The source, length, severity and cause of real estate bubbles throughout the world can vary widely based on country of origin, era, interest rates, leverage and more. When and how do government regulators, insurers and investors begin to alter their outlook of the sector, as well as their risk appetite? When do regulators begin to pull back on the reins of home price appreciation, when do they coast and when do they to go all-in? A look to our neighbor to the north can provide some insight.
There is no crystal ball that can accurately identify the precise moment when a rapid or prolonged increase in home values moves from "healthy" to "overheated" to "unsustainable." What is equally difficult to determine is when exactly, during a real estate cycle, that bubble truly begins to form. When studying the factors that contribute to unsustainable price increases it's almost impossible to separate portions of that increase which are healthy and justified from those which are not.
Overall, the U.S. mortgage market is roughly 10 times larger than Canada's. Structurally, however, the markets are parallel. The most common type of mortgage loan in the U.S. is the 30-year, self-amortizing loan, while in Canada the most common mortgage is a 25-year amortizing loan that resets periodically, offering the lender the option to renew the loan for a fixed period of time (usually five years).
Canada's insurable versus uninsurable market is similar to our government-guaranteed (or agency) and non-government-guaranteed (nonagency) structure. In both countries, regulators have direct influence over the total amount of mortgage debt guaranteed by the government. Their role both influences the amount of risk on the government's balance sheet, and indirectly determines the amount of mortgage risk borne by the private sector.
Both countries are required by charter to promote widespread investor participation in the capital markets. The government sets both the risk parameters and underwriting criteria for the loans they guarantee before placing their stamp of approval on the loan pools comprised of those assets.
An efficient and liquid residential housing market is the direct result of the confidence investors have in their government's ability to stand behind that guarantee. Government obligation however, is both to those that purchase securities, and the taxpayers (including those who do not own homes), who ultimately fund the day-to-day operations of the government.
The ability to avoid damaging housing bubbles is where Canada appears to have always had the upper hand. Managing long-term housing growth is the equivalent of running a marathon. Where Canada subscribes to the style of a distance runner, the U.S. has managed to act in a style more akin to a sprinter.
As regulators begin to see the early signs of a strong housing market, they must decide whether or not to take action. It's reasonable to believe that a healthy housing market should be allowed to grow; while a runaway market needs to be reeled in to prevent a bubble. Whether regulators choose to proactively act and throttle growth, do nothing, or — as has often been the case in the U.S. — loosen guidelines further in an effort to promote further growth remains to be seen.
To be clear, curtailing housing growth cannot be achieved through unilateral changes. It involves placing guidelines and/or pricing restrictions on loan groups (based on loan-to-value, credit scores, etc.) that have begun to show signs of excessive risk or exposure beyond a predetermined threshold.
Canadian and U.S. home prices have both been on the rise since 2013, increasing 28% and 21% over the past 40 months. However, Canada's response to these increases has been much more restrictive and proactive than that of the U.S.
Since 2013, Canadian housing regulators began a three-year campaign to tighten guidelines in an effort to reduce Canada's overall exposure to housing — even in the face of what looked to be a recovering housing market. For example, by increasing the threshold for borrower reserves, credit scores, down payments, debt ratios and loan documentation, Canada has effectively driven more borrowers toward the uninsurable (or non-government-guaranteed) marketplace — where mortgage rates, credit and underwriting standards are far greater than in the government-regulated, insured marketplace. Canada has always appeared ready to proactively stifle what they believe to be an unsustainable housing growth trajectory instead of having to react to an overheated and collapsing market, after the fact.
Canadian regulators continue to believe that a policy of managing housing risk through the preemptive use of constrictive measures is far safer than allowing homeownership rates (and home values) to continue to expand on what may ultimately be a risky foundation. These policies have proven to be beneficial to their economy and beneficial to the country as a whole.
Frank T. Pallotta is the owner of Steel Curtain Capital and has studied the Canadian mortgage market since 2013.