 47 percent of Canadian mortgages will “reset” within the next year. While the Bank of Canada expects the reset rates to be on par with what they were five years ago, even a slight rise could put Canadians with a high amount of debt at risk of default.

“We’re basically in a correction now, which most people believe will be a soft landing,” said Hilliard MacBeth, author of When the Bubble Bursts: Surviving the Canadian Real Estate Crash. “I’m pretty sure it’s not going to be a soft landing. It’s going to be a crash.”

Since the turn of the century, home prices in Canada have risen steadily, save for a slight downturn during the American housing bust. Low interest rates, strong immigration, and an influx of foreign money into the market have made Canada’s housing market lucrative, but over the last five years the boom has turned into a bubble.

One common measure of housing bubbles is the home price-to-rent ratio. If the home is worth more than what it can earn as a rental property, then the home is considered overvalued, and the price-to-rent ratio measures that. In the chart below, you can see that Canada not only has one of the highest price-to-rent ratios, but that the ratio is also well above what it was in the United States at the peak of its housing bubble.

However, the Canadian housing sector, which accounted for 13 percent of the country’s GDP in 2016, is starting to show signs of slowing, partly due to government policies aimed at cooling the overheated market. Toronto and Vancouver, the two hottest housing markets in Canada, imposed a 15 percent tax on foreign buyers in hopes of curbing soaring prices. Ontario also put together a 16-point “fair housing plan” to address the situation.

Use the scroll bar at the bottom of the data visual below to see how home prices have grown over time in different countries.

Effective this year, Canada imposed new regulations aimed at ensuring stability of the financial system. A qualifying rate stress test is now required on uninsured mortgages to make sure borrowers could withstand a rise in mortgage rates, and lenders must adhere to new loan-to-value limits.

Whether a result of the rules or not, the market is certainly starting to cool. In Toronto, home sales were down 35 percent in February compared to a year ago, and prices dropped 12 percent. Sales fell across Canada 14.5 percent in January compared to the previous month.

With home prices starting to correct, Canadians who bought homes at the peak of the bubble risk falling under water on their mortgages, which is defined as a home valued less than the amount owed on the mortgage. Furthermore, the Bank of Canada has raised its policy rate three times since July, which will impact the millions of homeowners whose rates will reset in the next year.

While there hasn’t been a rise in defaults like in the run-up to the American housing bust, the ingredients are present for a housing bust to turn into a financial catastrophe because of high private sector debt (218 percent of GDP) and high growth of private sector debt—two metrics often cited as precursors to a financial crisis.

Signs of trouble in the financial sector are already bubbling up. Home Capital Group, the nation’s largest subprime mortgage lender, had to buy back millions in mortgages sold to third parties for securitization because borrowers falsified their income, a problem that occurred during the American housing bubble. Laurentian Bank, Canada’s seventh largest bank by assets, had to do the same in December.

Canadian law requires home buyers to purchase insurance for lenders on mortgages with less than a 20 percent down payment, and insured mortgages account for roughly two-thirds of all Canadian mortgages. That insurance is guaranteed by the Canadian Mortgage Housing Corporation (CMHC), a government-sponsored enterprise. During inflation of the bubble, the government-guaranteed insurance has given lenders a false sense of security when making these riskier loans, as loose lending persists.

If defaults start to rise and a 2008-esque collapse happens, the Canadian government will be on the hook for millions of mortgages because of the insurance, the same way AIG was in the American housing collapse. AIG was ultimately bailed out by the American government in hopes of preventing the financial collapse from spreading.

The Canadian government could choose not to honor the insurance if it finds lenders culpable in situations where mortgages were given to borrowers who falsified their income or were otherwise not credit-worthy, but given mortgages are spread throughout the Canadian financial system, all that would mean is that the Canadian government would have to bail out the banks instead of itself.

Mortgage-backed securities, the collection of mortgages that are pooled together and sold as bonds backed by payments on those mortgages, picked up steam in Canada just before the American housing bust. Most securitization in Canada is done through the National Housing Act Mortgage-backed Securities (NHA MBS) Program and funded by Canada Mortgage Bonds (CMB), both public entities. (Private securitization of mortgages is almost nonexistent in Canada.)

Some of the riskiest bonds—those with a down payment of less than 20 percent—are securitized by the NHA MBS program and spread throughout the Canadian financial system. Mortgage-backed securities were hardly a blip in Canada’s financial system in 2000. Now it accounts for more than C$400 billion. For context, the top five Canadian banks have total assets ranging from C$1.2 trillion to C$528 billion

While it’s unclear if the housing correction will lead to a soft landing or a financial crisis, it’s easy to see how it could turn dire if mismanaged by the Canadian government or financial institutions.