Protecting the Canadian housing market against inflation and U.S.-style mortgage meltdown

Two recent articles from the Canadian Real Estate Association relate measures being taken to ensure the housing market remains economically sound. 

The measures have been undertaken as a result of economic conditions on both sides of the United States-Canada border.

On this side of border, the Bank of Canada rate is under scrutiny as a result of a rising inflation rate due to increasing fuel prices. There is ongoing financial turmoil in the U.S. with Fannie Mae and Freddy Mae experiencing serious mortgage losses. The U.S. Federal Reserve under Chairman Ben Bernanke’s leadership has adopted more stringent rules to protect home buyers from questionable lending practices. In Canada, Federal Finance Minister Jim Flaherty is going ahead with new restrictions on federal government-backed mortgages to ensure our system remains secure.

Different sentiments have been expressed on the new mortgage restrictions in Canada — some are less favourable than others. 

The Canadian Association of Accredited Mortgage Professionals (CAAMP) made the following observations:.

• Current Canadian house prices are in line with economic factors such as low interest rates, rising incomes and a growing population, which is a view supported by the International Monetary Fund. 

• Demand for residential housing continues to be strong. For example, housing starts are expected to remain above the 200,000 mark for the seventh consecutive year. 

• The percentage of bank mortgages in arrears is stable at 0.27 per cent, nearly the lowest levels experienced since 1990 and well below the highs of 0.65 per cent experienced in 1992 and 1997. 

The historically prudent and cautious approach taken by Canadian financial institutions regarding mortgage lending combined with a sound supervisory regime has allowed Canada to maintain strong and secure housing and mortgage markets. Sub-prime mortgages have been low in Canada, comprising less than five per cent of the market in recent years.

Bank of Canada holds interest rates steady

The Bank of Canada held its benchmark overnight lending rate steady at three per cent on July 15. The trend-setting bank rate, which is set 0.25 percentage points above the overnight lending rate, remains at 3.25 per cent.

 The bank’s decision to hold interest rates steady aims to boost its inflation fighting credentials. Financial markets widely expected the bank rate to be put on hold despite the lacklustre outlook for Canadian economic growth.

 “The bank is keeping interest rates steady even as sharp increases in energy prices boost inflation, since slowing factory sales to the U.S. are undercutting Canadian economic growth,” said CREA chief economist Gregory Klump. “Interest rates will be on hold over the summer, giving the bank time to judge the effect of previous interest rate cuts.” 

To stabilize credit markets in the aftermath of the U.S. sub-prime mortgage market meltdown, the bank cut the overnight lending rate by 1.5 percentage points from December 2007 to April 2008.

The bank recognized that while Canadian economic growth in the first quarter was weaker than expected, Canada’s domestic economy “continues to expand at a solid pace.” 

The bank expects overall Canadian economic growth to continue being squeezed by weak factory shipments to the U.S. due to protracted weakness in the American economy.  

 Revising its forecast for economic growth downward, the bank indicated it expects GDP to grow by one per cent in 2008, then 2.3 per cent in 2009 and 3.3 per cent in 2010.  Compared to its April 2008 Monetary Policy Report, this represented a cut in the Bank of Canada forecast for economic growth by 0.4 per  cent in 2008  and 0.1 per cent in 2009.

The bank also acknowledged that inflation is running higher than its earlier forecast. “Total CPI inflation over the next year is expected to be much higher than projected at the time of the April report ... total CPI inflation is projected to rise temporarily above four per cent, peaking in the first quarter of 2009.”  

It expects its core rate of inflation, which excludes food and energy, will “remain well contained ... averaging close to 1.5 per cent through the third quarter of this year and then rising to two per cent in the second half of 2009.” 

 The bank’s interest rate policy has a goal of maintaining the core rate of inflation at two per cent within a range of plus or minus one per cent. 

 When the bank left interest rates unchanged on July 15, the advertised five-year conventional mortgage rate stood at 7.15 per cent. This is less than one-10th of a percentage point below where it stood a year ago.  Competition among mortgage lenders remains stiff, but discounts off advertised mortgage interest rates have shrunk because of the U.S. sub-prime mortgage meltdown and the resulting global credit crunch has raised banks’ cost of borrowing funds.

