What a housing bubble looks like

The Canadian example shows the Reserve Bank must be careful not to keep rates too low if it is to play a meaningful role in preventing a housing bubble burst.

Calgary — The road ahead for Australia's property market features predictions of an urban housing boom, as well as a housing bubble and an openness on the Reserve Bank of Australia's part to taking interest rates deeper into record-low territory.

But what does that rock-bottom interest rate-fuelled housing boom-to-bubble scenario look like?

There's no need to deal in hypotheticals when Canada is already there.

The Bank of Canada's benchmark rate has remained at a record low 1 per cent since September 2010, effectively putting the country's central bank on the sidelines of the debate about what Canadian politicians can do to take the steam out of Canada's overheated real estate market without risking a crash.

The average housing price in Canada is about $C380,000 ($A394,331) nationally, up 8 per cent over the past year. That growth has largely been fuelled by a few core urban markets, such as Toronto, where the average price of a detached home hit $C783,708 ($A812,530) in August, Vancouver where the average price for a two-storey home is about $C1.1 million ($A1.14 million) and Calgary, where single family homes hit a record average price of $C465,000 ($A482,000) in August.

Unlike the United States, Canada's real estate market never popped during the global financial crisis. Although that helped the Canadian economy survive the crisis, the property market's continued growth, and the extent to which record-low interest rates fuelled that growth, has worried politicians – who have moved four times to tighten mortgage lending rules in an effort to engineer a soft landing.

Since 2008, the government has shortened the maximum amortisation period on mortgages the government will insure from 40 years to 25 years, scaling it back in five-year increments between 2008 and mid-2012. Insurance is mandatory for home buyers who have less than a 20 per cent down payment.

The government of Stephen Harper also limited in mid-2012 the maximum amount Canadians can borrow when refinancing their homes to 80 per cent, from a previous ceiling of 85 per cent, of the value of their home. The move was made to limit the shifting of consumer debt onto mortgages insured by the government, or as finance minister Jim Flaherty likes to say, consumers “using their homes like ATM machines”.

The Harper government also lowered the debt service ratio for government-backed insured mortgages to 39 per cent, calculated by comparing consumers' total monthly housing payments to their monthly income. The limit for the total debt service ratio (total monthly debt payments to monthly income) was reduced from 45 per cent to 44 per cent.

And lastly, the government made state-backed insured mortgages available only to homes with a purchase price of less than $C1 million in an effort to reduce taxpayers' exposure to liabilities on the higher-end of the real estate market.

The conservative Harper government hoped in particular that the shorter amortisation period, and the resulting higher monthly payment and higher income required to qualify for a mortgage, would reduce the number of high-risk mortgages being issued to homebuyers who may struggle to carry mortgages costs when interest rates rise or if their home value declines.

For the most part, the changes resulted in a short dip in home sales and in some cases prices, but sales and prices have largely continued their steady march upwards.

And most importantly, the reforms have done little to discourage Canadians from taking on debt. Canada's ratio of household debt to after-tax income rose to a record 163.4 per cent in the second quarter of 2013, well above peak pre-GFC household debt levels in the US and Australia's 130 per cent household debt ratio.

The Economist recently determined Canada's housing sector is over-valued by 74 per cent compared to average rents and by 30 per cent relative to average disposable income. (The same report found Australia's housing sector to be overvalued by 46 per cent and 24 per cent, respectively.)

Such indicators have prompted the government to consider further measures it can take to essentially save Canadian homebuyers from themselves.

With the Bank of Canada forced to the sidelines, having already taken the benchmark rate to record lows, the government has turned to the banking regulator for help.

The regulator has begun quizzing Canadian banks about the impact of the 2012 changes, while surveying the impact of further rule tightening.

One possible change would involve cracking down on uninsured 30-year mortgages, which banks continue to offer to homebuyers who have a 20 per cent or more down payment, to force more homebuyers into the 25-year cap for government-insured mortgages.

The changes may be too little, too late.

The head of investment at Canada's largest insurance company, Sun Life, has warned that growth in Canada's real estate market is a “dead cat bounce”, or a brief recovery in the price of an asset in overall decline, while warning that housing prices will fall 10-15 per cent.

Meanwhile Robert Shiller, an economist credited with predicting the US housing crash, has said he sees trouble ahead for the Canadian housing sector, saying it is at risk of “a slow-motion version of what happened to the US”.

Residential sector building permits fell 12.9 per cent in June, and were down 18.8 per cent for multi-unit dwellings, while in the largest markets such as Toronto, Vancouver and Calgary, residential land investments for home building has plunged 51, 52 and 30 per cent, respectively, pointing to trouble ahead.

The stakes are high. The housing sector, including construction, renovation and ownership cost, accounts for 20 per cent of Canada's GDP, whereas the US peaked at 18 per cent in 2005, and construction jobs account for a record 7.4 per cent of total employment, compared with 4.2 per cent in the US.

If the Reserve Bank does lower interest rates further and predictions of rising housing prices hold true, Australia may well be headed for Canada's current situation.

If anything, Canada's model suggests a go-slow approach on the Reserve Bank's part would give it the chance to play a lead role in managing future housing bubble concerns, rather than risk finding itself in the Bank of Canada's position on the sidelines of a potential crash in the making.

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