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July 22, 2015 | What Could Go Wrong?

A best-selling Canadian author of 14 books on economic trends, real estate, the financial crisis, personal finance strategies, taxation and politics. Nationally-known speaker and lecturer on macroeconomics, the housing market and investment techniques. He is a licensed Investment Advisor with a fee-based, no-commission Toronto-based practice serving clients across Canada.

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“I’m wondering,” says David, “what your thoughts are on possible catalysts to spark a housing correction in Toronto/Vancouver–especially ones other than rising interest rates.”

This is a good question. Especially because most Canadians have deluded themselves into believing rates will never go up again, that the government ‘would not allow’ mortgages to become more costly, and that (consequently) real estate is safe as your momma’s embrace. (Especially if she holds the down payment.)

“The US experienced imploding subprime mortgages (due to rate reset, poor underwriting and wrong default risk assumptions), leading to massive foreclosures, dumping real estate on the market and a complete freeze on mortgage lending (affecting refinancings)–creating a vicious downward spiral,” David adds. “I can’t see the same thing happening here.

“If/when the BoC raises rates, won’t they do it in a slow enough fashion and use anything in their power (with the housing bubble in mind) to avoid a crash? I really can’t think of anything else that will set off a correction.”

Well, the American real estate crash was not caused by imploding subprimes, because that was actually a consequence. So was the blow-up of Lehman, Bear Stearns etc. The real cause was an economic slowdown brought on in part by rising rates, but really affecting people through an employment slowdown. When families fear job loss, they stop speculating on real estate, buying beyond their means, taking on huge debt, or using their houses like private ATMs.

So, house values fell from an inflated level that had resulted from greed and speculation. Because so many people were highly leveraged (like here), the number of families under water soon exploded, leading to non-performing loans and massive consequences on Wall Street, where mortgages had been packaged as gold-plated securities and sold to greater fools. The dominoes then cascaded, leading to a credit crisis, severe job loss and a 32% decline (national average) in house values.

But that can’t happen here, right?

Well yesterday I showed you it did. In Toronto. A 27% drop in house prices from a speculative high (1989) like the one we’re in now. But the decline was long and relentless, which meant it was called a correction, and continued to attract buyers year after year who thought they were being so clever.

Lesson one: a correction is not a crash. But it hurts just as much. Maybe more, since there’s buying all the way to the bottom.

Another common myth is that Americans were financial subprimates – an entire nation filled to the gills with NINJA loans (no income-no job-no assets), zero-down financing, adjustable-rate debt, jumbo mortgages and with unemployed janitors routinely buying McMansions in Florida and Phoenix. So, they brought all that misery upon themselves.

Untrue. As an interesting Morningstar report outlined, in 2005 America looked disturbingly similar to Canada today. Oops.

Just before the US real estate crash about 70% of Americans owned houses. Ditto for us now. In Canada today homeowners, on average, have 55% equity and 45% debt. That was exactly the same ratio in the States in 2005. Currently 23% of Canadian mortgages are for 80% or more of the value of the homes financed. That is weirdly similar to the number of American loans of similar risk (22%) at the height of their pre-crash bubble.

Lesson two: we’re not immune. Or better. Or wiser. In fact, Canadians have allowed the national economy to become just as dependant on real estate as Americans did before they learned a valuable lesson.

Higher interest rates (inevitable as they are) won’t be the catalyst, David, but they sure won’t help. Instead the thing we need to watch out for is simple economic fear. Perhaps that has already started to mount, and with good reason.

The financial news is dreadful. On Wednesday the dollar sat near 75 and a half cents US, the lowest in over a decade. Oil soundly crashed through the $50-a-barrel mark, putting an end to all that brave talk in Alberta about a quick rebound. Remember, oil is our biggest export. And the world is now swimming in the stuff. All this has dragged down the Canadian market, with the TSX giving up 4% over the past year while US, euro and Asian markers rock. And remember that balanced federal budget we received just two and a half months ago? Well, kiss that sucker goodbye. It’s now a $1 billion deficit, says the Parliamentary Budget Officer.

So the focus will quickly become jobs. They’re being shed in droves in the oil patch. Manufacturing continues to decline. Even the railways and truckers are punting people – a sure sign of economic malaise. Bombardier’s in trouble again and some think GM will be pulling out of Oshawa, taking 30,000 jobs and $5 billion in GDP with it. As you know, the Bank of Canada is so worried it’s cut interest rates twice in the past seven months, even as the US prepares to raise them.

Says Capital Economics, which was spot-on with its rate cut forecast: “The slump in oil prices has already pushed the Canadian economy into a mild recession and things could yet go from bad to worse. Falling energy investment will hit both production and jobs, which will further depress incomes and spending. Meanwhile, housing corrections in oil regions could be followed by busts elsewhere when bond yields rise.”

So, David, I wouldn’t obsess about mortgage rates, nor feel we dodged the Yankee bullet. People are simple. They fear, they freeze. The music stops.

When you read about it, well, too late.

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July 22nd, 2015

Posted In: The Greater Fool

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