Canada’s Flaherty Tightens Mortgage Rules to Avert Bubble

Canadian Finance Minister Jim Flaherty
Canadian Finance Minister Jim Flaherty has already reduced the amortization limits twice since 2008, cutting them from 40 years amid concern historically low borrowing costs are fueling a housing bubble and pushing household debt to record highs. Photographer: Nelson Ching/Bloomberg

Canadian Finance Minister Jim Flaherty said he will tighten mortgage terms as the Group of Seven country with the soundest government finances tries to avert a household debt crisis.

The government will shorten the maximum amortization period on mortgages the government insures to 25 years from 30 years, and lower the maximum amount homeowners can borrow against the value of their homes to 80 percent from 85 percent, Flaherty said in a statement delivered in Ottawa.

Flaherty has been relying on regulatory steps to rein in mortgage borrowing, as concerns about a deepening debt crisis in Europe handicaps Bank of Canada Governor Mark Carney’s ability to raise historically low interest rates at home. The government has already reduced amortization limits twice since 2008, cutting them from 40 years.

“This will further reduce the total interest payments Canadian families make on their mortgages, helping them build up value in their homes more quickly and pay off their mortgage debt sooner,” Flaherty told reporters today in Ottawa. Government measures to reduce amortizations since 2008 will save a typical Canadian family with a C$350,000 ($342,064) mortgage about C$150,000 in debt costs, he said.

Canada will also cap debt payments at 39 percent of income and limit government mortgage insurance to homes worth less than C$1 million, Flaherty said.

The changes take effect July 9.

Rules Reversal

The move extends a reversal for the Conservative government of Prime Minister Stephen Harper, which came to power in 2006 and initially lengthened mortgage terms to make it easier for Canadians to buy homes. Harper said today that the government may take additional action to cool the housing market if needed.

Homeowners have taken advantage of the longer-term mortgages to lower their monthly payments. The share of new mortgages with amortizations of more than 25 years was 41 percent last year, compared with 8 percent between 2000 and 2005, according to a survey by the Toronto-based Canadian Association of Accredited Mortgage Professionals.

Carney, who has warned that monetary policy should be used to address rising levels of household debt only as a “last line of defense,” had been involved in the discussions on the matter and encouraged Flaherty to tighten regulations, a government official said, speaking on condition they not be identified because they aren’t authorized to discuss details of the talks.

Welcomed Measures

Carney told reporters in Halifax, Nova Scotia that he welcomed the measures and was consulted by the government.

“Yes we’re involved in these discussions but that’s normal course,” Carney said. “There’s a broad consultation and we meet regularly, as you’d expect us to.”

The move may give Carney more scope to extend a pause in interest rate increases, said economists including Derek Holt of Scotia Capital and Mark Chandler of Royal Bank of Canada. The central bank has kept its benchmark rate unchanged at 1 percent since September 2010.

“At the margin it does give them more room for patience,” said Chandler, Toronto-based head of fixed-income and currency strategy at Royal Bank’s RBC Capital Markets.

Holt, vice president of economics at Scotia, said in an interview that “there’s no way they’re moving for a good long time yet.”

Swap Rates

Canada’s 12-month overnight index swap rate, which is tied to forecasts for the Bank of Canada’s policy rate, fell to 0.9391 percent today at 4:23 p.m. in Toronto trading, from 0.9842 percent yesterday.

Those swap trades suggest investors are placing bets that Carney may cut borrowing costs this year, with the odds of at least one rate cut by December at about 28 percent, according to Bloomberg News calculations.

Carney has said a surge in household debt has become the economy’s biggest domestic risk, with levels relative to income surpassing those in the U.S. and the U.K. Like other countries such as Australia that largely escaped the global financial crisis, Canadian banks continued to expand lending at a time when record low borrowing costs fueled demand.

The risk to Canada’s economy is that a growing number of Canadians taking on too much debt at low interest rates today may not be able to afford their payments when borrowing costs rise, Carney has said.

Debt Levels

In a speech in Vancouver last year, Carney said the increase in debt over the past decade has been driven by households with the highest debt levels and the proportion of Canadian homes that would be vulnerable to an adverse economic shock is at the highest level in nine years.

The measures will “slow down demand and make sure that the quality of loans are going to be better,” said Sadiq Adatia, chief investment officer at Sun Life Global Investments in Toronto. “It makes it a much better situation.” The unit of Sun Life Financial Inc. oversees about C$4.4 billion for clients.

The monthly payment on a C$350,000 mortgage with an interest rate of 3.29 percent would rise to C$1,713.01 under a 25-year amortization period from C$1,530.92 over 30 years, Bloomberg calculations show.

