By Peter Diekmeyer, Bankrate.com, January 29, 2011
Flaherty's tough love
Recent tightening of mortgage rules may slow some new homebuyers.
In his famous book The Art of War, Sun Tzu wrote that skilled warriors remain strong by avoiding unnecessary battles. Judging from his latest moves, it would seem that Canada's finance minister Jim Flaherty is a fan of that ancient Chinese military strategist.
Flaherty recently tightened mortgage lending requirements for the second time in 12 months. Though he did not say so directly, the move was likely motivated by a desire to help Canada avoid the troubles that the United States is now going through, because regulatory authorities there declined to show similar restraint.
Flaherty, like most Canadians, got a chance to witness first-hand what happened during the years when our southern neighbour's financial institutions lent money to seemingly almost anyone who could pick up a pen to sign a mortgage. The result was a massive subprime, lending-led real estate bubble, which when it burst, chocked up much of the global financial system.
Today, the U.S. continues to battle high unemployment, a shrinking and increasingly discouraged workforce, massive government deficits and an economic malaise that experts say will take years to overcome. With a ready-made lesson like that unfolding on our southern border, it is not surprising that Flaherty should decide to act.
Earlier this month, Flaherty announced three major changes that would tighten lending in Canada ever so slightly. Firstly, the maximum amortization period for mortgages eligible to be guaranteed by the Canada Mortgage and Housing Corporation was lowered from 35 to 30 years. Secondly, the upper limit that Canadians can borrow against their home equity was lowered from 90 to 85 per cent. And lastly, the government announced that it would stop insuring home equity lines of credit (HELOCs).
A lot can happen in thirty-five years
While on the surface, Flaherty's actions fly in the face of classic laissez-faire economics, underneath they make a lot of sense. There are several reasons for this. The most important boils down to the fact that if America is any example, many heavy borrowers simply have little idea how much trouble they can get into by piling on debt. A surprising number of Americans and Canadians suffer from "innumeracy," which is an inability to use or understand basic mathematical concepts.
Innumeracy is what caused many Americans, and some Canadians, to borrow unthinkably, by merely focusing on what they have to pay each month, rather than coolly assessing the effects of their total debt burdens. It is the reason that Canadian household debt recently spiked to a record 148 per cent of their total household income, above even U.S. levels.
For example, few people with a solid grip on risk probabilities would borrow money for 35 years. Even at a low five-year closed rate of 4.75 per cent, borrowers that bought a home today, and financed the entire borrowing cost over that time period, would pay more in interest payments than they would for the actual house. In the U.S., where mortgage interest is tax deductible, a case can be made for heavy mortgage borrowing under some conditions, but here in Canada, paying down mortgage debt is one of the first things that most financial advisers tell you to do.
As a result, many families that are forced to pay off a home over 35 years are likely doing so because they cannot afford a shorter amortization period. This raises another cause for concern: if those families are that tight for cash, what would they do if anything went wrong? In today's economy, few, if any, jobs other than in government can be relied on to provide a steady stream of income for 35 years. What would long-term borrowers do when they, almost inevitably, lose their jobs and have to find another? How would they finance unexpected expenses?
Yet ironically, despite the huge risks that Canadians who took out 35-year mortgages assumed, there is surprisingly little evidence that any large number of them have suffered for it.
Quite the contrary, Canada's housing market has been doing quite well. Although house prices have inched down slightly and are expected to continue doing so this year, they are far ahead of where they were ten years ago. As a result, many of those innumerate Canadians have stumbled into considerable wealth, particularly those who bought real estate in the once red-hot Vancouver and Alberta markets.
Lessons from south of the border
However, the chickens did come home to roost for those innumerate, or just plain greedy, Americans who bought highly leveraged homes during the past decade. Although house prices there rose year after year, when the crash came those who had borrowed too much were the first to get hit. As a result, millions of Americans faced, or will face, foreclosure during the coming years and housing starts there, a major driver of economic activity, are down to near half pre-recession levels.
While few experts believe that Canada's housing market is in bubble territory, there is a broad consensus that it is at least somewhat over-valued. Right now, it is far from clear whether Flaherty's moves to save Canadians from the economic battles that America is facing will work. Several earlier attempts at restricting borrowing did little good, and there is no guarantee the current round will do much better.
Flaherty had better hope they do. Otherwise, he'll have to pick up that old Sun Tzu text and read the chapters about actually fighting battles, not just avoiding them.
Peter Diekmeyer is a Montreal-based freelance business writer.