How to profit as Canada’s housing bubble pops

Bank of England boss Mervyn King gave his farewell speech yesterday.

He was putting a brave face on the economy, no doubt with his legacy in mind. But now all eyes are on his successor, Mark Carney, who takes over from July.

One reason Carney was picked is because he ‘saved’ Canada from recession as governor of its central bank. George Osborne is hoping he can do the same for Britain, by thinking ‘outside the box’ on monetary policy.

But George should be careful what he wishes for – because the Canada that Carney leaves behind is looking distinctly wobbly.

Canada’s miracle recovery stored up trouble for the future

Canada is one of the few countries in the world that got off light during the financial crisis. Canadians might not see it that way of course. But while in the UK, we talk about the worst crisis in living memory, theirs was less severe than the downturns in the 1990s and 1980s.

The dominant narrative is that Mark Carney bailed Canada out by slashing interest rates, keeping banks lending and consumers spending.

It’s a nice story. Trouble is, it seems far more likely that Carney’s actions just stored up trouble for the future – a future which looms closer by the day.

The most obvious threat to Canada’s economy is its rampant house price bubble.

Most global property markets saw at least some sort of correction following the financial crisis. In real terms (after inflation), house prices in the US halved. Even in the UK, real prices are down by around 30% if you ignore trophy hunting in central London.

In Canada however, prices kept on rising. As a result, the nation now has some of the most overvalued real estate in the world. Not a bad achievement, given that Canada isn’t exactly crowded.

How did this happen? One key cause of the US bubble was the banks’ willingness to lend lots of money to borrowers who clearly couldn’t pay it back. Lenders were aided and abetted by the existence of Fannie Mae and Freddie Mac, two quasi-state agencies which underwrote bank lending.

Supporters of Fannie and Freddie note that these institutions never underwrote the very worst loans. But that’s not the point. The very fact that they were insuring mortgages at all encouraged banks to take ever more risky bets, knowing that a large part of their book was guaranteed.

It’s called ‘moral hazard’. And precisely the same thing has happened in Canada. Joelle Fricot of brokerage Euro Pacific Canada estimates that over half the outstanding mortgages are backed by Canada’s equivalent body, CMHC.

However, the two private sector insurers, Glenworth Financial Canada and AIG, receive 90% state backing. This means that the government underwrites, directly or indirectly, nearly all of the C$1.1trn (the Canadian and US dollars are roughly equal at the moment) market.

The poor quality of the loans is such an open scandal that the government has been forced to try to toughen up standards. Last year, it tried to cap loan-to-value at 80%. In other words, you need a 20% deposit or equity before you can get a loan.

However, these restrictions are easy to get around. For example, many people now simply break the loans into two or more mortgages. And in any case, it’s probably a case of too little, too late. Euro Pacific reckons that half of all outstanding mortgages are “high-risk”.


No question about it – Canadian property is in a bubble

Canadian papers and real estate brokers will debate the issue of whether or not there’s a bubble until they’re blue in the face.

But anyone with any kind of objectivity can see there’s a problem there. House prices have risen by 123% since January 2000. Even at the peak, US prices were only 90% higher than they were in 2000 – and in real terms, US prices are now slightly lower than they were back then.

According to the Royal Bank of Canada, the average bungalow goes for roughly six times household income. This rises to seven times household income for two-storey houses. According to the Halifax, the comparable ratio for London houses is only 5.6 times earnings – and that’s high by historic standards.

Meanwhile, The Economist estimates that the ratio of rents to prices in Canada is 78% higher than its long-term average. This is more extreme than any other major property market in the world – even Hong Kong is only 68% above its long-term average.

So Canadian prices are in a bubble, no question about it. And now the bubble might be popping.

The first sign of an impending crash is falling sales. In Toronto, sales are down 40% compared with a year ago. That’s led the property pundits to start talking of a “soft landing”.

But this phantom soft landing goes against all past experiences of housing crashes. Like most investment markets, property prices are driven partly by momentum.

In the boom times, rising prices feed off themselves, as people rush in, hoping they can sell the house later for a profit. The same thing happens when prices fall. People rush for the exits all at once, and prices often end up under-shooting ‘fair value’ rather than simply plateauing.

Overall, it looks like the Canadian government will be facing a huge bill for bad mortgages, as well as the impact that a housing crisis will have on consumer spending. Throw in the uncertain outlook for commodity and energy prices, and the economic outlook for Canada is grim.

This is likely to lead to a long period of low interest rates and potentially even money printing, which will hit the Canadian dollar hard. It’s straightforward enough to play it with a spread bet, although bear in mind that this is very risky – if you want to know more about how to do it, sign up for our free MoneyWeek Trader email. You could also consider a short Canadian / long US dollar exchange-traded fund.

But perhaps more important to UK investors, is what Carney’s arrival could mean for the pound. With the 2015 election uppermost in politicians’ minds, Carney will be under pressure to work his magic over here.

While Mervyn King and the Bank of England have been talking down the prospects for ‘radical’ monetary policy, it’s worth remembering that Japanese politicians did something similar just before their central bank unleashed the biggest tide of money-printing yet seen. Dampening market expectations before something big happens is one of the oldest tricks in the book for maximising the ‘shock and awe’ impact.

