Introduction
Housing bubbles have happened in different economies around the globe. The most recent and most publicized was the subprime mortgage crisis in the United States of America. Understanding what a housing bubble entails in very important in determining whether any economy is experiencing a housing bubble. In economic terms, a housing bubble is the unprecedented increase in the prices of houses because of an increase in demand for housing units, speculation on the prices and the belief that the recent trends in demand and price are surefire forecasts of future trends in the housing market.
A housing bubble starts when the demand for housing units increases. This implies a shift from the left of the demand curve to the right of the demand curve. The increase in demand for housing units coincides with a limited supply of housing units. The supply also takes too long to not only replenish, but also increase in the number of housing units. Due to the confluence of these factors, speculators delve into the housing market in order to make profits through the purchase and sale of housing units in the short-term. The entry of speculators into the housing market drives up the demand because of the increase buying of housing units.
However, the convergence of historically low interest rates and loosened standards of credit underwriting has served to bring borrowers into the housing market. In the case the credit underwriting standards are tightened and the interest rates are increased, this could cause a burst in the housing bubble. This paper looks at housing bubbles in relation to the Canadian housing market. This paper will ventilate on whether the Canadian housing market is experiencing a housing bubble. The paper will also delve into the methods that economists use when assessing he price overvaluation of houses.
- The Housing Bubble in Canada
As highlighted above, a housing bubble is predicted on an increase in the demand of housing units, causing speculation on the prices of housing units. Such speculation fuels the construction of housing units in order to meet the increasing demand. A housing bubble occurs when the demand stagnates or reduces due to an increase in interest rates of other financial factors, causing the prices of houses to nosedive. This is the criteria that the paper will utilize in determining whether Canada is experiencing a housing bubble. One of the indicators that Canada is experiencing a housing bubble is the securitization of loans.
In order to understand this viewpoint, it is essential to consider that the tightening of the standards of credit underwriting helps curtail sharp increases in demand of because many people are not able to acquire loans. In 2007, the Harper administration mandated the Canadian Mortgage and Housing Corporation to significantly alter its rules. Under these changes, the down payment requirements for loans were reduced to zero per cent. Additionally, the amortization period for the loans was extended to forty years. The mortgage meltdown of 2008 in the United States of America prompted the finance minister to moderate the amortization period and the down payment requirements in 2008.
This saw the down payment requirements increased to five per cent and the amortization period decreased to thirty five years. Even with these moderations the lending requirements are still loose. The implication of this is that virtually anyone with five per cent of the value of the house can apply for loans that are securitized by the government through the Canadian Mortgage and Housing Corporation. This move by the government resulted in increased borrowing in order to invest in real estate. For instance, in 2007, the amount in pools that were securitized under the National Housing Act amounted to 138 billion dollars.
These were outstanding and also guaranteed by the Canadian Mortgage and Housing Corporation. This amounted to 17.8% of the outstanding mortgages in Canada. In the next six months, this figure skyrocketed. More precisely, the amount of pool outstanding that were guaranteed by the Canadian Mortgage and Housing Corporation and securitized under the National Housing Act amounted to 290 billion dollars. The targets for the Canadian Mortgage and Housing Corporation were to guarantee 340 billion dollars by the end of 2009 and reach the 500 billion dollar mark by 2010. As a result of this increased lending, the total mortgage credit would increase be between twelve and fourteen percent of the gross domestic product in 2009.
Additionally, the Harper administration gave directives to the Canadian Mortgage and Housing Corporation to increase the approval of high-risk borrowers in 2008 in order to shore up the housing market. As a result, the approval rates for these loans increased to forty two percent in 2008 from thirty three percent in 2007. There was a resultant decrease in average equity as a proportion of the value of the home from 48% in 2003 to 6% in 2007. There is a concern for a housing bubble. Due to the Mortgage Purchase Program that is insured by the federal government, many banks were sourcing for capital to put into this program. The concern is that when the Bank of Canada decides to increase the interest rates, several of the mortgages under this program will be at risk.
The facts adduced above are consistent with the criteria discussed previously. The loosening of the standards of credit underwriting caused more people who would otherwise been unable to qualify for a loan to get approvals. This was also caused by the alterations that resulted in the reduction in the amortization period for loans and the down payment requirements for loans. These factors translated to an increase in the demand for housing units because credit was available. This is consistent with the criterion identified earlier for determining whether Canada is experiencing a housing bubble. This is more so the case because the increased availability of credit does not coincide with an increase in the income of the borrowers. As a result, many of these borrowers would be at risk of defaulting because of the increased carrying costs if the Bank of Canada were to increase the interest rates.
The other element highlighted as an indicator of a housing bubble is an increase in the supply of housing units. This is the result of speculation from the investors on the prices of housing units. This part of the paper will look at a case study of Toronto, a city in Canada and the influx of investments in the real estate market. The condominium market in Toronto is a good example of the Canadian housing bubble. The number of condominiums under construction in Toronto doubles the number of condominiums under construction in New York City. In order to put this to perspective, it is important to consider the fact that the population in New York City is three times that in Toronto city. This shows an oversupply in the housing market in Toronto.
This also coincides with the loosened standards for credit underwriting, increase securitization of mortgage loans, and the unprecedented approval of high risk loans by the Canadian Mortgage and Housing Corporation. The housing bubble may burst if the demand for the housing units stagnates or declines. This might be caused by an increase in the interest rates of the loans by the Bank of Canada. In fact, the Bank of Canada has decried the increasing household debt. The Canadian Mortgage and Housing Corporation securitized many home loans when the interest rates were low. This implies that the inevitable rise in interest rates will increase the carrying costs of these mortgages making them unaffordable.