Flaherty has also acted recently to reduce taxpayer exposure to the market. In April, he introduced legislation that prevents lenders from using government-insured mortgages as collateral for covered bonds.

Insurance Cap

The government doesn’t plan to raise the mortgage insurance limit of the Canada Mortgage & Housing Corp., which had C$570 billion of insurance in force at the end of March, Flaherty said today. He said the government plans to instead raise the limit for private mortgage insurers such as Genworth MI Canada Inc. to C$300 billion, from C$250 billion. “The government doesn’t necessarily need to be, at the end of the day, in the mortgage insurance business,” Flaherty said.

The federal housing agency has already begun rationing bulk insurance for financial institutions. Canadians who make a down payment of less than 20 percent of the home’s value are required to insure their mortgages.

Some banks have already sought to cut the exposure to long-term mortgages, and said they welcomed today’s announcement.

In separate statements today, the Bank of Montreal said it “strongly endorsed” the changes, while Toronto-Dominion Bank’s Tim Hockey, who heads that lender’s consumer banking division, said the changes “should have a substantial moderating effect on the growth of Canadians’ debt levels.”

Smaller Downpayments

Bank of Montreal Chief Executive Officer William Downe said in March the trend toward smaller down payments and longer term mortgages coupled with low interest rates on mortgages had put more borrowers at risk.

Canada’s fourth-biggest bank is seeking to make 25-year amortizations more attractive by offering lower interest rates on such loans. That’s helping the Toronto-based lender increase the current share of new mortgages it issues with amortizations of 25 years or less to about 70 percent, from 40 percent last June, Downe said.

“We took a long, hard look at the Canadian housing market and concluded, on the one hand, there was a legitimate concern that house prices - particularly in the largest cities - had been rising at a rate that was simply unsustainable,” Downe said in a speech at the bank’s annual general meeting in Halifax, Nova Scotia on March 20. “With growing concerns over household debt, a soft landing in housing is in the best interests of our customers and the national economy.”

Mortgage Origination

Canadian Imperial Bank of Commerce, meanwhile, said yesterday it plans to shutter its mortgage-origination business next month after failing to sell the unit.

Toronto-based CIBC, the No. 5 bank, said in March it was reviewing options for the FirstLine mortgage brand, including a potential sale, and would retain the division’s loan portfolio.

The average sale price of a home in Canada has risen 98 percent over the past decade, and 35 percent since January 2009, according to data from the Canadian Real Estate Association. Canada’s household debt relative to disposable income rose to a record 154.3 percent in the first quarter.

Vancouver, where home prices had almost tripled in the decade through last year, and Toronto are the country’s most expensive markets.

Housing Recovery

Flaherty’s move comes as he tries to avert a bubble in overheated areas without triggering a widespread drop in house prices that could undermine the recovery at a time of weak global demand. At a March 22 press conference, Flaherty said the housing market is a source of jobs in the economy and that it’s up to the lenders to tighten their own lending practices.

“I do find it a bit much when some of the bank executives turn to the government, the minister of finance, and say ‘You ought to change the rules and make it tighter,’” Flaherty said at the time, adding bank executives have been calling on the government to tighten mortgage insurance rules.

The share of gross domestic product in the world’s 10th-largest economy linked to housing -- including construction, renovation and ownership cost -- was 20.1 percent in the fourth quarter of last year, up from 19.2 percent in the third quarter of 2008. In the U.S., a similar measure peaked at 18 percent in 2005.

Construction Jobs

The share of construction jobs in total employment is at a record of 7.4 percent of total employment. Construction employment makes up 4.2 percent of total jobs in the U.S.

Policy makers are wary of being blamed for choking off what may be a smooth expansion of the housing market, said former Toronto-Dominion Bank Chief Economist Don Drummond.

“As we saw in Spain and the United States, it’s pretty hard to determine if it’s going to go and when it’s going to go,” Drummond said.

Canada has relied on households to drive its recovery, in contrast to its three previous recessions, where rising exports led growth. The domestic strength has helped the government increase its revenue and implement a fiscal plan that projects a return to balance by 2015. Canadian government net debt, at about 33 percent in 2011, is the lowest in the G-7 and less than half the level in the U.S.

“This means the consumer will not be a major factor supporting activity, and the housing market until now an engine of economic growth will be a lot softer,” said Benjamin Tal, deputy chief economist at CIBC World Markets in Toronto. “But it also means the quality of mortgages in Canada will improve and you’re preventing the risk of a bubble.”

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