The mortgage structure in the US and Canadian markets is different. While US consumers have locked in low-rate mortgages for longer, Canadian consumers seem to have made the opposite choice. Canadian households are also quite leveraged. However, both the US and Canada face similar challenges on the housing supply side. In our view, a search for a solution to these challenges should start outside the ambit of monetary policy.
Broadly, both the US and Canadian economies have shown impressive resilience in the face of the intense monetary tightening cycle of the past year. However, housing is the exception to this story of resilience. If the US housing sector suffered intensely during the Global Financial Crisis (GFC), vulnerabilities appear more significant in Canada today.
In our view, these vulnerabilities are related to two major challenges that the Canadian housing sector faces: one related to household balance sheets and the other to the mortgage loan structure.
With their mortgage debt service ratio recently hitting a new all-time high, Canadian households have set an unenviable record. Given that overall debt service ratios are hovering near record highs, the broader picture of household balance sheets also looks rather troubling (Figure 1).
These levels are high not only in relation to Canada’s own historical context but also to the larger global context. Among key developed market economies, only Australian consumers face a higher overall debt service burden. In other words, while most key development market households have undergone a substantial deleveraging process following the GFC, Canadian households have failed to follow suit (Figure 2).
Conditions are poised to deteriorate further—quickly and substantially—even though the Bank of Canada’s (BoC) tightening cycle looks to have ended (the policy rate has been steady at 5.0% since July). Unlike in the US where consumers can lock in fixed rate loans for 30 years, the longest tenure for fixed rate mortgages in Canada is five years.
Unfortunately, either due to a lack of financial acumen or due to misleading lending practices, Canadian consumers seem to be making the wrong borrowing choices. In early 2022, when the BoC was just starting to hike rates, a record share of new mortgages had variable rates instead of fixed rates. Yet, this would have been the ideal time to lock in low mortgage rates for as much as possible.
Fast forward to the second quarter of this year and the exact opposite picture emerges: almost a record low share of new mortgages has variable rates, meaning borrowers will be locked into the current high rates long after the BoC starts cutting. In short, in Canada, lenders have an upper hand in relation to borrowers (Figure 3).
Repayment challenges are likely to intensify even though consumers have the option of extending the duration of the loan in order to either keep the monthly payment constant or control its increase. Regardless, in certain situations the outgo will still increase since the fixed payments may fall short of surging interest service costs.
Canadian banks have good portfolio quality and strong underwriting standards, enabling them to withstand significant losses. However, the share of uninsured mortgages has risen to 80% today from about 60% in 2019 (mortgages with a downpayment of over 20% or those priced over C$1,000,000 do not need to be insured).
The average home price in September was C$753,900, and those mortgagees that choose to or have to be insured will end up paying a higher interest rate due to an additional insurance interest component. These factors make uninsured mortgages attractive, but the risk in the economy also increases in the aggregate.
In contrast, the current dynamics of the US mortgage market is a study in contrast. In fact, the fixed-rate, long-term nature of US mortgages is creating a different type of challenge as it is substantially blunting the impact of central bank tightening. For example, while the rate on a new 30-year fixed rate mortgage has recently neared 8.0%, the vast majority of mortgage holders have locked in far lower rates for longer (Figure 4).
Over time, the lower sub-4.0% average will drift higher but in a more contained fashion, thereby helping to mitigate potential risks in the US mortgage market.
Despite these differences, high interest rates and supply constraints pose some common challenges to both the markets. Normally, high interest rates would restrain demand enough to lower home prices, re-establish affordability as well as help reduce inflation. However, since both the US and Canada structurally suffer from insufficient housing supply, house prices have proven to be quite sticky in the current cycle.
In the US, because existing homeowners are locked into mortgages at low rates, they are highly disincentivized to sell, exacerbating the negative feedback loop on supply. On the other hand, in Canada, plans to boost immigration materially in coming years (to half a million by 2025 in a country with a population size of 40 million) is creating a source of housing demand entirely independent of interest rate conditions.
The resulting price rigidity is blunting the Fed Reserve’s and the Bank of Canada’s (BoC) efforts to fight inflation.
The housing challenge is reminiscent of the early days of the pandemic when there were comparable supply chain bottlenecks. But unlike those days, central banks may have their hands tied for now.
For one, central banks can do little to unfreeze the supply side of the economy, no matter how much the rates are cut. Likewise, despite continuing to raise rates, there is a limit as to how much a tight policy can do to destroy demand—after all, shelter is a necessity, not a luxury. Consumers may forgo eating out, but they still must eat. And they may forgo the nicest home, but they still need a place to live.
This necessitates us to search for a solution outside the ambit of monetary policy.
Pushing too hard on rate hikes alone would end up exacerbating financial stability challenges without addressing the underlying problem. In our view, a robust solution should consider government-driven intentional action to augment housing supply.
Carolyn Rogers, the BoC’s Senior Deputy Governor, appeared to agree, when she spoke about the “focus governments are putting on increasing housing supply” at the latest press conference.