The banks may not suffer significantly from the subsequent default rates because they did not assume significant risks. Most of the loans were securitized by the Canadian Mortgage and Housing Corporation. Nonetheless, there is a threat to the economy in the case of an increase in interest rate because of the high household debts. This is exemplified by the ratio of household debt versus disposable income in Canada which sits presently at 163%. This ratio indicates that for every dollar that Canadians earn, they owe 1.63 dollars. An increase in interest rates will plunge Canadians into more household debt meaning that they will owe more for every dollar they earn
A survey of some of the methods that are employed by economists will show that the housing prices in Canada are overvalued to a great extent. A report by the International Monetary Fund showed that despite the 11% correction of the house prices after the 2008 subprime mortgage crisis, house prices have doubled in the last ten years. Some territories in Canada have experienced unprecedented increases in house prices. For instance, British Columbia has experienced a 163% increase in house prices since the second quarter of the financial year ending 2001. After reducing by 10% after their peaks in the first quarter in the financial year ending 2009, prices of houses in British Columbia have increased by a further 41%. In Ontario, the increase from the fourth quarter of the financial year ending 2008 was by 29%. The International Monetary Fund also reports that the increase in the price of houses has outpaced the growth rate of rent and incomes. The result of this is a historically high price-to-rent ratio and price-to-income ratio.
In another report by the International Monetary Fund, the price-to-rent ratio in Canada was 60% more than the historic averages for the country. On the other hand, the price-to-income ratio for Canada was 40% more than the historic average for the country. Based on these statistics, the International Monetary Fund concluded that the housing prices in the country were overpriced by 10 to 15%. This is more than the fundamentals in the country can support. Additionally, the International Monetary Fund noted an increase investment in the construction industry, particularly housing projects. The residential investment in Canada had reached 7% of the gross domestic product, a figure that was the highest in the last twenty years. This is in line with the increased investment in condominiums in Toronto. The report also indicated there was an excess in the supply of houses in Quebec and Ontario.
- Fundamental Variables in Housing Prices
- Growth of income
One of the most significant fundamental variables in the prices of houses is income. This axiom has been used by economists as he basis upon which empirical and theoretical models of evaluating housing prices is based. The variable has also traditionally been included as an important determinant of equilibrium pricing models. The development of prices in the housing market is dependent on the income. Rising incomes means that people have more disposable incomes that can be spent in financing the purchase of houses. In terms of supply and demand, rising incomes result in an increase in the demand of housing units. An increase in the demand of houses results in an increase in the prices of housing units, especially when it coincides with a stagnating of declining supply of housing units. In this case, a growth in income leads to increased housing prices because of the resultant increase in demand. Often, the demand for housing has been described as income elastic.
This implies that a growth in the income levels fuels an increase in the demand of housing units because under this model, it is seen as a luxury good. The inverse is true where a decrease in income levels would result in a decrease in the demand for housing units. For instance, if there was a sustained increase in the rate of unemployment, would affect the income in a market. This would further affect the demand for housing units because of reduced disposable income, thereby affecting the prices of housing units negatively. This can be seen during an economic recession where people are not able to afford housing units because of waning incomes. Even through the interest rates may be reduced in order to encourage investment, the waning incomes means that prospective buyers may default on their mortgage payments. This can be a discouraging factor, an element that reduces he demand in housing units.
- Populations
Population is another fundamental factor that influences the development of housing prices. Various indicators of population have an influence on the increase or decrease in housing prices. For instance, population growth over time means that people will require more housing units. in an indirect way, population growth contributes to the increase in demand for houses. Of course this is tempered by other factors such as income and economic conditions. Another indicator of population that has an effect on the development of housing prices is population density. The emigration of people into a general, probably because of employment opportunities creates a localized demand for housing units in this general area. This would cause housing prices to increase in that particular area compared to other areas in the same territory. For instance, the emigration of people into the Greater Golden Horseshoe area because of favorable economic conditions precipitated the increase in the housing prices in this area.
Conclusion
A housing bubble is the convergence of many factors. The unprecedented increase in prices of house is caused by speculation on the prices of houses by investors, resulting in an increase in demand due to the short term buying and selling, something that results in an increase in the prices. Based on these criteria, Canada is experiencing a housing bubble. Literature has produced evidence to back these assertions. For instance, some of the methods that are used to evaluate the overpricing in the housing market show an increase in the housing prices in the Canadian market. The price-to-rent ratio in Canada was 60% more than the historic averages for the country. On the other hand, the price-to-income ratio for Canada was 40% more than the historic average for the country. This has translated to an increase in prices amounting to 163% in certain areas such as British Columbia.
The other element of thus criteria that indicates the presence of a housing bubble in Canada is the increase in the residential investment to 7% of the gross domestic product. This is particularly so in Toronto where the construction projects for condominiums are double the number in New York City, a city that has triple the population of Toronto. This increased investment in the residential housing sector has resulted in an oversupply of housing units in some areas. There is also the fact that the loosening of the standards for credit underwriting standards and the increase approval of high risk loans and the increase of the amortization period has increased the demand of housing units. An increase in the interest rates will result in a burst of the bubble because of the increase in the carrying costs of the mortgages.
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