“…The changes to mortgage insurance criteria are unnecessarily jeopardizing the health of Canada’s housing markets and the broader economy.”

That’s the conclusion from economist Will Dunning in CAAMP’s just-released State of the Residential Mortgage Market report. (Link)

Dunning says his research suggests the Finance Department has created “a policy-induced housing market downturn” that could reinforce existing weakness.

He calculates that the most recent (July 2012) rule changes will knock 11% of potential high-ratio homebuyers out of the market—that is, until they can come up with more net income or a bigger down payment.

He lays out the following arguments:

Jobs underpin the market…

• “Job creation is the key driver of housing demand” writes Dunning.
• “The ‘housing wealth’ effect (the increased confidence, and willingness to spend and invest, that results from rising house prices) is the single most important driver of job creation”
• What’s more, in the prior five years, 18% of job creation in Canada has originated from housing and mortgage activity.
• If mortgage rule tightening drives down home prices, job creation will suffer and it could trigger a negative “feedback” loop between the housing market and the economy.

Price risk…

• Dunning writes: “Experience around the world has shown that once house prices start to fall, the outcome is unpredictable, and can turn into a downward spiral that wreaks substantial economic damage.”
• He adds: “It can happen that the loss of jobs affects housing demand, leading to further price drops and a vicious downward spiral.”
• There is growing evidence to suggest that the combined mortgage rule changes of the past four years may now be “significant enough to substantially reduce housing activity.”

What’s happened so far…

• The government has handed down four sets of insured mortgage restrictions since July 2008. Dunning summarizes them in the list below:

(Source: Will Dunning)

• He says the cumulative effect of these four sets of changes “have resulted in a massive contraction in credit availability.”
• From August to October, home sales were 7.8% lower than the prior year.
• Some analysts downplay the effects of past mortgage rule changes, pointing to the subsequent sales rebounds that took place.
• Dunning notes that those rebounds coincided with falling mortgage rates. “It appears that the movements of mortgage rates were more important than the changes in the mortgage insurance criteria,” he says.

The effects…

• “16.9% of high-ratio mortgages that were funded in 2010 could not have been funded under the revised criteria.”
• “…The final set of changes that was announced in June 2012 and took effect in July will have had the most significant consequences, accounting for about 65% of the impact (11.0% out of 16.9%).”

Time for young buyers to save up…

• “…Simulations indicate that on average (based on 2010 real mortgage data), the additional down payment required is about $25,000, 7% of the purchase price.” That’s what it takes to offset the mortgage rule effect.
• “If we assume that these households can devote 10% of their pre-tax incomes to enlarging their down payments, on average it will take 3.5 years to re-qualify – and this assumes that house prices and interest rates do not increase.(10% may be optimistic. Doug Porter recently estimated that the median family saves only 4%, or $2,800 a year.)

What happens next…

• 55% of buyers need high-ratio mortgages, according to Maritz. “If 16.9% of potential high ratio buyers are removed from the market, this would reduce total home sales by about 9%,” Dunning states.
• “…It will become more difficult for people who want to move-up in the market to sell their current home. In consequence, over time, we should expect to see reduced activity in upper segments of the market.”
• “…Declines in activity will be partly (and gradually) mitigated, as some of the affected potential buyers save additional down payments and can return to the housing market.”
• “…It now appears that the 2010 changes had a lasting negative effect (on home sales).”
• “…the negative effects on housing activity will be quite prolonged…the damage is not yet fully developed.”

Was it necessary?

• “The average resale house price in Canada had been essentially flat since early 2011,” Dunning says. On top of that we faced (and still face) material risks from the U.S., Europe and from domestic budget tightening.
• “There was no need to further cool the housing market,” he concludes.

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Stricter mortgage rules will be a drag on demand until the market has time to adjust. Let’s just hope the new rules aren’t coupled with an economic slowdown or a natural cyclical home price correction. In that case, the latest rule changes could prove to be very bad timing.

Of course, low rates could always save the day once again—or delay an inevitable correction if you want to look at it that way. We could also see buyers get off the sidelines and purchase on dips—i.e., buy if home prices drop 10% or so. Both of those factors could pad a fall, at least somewhat.

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Rob McLister, CMT