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Jim-Flaherty Finance Minister, Jim Flaherty, told CTV yesterday that the federal government would “take some action” and tighten mortgage guidelines if borrowers (or real estate prices) become irrational.

Flaherty said:  "The likely action we will take is to increase the size of the down payment from 5% to a higher figure, and probably once again, reduce the amortization period – so bring it down from a maximum of 35 years to something less."

Flaherty’s statements come amid ascending home prices, a threat of rate hikes in 2010, and lots of “bubble”-talk in the press.

His worry, of course, is that homeowners are taking on too much debt and won’t be able to handle:

A)  The higher payments that come with rising interest rates; and/or,

B)  Losses from falling home prices

If Flaherty changes lending guidelines, the impact on Canadian housing could be significant and immediate. 

On the plus-side, Flaherty would be keeping a certain number of Canadians out of trouble.  That’s a good thing because overinflated real estate markets usually end badly…and people can be financially ruined when they buy into them with little equity.

On the other hand, the dosage of Flaherty’s medicine must be carefully measured. He first needs to understand how many home buyers are actually at risk (see Rising Rates & Mortgage Arrears). He then has to determine what action is needed to save them from themselves. 

If rates jump in 2010 as many expect, this in itself will brake the housing market without any government intervention. Low rates are fuelling home prices more than any other factor.

Economists also have another worry.  Canada’s real estate market is like a giant airliner. Turning the rudder too quickly can rip the tail right off.  If 90% LTVs and 30-year amortizations are imposed in knee-jerk fashion, it would eliminate significant demand from the market.  Home values could drop shortly thereafter, and no one knows how much.  Canadians who rely on their home equity could be hurt (perhaps more than if the government did nothing) and hundreds of thousands of young buyers (mostly well qualified young buyers) would be shut out of home ownership.

That’s not to say tightening mortgage standards is necessarily a bad idea. If home prices and debt ratios continue climbing, it may be quite appropriate. The issue is, which tool does one use to remove the “cancer”: a chainsaw or a scalpel. 

Many would argue there are more surgical alternatives than what Flaherty proposes.  Instead of dropping an A-bomb on the whole market, Flaherty could instead make precision strikes where the threats are high. The finance department could require that lenders:

  • Not extend 95% financing to borrowers with debt service ratios over the standard 40%.
  • Increase minimum credit score requirements for 95% financing. (e.g.  From the current 600, to 650 or 680)
  • Tighten down payment guidelines in locations with overinflated home prices–using the Finance Department’s definition of “overinflated”, or some other objective measure.  (It’s important to remember that most local Canadian real estate markets are not materially overvalued.)
  • Impose small but reasonable minimum net worth requirements on 5/35 mortgages (those with only 5% down and 35-year amz).

These things, singularly or in combination, could address the problem of overleveraged home buyers while encouraging a softer landing for house prices. 

More importantly, a targeted solution would avoid penalizing the majority of well-qualified and responsible Canadians, for whom 35-year amortizations and 5% down payments are sometimes reasonable choices.

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