Down Payment Size & a Housing Bear Market

Housing-Correction“The housing market will eventually correct.”

That’s a quote from economist Ben Tal in this CIBC report from last week.

There’s nothing earth shattering about that because corrections are to be expected. The more interesting question is: how big will the next selloff be?

Tal’s conclusion was that the next downturn “is likely to be gradual.”

Values are “overshooting” fundamentals but that doesn’t presage a crash, says Tal. He says a crash requires one of two things:

  1. A “significant and quick rise in interest rates…akin to the one that led to the 1991 recession and housing market correction,” and/or
  2. A “high-risk mortgage market that is highly sensitive to any changes in economic realities, including hikes in interest rates.”

#1 is unlikely because, among other things, the Bank of Canada keeps a tight leash on inflation (which is the biggest catalyst for rising rates). Moreover, economic growth is widely projected to remain near or below the long-term average.

#2 has never been a serious threat in Canada and vigilant regulators are dead-set on ensuring it never will be.

From a numbers standpoint, Tal identifies “risky” borrowers as those individuals with total debt service ratios over 40% and equity under 20%. Those people comprise 3.2% of total mortgages, a number he says would grow to 4.5% if rates soared 300 basis points.

Yet, even in this high-debt/low-equity group, defaults have been “well below 1%,” Tal adds (which is a positive reflection of Canadian lending standards). By comparison, 8.1% of U.S. mortgages are 90 days delinquent or in foreclosure.

“Thus, short of a huge macro shock,” says Tal, “there does not appear to be the risk of large scale forced selling that would typically be the trigger for a precipitous plunge in the national average house price.”

CIBC’s report aside, most analysts seem to be projecting a minimum 5-15% price drop in the next housing downturn. Consider that if you’re putting only 5-10% down on a home purchase. Here’s why:

  • After five years, a household putting down only 5% on a $300,000 house (with a thirty-year mortgage at 3.75%) would be left with a $264,166 mortgage balance.
  • If prices dropped 10% and they paid 5% in Realtor commissions to sell (commissions vary by province), they’d owe over $9,000 more than their proceeds from selling—assuming $1,500 for legal and discharge costs.

But who cares if you don’t sell, right?

Well, even if you’re planning to buy with a long-term time horizon, life does throw us curveballs (job relocation, unemployment, a growing family, disability, divorce, etc.). When you have to sell, you need equity as a buffer and falling prices can quickly eat that up.

Notwithstanding a “gradual” home price correction, it therefore makes little sense to rush into buying if your financial outlook isn’t rock solid. For tens of thousands of Canadians who haven’t been able to sock away a 3-6 month emergency fund and a decent-sized down payment, renting is economically superior to buying…..crash or no crash.

Sidebar: “Not surprisingly,” says Tal, Vancouver and Toronto have the highest percentage of mortgagors with debt ratios over 40% and less than 20% equity.

Rob McLister, CMT

  1. Hi Sudip, The purpose of Tal’s paper was to argue against a housing crash. He states two pre-conditions for a serious price decline in the report and suggests that those two factors don’t exist at the moment.

  2. I agree with Tal, there needs to be a small correction at some point.
    Is Tal saying only 3.2% of all mortgages have TDS over 40%?
    If so, I find that hard to believe. I would have thought that number would have been higher, somewhere closer to 15%.

  3. Comparing the percentage of defaults in Canada vs. the US is meaningless… why would anyone in Canada default when prices are still going up?
    Wait until 5 years after the correction (which is where the US is now), and that would be a valid comparison. Canada will never get up anywhere close to 8.1%, but at least you’d have more of an apples-to-apples comparison.

  4. This market will NEVER correct. Canadian real estate is rock solid. Why do you think more than 60% of condos in Toronto are sold to investors. Foreign investors are arriving in droves because they know something that Tal and all the other economists dont know. Prices in Canada will never decline. Their investments are safe.

  5. Stats,
    Thanks for the post. Eliciting a response like that (i.e. that Canada will never approach U.S. default levels) was exactly the meaning behind this comparison. :)
    Further to the point about comparability:
    * If your financial resources don’t allow you to pay your mortgage, the direction of home prices is mostly trivial.
    * The latest data from Experian shows only 17% of U.S. defaults are deliberate. Also know as “strategic defaults,” these are the homeowners you’re referring to — those who stop making their mortgage payments because they owe more than their home is worth. Most of the other 83% simply can’t handle their payments.
    * Moreover, if you’re lucky enough to find a U.S. default breakdown by debt ratio and LTV, you’d likely see an ever more dramatic difference in an “apples-to-apples” comparison. Remember, the U.S. mortgages in that 8.1% figure weren’t limited to people with high debt ratios and low equity (like the Canadian figure was).
    * Mortgage underwriting focuses much more on your willingness and ability to pay than on home price direction (which no one can predict consistently). The point stands that a 1% default rate is extremely reasonable for higher risk mortgages, and that again is due in large part to stronger underwriting on this side of the border.

