Canada Tries to Cool a Hot Housing Market

For nearly a decade, Canadians have watched as housing prices registered  double digit increases year after year. This past year was no exception as house prices in Toronto increased by nearly 20 percent. Vancouver prices, although having slowed down somewhat, continue to be the highest in the country; the average  detached home in that city exceeds $ CDN 1.2  million ( US$ 900,000). Associated with the rise in home prices has the steady rise in household debt which has been a source of great concern to the Bank of Canada in setting monetary policy. The government has been under pressure to cool off the market, but just enough not to initiate a crash. Walking that fine line is what the recent changes in housing financing are all about.

By way of background, the Canadian banking industry, the largest supplier of home mortgages, has enjoyed a “unique situation”, in the words of the Minister of Finance, Bill Morneau.  The government fully backs the mortgage insurance obligations in the marketplace. Insurance is sold by a government agency, Canada Mortgage & Housing Corp, and by private insurers like Genworth MI Canada Inc. This rock solid support for insured mortgages provides considerable comfort for lenders. According to figures released by the Bank of Canada, more than half of Canada’s C$ 1.4 trillion home loan market is comprised of insured mortgages. By law, a purchaser must buy insurance if the down payment is less than 20 per cent of the house value. And, in many cases, banks insist on borrowers taking out insurance even when that requirement is met.

The Minister just announced two major changes in the way mortgage insurance applies to both borrowers and lenders.

First, while keeping the insurance system in place, the rules regarding how borrowers are to be qualified have tightened.  The home purchaser will need to qualify for a mortgage based upon the 5 -year posted mortgage rate, which is currently at an average of 4.6 per cent. The vast majority of borrowers are able to negotiate rates as low as 2.5  per cent which allows for a larger mortgage than would be possible if the posted rate were to apply. This change reduces the purchasing power of the buyers by up to 20 percent. This will eliminate some borrowers altogether and/or reduce the size of the mortgages available. Either way, the government see this as a means to take some of the froth out of the market.  This puts the burden of adjustment to a new housing policy squarely on the shoulders of the borrower who has to produce a bigger down payment or to accept a smaller loan.

Secondly, The Finance Minister made it clear that he wants the banks to share some of the risk in mortgage lending. Currently, the federal government assumes full liability of an insured mortgage in the event of a default.  The Minister would like to see changes that:

“would require mortgage lenders to manage a portion of the loan losses on insured mortgages that default, rather than transferring virtually all the risk onto the taxpayers via government guarantee for mortgage insurers.”

He proposes to consult with the banks on how some of the risk of mortgage lending can be borne by the banks. Such a shift in liability would impact the credit worthiness of the banks, since mortgage loans are their single largest credit category.  In addition, the banks may reduce their mortgage portfolio in order to manage risk better. On the other side of the issue, the insurers welcome such a change since they have always maintained the banks never had any “skin in the game” and have enjoyed an unfair competitive advantage.

The immediate reaction to these suggestions was apparent in the publicly traded  alternative (non-bank)  mortgage lenders, such as Home Capital, Equitable Group and others, whose stock prices tumbled on the TSX. These companies are not as well capitalized as the Big Six banks and have less capacity to assume greater risk. At this early stage, no specific changes have been introduced, but the trend is clearly towards a new order of business for bankers and insurers.

What remains to be seen is how these policy changes will slow down rising house prices. Dealing with the surge in prices is more complex than just changing the conditions regarding who bears the financing risks. Toronto and Vancouver are the recipients of the majority of the 300,000 immigrants Canada takes in every year. Household formations are on the rise in both cities and this has been a constant source of growing demand.  Toronto lacks sufficient inventory to satisfy that demand. Frustrated buyers face a dearth of new listings in the core city. And, zoning restrictions in the Greater Toronto Area are often cited as the main culprit behind the shortage of developed land in the suburbs.   

Nonetheless, this new financial order is an important step in re-structuring the home mortgage business. The remaining question is how much will this curb real estate inflation.