 “National sales activity will be down from last year’s record,” said Klump. “Rising home prices and changes to mortgage default insurance that take effect later this year will continue undermining affordability at the margin.”

Government changes mortgage rules for CMHC

The federal government is taking action so Canada can avoid the kind of sub-prime mortgage meltdown plaguing the United States. 

Effective October 15, 40-year mortgages with no money down will no longer be covered through the federal government insurance program administered by Canada Mortgage and Housing. Instead, the longest amortization period for a Canadian mortgage insured by CMHC will be 35 years. In addition, a buyer insured by CMHC will have to make a minimum down payment equal to five per cent of the home’s value. Canadians already holding 40-year no-money-down mortgages won’t be affected by the changes. 

The regulations will only apply to federal agencies such as the CMHC, which has an estimated 60 per cent share of the mortgage insurance market. Private-sector mortgage insurance rivals such as Genworth Financial, PMI Mortgage Insurance Co. Canada and AIG United Guaranty are free to offer the product. 

One difference is that the federal government will no longer provide insurance that protects lenders in the event of a default by the insurers. 

“Today's announcement marks a responsible and measured approach by the government to ensure Canada's housing market remains strong, and to reduce the risk of a U.S.-style housing bubble developing in Canada,” the federal finance department said in a press release.

 Existing 40-year mortgages will be grandfathered, a finance department spokesman said. 

In 2006, the maximum amortization period was extended to 40 years from 25. Longer-term mortgage products became increasingly popular with buyers looking for lower monthly payments as the price of Canadian homes soared.

In 2007, 37 per cent of new mortgages were for terms of longer than 25 years, according to the Canadian Association of Accredited Mortgage Professionals. But while longer amortization periods stretch out monthly payments, they also greatly increase the cost of a mortgage over its lifetime. For example, the total interest on a $300,000 mortgage can soar from $286,161 over the life of a 25-year mortgage to $498,416 over a 40-year amortization period, adding more than $200,000 to the cost of the home.

This, combined with the fact that these mortgages are often associated with little or no equity, raised alarm bells with policy makers looking at the turmoil that took place in the U.S. when house prices started to fall.

 According to analysts, the Canadian housing market would have slowed sooner if longer- term amortizations had not been introduced. The longer amortizations mean greater interest costs over the life of the mortgage, but smaller monthly payments, which allows buyers to bid on a more expensive home than they otherwise could afford. 

Bank of Canada Governor Mark Carney said in May he was concerned about the prevalence of long amortizations. “They add to the momentum in the housing market, and if everyone has a 40-year amortized mortgage, then you just have higher housing prices.”

“We've seen an inclination now — a trend — toward longer-term amortizations and smaller down payments and that is a matter of some concern,” said Flaherty  in a speech in May. Flaherty was not available for comment on Wednesday.

Jim Murphy, president and chief executive of CAAMP, said the government has expressed concern about the risky lending products that collapsed the U.S. housing market. 

Murphy said the finance department was also worried about the future impact of competition between mortgage insurers, which led to the introduction of 40-year mortgages in 2006.

“I think you have a clear case of the government sitting down and looking at its risk exposure and wanting to review that,” he added. “They have financial guarantees in place for the CMHC and private insurers, and they were saying, ‘What is our risk, and what is the risk to the Canadian taxpayer?’”

 Reaction from the industry was mixed. 

“CMHC supports the new parameters ... We also support their efforts to maintain the strong Canadian housing market,” said spokesperson Stephanie Rubec.

“It's the right move,” said Nick Kyprianou, president of Home Capital Group Inc., whose principal subsidiary, Home Trust Co., provides alternative mortgages. “Why get people overextended? Nobody wins by getting people right to the end of the cliff.”

Others, however, say home buyers and banks have been prudent with their finances and are being punished for the more lax approach south of the border. 

“Things here are not like they are in the U.S. where they had those NINJA loans, no income, no job, no assets ...  It's only going to hurt the consumer,” said John Panagakos, owner of the Toronto brokerage Mortgage Centre.

The housing move actually comes at a time when other concerns are being expressed, the most pressing of which is chilling consumer sentiment due to high fuel prices, said Douglas Porter, deputy chief economist at BMO Nesbitt Burns Inc.