  6. Hi, if the foreign investors you are refering to are ones that come on investment immigration visa, than you can forget about it: a week ago Canada immigration put a limit on the amount of investment immigrant cases to be completed yearly to 700 cases max per year for investment immigrants from all over the world. To give you all an idea of the magnitude, last year over 10000 Chinese immigrated to canada on those terms, next year they will not. Immigration consulting companies called it the darkest day for immigration.

  7. Investors, foreign or local, tend to invest for the long run, not for short-term upticks in prices. If your commentator really means that Canadian housing prices will “never” decline if viewed from one housing pricing cycle to the next, he’s probably correct, but if he means that Canadian housing is immune to market forces and price fluctuations in the short and medium terms, he’s hopelessly naive or perhaps this comment is really just tongue-in-cheek.
    Mind you, never doubt the simple minded faith of a fanatic.

  8. Rob, interested in your take on this thought. Tal, suggests that one of the factors of a correction are a significant rise in rates. I agree. However he says that “1 is unlikely because, among other things, the Bank of Canada keeps a tight leash on inflation (which is the biggest catalyst for rising rates). Moreover, economic growth is widely projected to remain near or below the long-term average.” However, if LONG term rates rise, which there are many indicators this may continue, and may be sharp (european and US debt challenges to name a few, sell-off of bonds to equities) then higher fixed rates still serves to slow the market significantly due to qualifying for variable based on the higher fixed rates?

  9. Hi Greg,
    Thanks for the note.
    Long-term rates have to rise materially at some point but a sustained 3% jump in the 5-year bond would be unusual given that:
    * This would imply a notably greater increase to the overnight rate, which would put us far above a “neutral” policy rate (estimated by economists to be somewhere around 3.00-3.50%).
    * It takes a lot less tightening today to have the same effect as in the past, given today’s highly leveraged consumers.
    * Rising rates will move an already-high loonie even higher, which will slow growth even faster.
    * I’m not sure that European debt issues would drive up Canadian yields in any kind of sustained manner. There’s a possibility Canadian yields would actually fall as investors buy bonds in safe haven countries that actually know how to balance a budget.
    All that said, even a 150-200 basis point rate increase could have a chilling effect on home prices. In the context of a “crash,” however, 150-200 bps is not the significant and quick” rise that Tal suggests would seriously damage housing.
    Regarding it being harder to qualify for variables, you’re right. At the same time, one might argue this would merely shift more homeowners into fixed rates and not considerably impact housing demand.
    As a quick point of clarification, the “1 is unlikely…” wording is ours and not Ben’s.

  10. Hi Rob, the turnaround was already very fast, that is not the reason for the cap, I suspect they don’t want foreigners to drive up the prices in Canada, especially because they don’t want a bubble effect when it is revealed what type of problems china has.

  11. Hi Tom, Perhaps it’s worthy of further inquiry. CIC publicly cited backlogs as a reason for the changes in its release. For entrepreneur applications they said: “Wait times for this program currently stretch to eight years in some visa offices.”

  12. In my view the boom in Canadian housing prices was caused by low Interest rates and low down payments, by the way similar conditions caused the now busted boom in the US. Speculative demand is also attracted to the above conditions and aggravates an already hot market, this causes the cycle to feed on itself and prices keep going up because people buy on the expectation of a never ending cycle of higher prices.
    The current housing valuations in Canada are not in line with incomes or rents and inevitably they would have to adjust.
    I can not predict when the correction will start, no one can, but it will start and it will last for several years.

  13. You’re right about low rates but I disagree on several other counts.
    5% down payments have been around since the early 1990s. They aren’t new and they haven’t contributed to any bubble whatsoever. Longer amortizations have had way more impact than down payment size.
    The US bubble burst mostly because of horrible underwriting and irresponsible securitization.
    Rent ratios and price to income ratios are almost meaningless. Housing values are sky high because of one thing more than any other, affordability. Affordability is good historically speaking and that is what matters to buyers.
    If you’re trying to predict a correction you better be good at predicting interest rates. Only rising rates will kill affordability.
    P.S. No one can say for sure that the correction will last “for several years.” That is exactly what naysayers said in 2008. Look where it got them.

  14. Should also mention that processing times for investors are not very fast (as long as 53 months, and an average of 40 months for applications processed through the Beijing office).
    CIC has zero interest in manipulating the fundamentals of the housing market.

  15. Not sure how much validity to the movie but according to Inside Job, the US bubble burst because the banks were allowed to transfer mortgages to investors to remove any liability on their end and pass it over to investors instead. It encouraged the banks to provide mortgages to people beyond their means as they would not be the ones suffering when someone defaulted on the mortgage. On top of that, they also managed to create a new product to insure against mortgage defaults which basically encouraged them to give out mortgages to people who barely qualified, pass on the liability to investors and then cash in when the mortgage defaulted by cashing in on the insurance they had placed on that mortgage.

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