So we think it’s a good idea to have exposure to non-sterling denominated assets in your portfolio. My colleague John Stepek has written more about this in the latest issue of MoneyWeek magazine, out on Friday. If you’re not already a subscriber, get your first three issues free here.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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  • Bob

    Having looked at photos on-line of what appear to be tin garden sheds and which are actually Vancouver houses on for asking prices of half a million or more, I fear for the UK and a bubble on a bubble that Carney and Osborne may create.

  • Changing Man

    “So we think it’s a good idea to have exposure to non-sterling denominated assets in your portfolio.”
    So would we not expect to see a similar effect to Japan where a wave of foreign investment floods in to buy UK equities, sending prices up with gains exceeding the fall in the value of Sterling? Or perhaps we should buy US funds holding UK assets for a “double whammy”?

  • Xian

    I live in a five bedroom house with a pool in a city of 50,000 less than an hour’s drive from one of Canada’s largest cities. It is valued at $170,000 – that’s under £110,ooo. Does that sound like a bubble price?

    Yes Vancouver and Toronto are expensive, but that’s mostly to do with the injection of Chinese cash.

  • JoeO’Hare67

    Canadian bubble clearly exceeds the housing bubble in the United States! Just look at those graphs below

  • Spook

    Xion got it right – housing prices in Vancouver and Toronto are ridiculous, and Calgary is pretty pricey. Farmland also seems over-priced. Other than that, it is doubtful that Canada will suffer a housing price drop of more than 5% maximum. Canadian bankers have been MUCH more prudent than those in the USA and the UK. Mark Carney – a really nice personable guy, who has had very little influence on Canadian monetary policy. We have a nice 2-storey house in a city of nearly 1/2 million – $175,000 Cdn or US would buy it

    • HFX_PEAT

      Where are you folks living? Here in Halifax you can’t find any decent detached single family homes on the peninsula for less than $275K, I’ve had friends pay $290K+ for garbage cookie cutter housing 20min outside the city that was selling for $250K just 2.5 years ago – and even at that price it was overvalued!! We’re feeling the bubble out here on the East Coast, the froth is thick, and we’re overdue for a severe correction.

  • Marco

    lightly …

  • David H

    From observing the UK market as an owner and landlord our price bubble was sustained by the availability of easy credit. When this stopped the housing market stopped. Prices have continued to slide since 2008 and this is continuing as I am finding in currently selling my portfolio.
    It sounds as though the the restriction on the availabilty of credit has now started in Canada.
    Prices will fall in both high and low priced areas. Adjustment to the new situation takes time and will be painful at all levels in the market.

  • 4caster

    Matthew writes: “The Economist estimates that the ratio of rents to prices in Canada is 78% higher than its long-term average.”
    I cannot for the life of me see why that means house PRICES are in a bubble.
    If the rental yield on, say, a $250,000 house is 78% higher than normal, surely that means the house is underpriced (or rents are overpriced).

  • Ed

    Xian, well, these days in Canada they call a shoebox a “modern, spacious suite” so yes, Canada is a bubble’s bubble. Even a plywood spec house in Hickville has doubled or tripled in price in the last 5 years. This will not end well.

  • frcaster

    Just sold in the Vancouver area and was going to buy on Vancouver Island. Watching the prices there dropping drastically Nanaimo officially down 9% over the year. In the last 6 weeks I estimate they have dropped another 10 % at least.I have changed my mind and will not buy at all. The fall is
    increasing rapidly. Vancouver city and suburbs not so fast but its getting weaker every day. Th newspapers are full of down forecasts so the public will soon stop buying and wait.

  • Berniebee

    The typical Canadian thirty-something buyer gets all their housing information through an industry cartel whose livelyhood depends on selling more houses, an industry which pays newspapers to disguise blatent advertising as genuine news. It’s ittle surprise that most buyers in this country are blissfully unaware.

    And of course when the bottom drops out, our governments leaders will be shocked, shocked to learn that Canadian banks made many questionable mortagage loans garanteed by the taxpayer , ie: the CHMC.

    Interesting times indeed.

  • MarKoz

    The Economist article is saying the opposite of what you suggest. Yields on rental real estate are negative. I pay $2,050 per month to rent a house in Vancouver (it is livable, but in this neighbourhood it would be considered a tear down) that would sell for approximately $850,000. Owners of rental property have purchased with the expectation of capital gains on rising prices.
    @ Bob
    Half a million dollars in Vancouver buys a condo. “Tin sheds” on standard city lots go for $750,000+

  • MarKoz

    The Economist article is saying the opposite of what you suggest. Yields on rental real estate are negative. I pay $2,050 per month to rent a house in Vancouver (it is livable, but in this neighbourhood it would be considered a tear down) that would sell for approximately $850,000. Owners of rental property have purchased with the expectation of capital gains on rising prices.
    @ Bob
    Half a million dollars in Vancouver buys a condo. “Tin sheds” on standard city lots go for $750,000+

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