A Brewing Canadian Crisis, and What Americans Learned About Bubbles

The Canadian housing market looks awfully like America’s before the crash. Here’s what we learned.

| More on:
The Motley Fool

Americans don’t like admitting failure. But after the 2008 global recession, something became unavoidably clear: The Canadian economy fared better than the United States.

Your banking system didn’t crumble like ours. Your unemployment rate didn’t rise as much as ours. Your budget deficit didn’t balloon like ours. When the headline, “For the First Time, Canadians Are Richer Than Americans,” appeared last summer, we cringed. Americans did something wrong. Canadians did something right.

But what?

In short, Canada avoided a housing bust. History makes clear that as goes housing, so goes the overall economy. And as American home prices took a bath from 2007 to 2012, Canada’s housing market marched higher. This alone explains most of why America suffered while Canada prospered.

But things are starting to turn.

American home prices are growing again. Canadian home prices are beginning to dip. A new theory is emerging: Canada didn’t avoid a housing bust. It’s just late to the party. As Robert Shiller, the brilliant Yale economist who predicted America’s housing bubble, put it: “I worry that what is happening in Canada is kind of a slow-motion version of what happened in the U.S.”

A reckoning by the numbers

Investor Marty Whitman once said that “Rarely do more than three or four variables really count. Everything else is noise.”

One variable that “really counts” in real estate is home prices in relation to average incomes. People have to pay for their homes over time, and that money has to come from income. While the short run is dominated by changes in interest rates and supply, there is little historical precedent for home prices growing faster than incomes over time.

Measure average home prices against average incomes, and you get this:


During America’s bubble, we made all kinds of excuses for home prices growing faster than incomes. We said housing was special. We said mortgage rates would stay low.  We said we could always sell our home to someone else. And we were wrong about all three. By 2010 the price-to-income ratio of American homes plunged back to historic average levels, where the humble laws of financial arithmetic said they belonged.

Another useful metric is home prices measured against average rents. It shows more of the same:


Americans once tried to justify home prices rising faster than rents. We said there was pride in owning a home. We said renting was throwing your money away. We said owning a home provided freedom. But we ignored that rents are to homes what earnings are to stocks — a symbol of valuation that, over time, act as an anchor on prices. The price-to-rent ratio in Canada has risen by 70% since 2000. One Canadian commenter told a personal story at The Daily Beast recently: “Buyers in Toronto are paying $1,958 a month to buy a place they could rent for $1,104.” That is neither sustainable nor rational over time.

Canada, you have a problem.

Economists at TD Economics forecast a decade of flat Canadian real estate prices after inflation. Others predict a plunge of up to 25%. Moody’s is contemplating a 44% crash.

Could they be wrong? Of course. There are a few arguments for why Canadian home prices won’t crash like America’s. None, however, are watertight.

Canada has more sensible rules regarding a borrower’s ability to walk away from a home even when they can afford the mortgage — although some say that law actually helped America’s housing bust end sooner. Chinese investors have provided outside demand to Canadian markets. But that may be just as big a bubble. Canada’s banking and mortgage system is often seen as more resilient than America’s was last decade. But that’s now being questioned, too. Morningstar analyst Dan Werner recently showed that the loan-to-value ratio in the Canadian market is similar American circa 2007. He wrote:

If 20% of the uninsured underwater residential loans are losses, the impact on tangible capital levels becomes meaningful with a 30%-40% reduction in pricing. In a worst-case scenario, if all of the uninsured loans were losses and residential prices fell 30%, we think nearly half of most banks’ tangible equity would be affected.

Werner singled out National Bank of Canada (TSX:NA) and CIBC (TSX:CIBC) as particularly vulnerable, according to CNBC’s John Carney. Toronto-Dominion Bank (TSX:TD) and Bank of Montreal (TSX:BMO) appear the strongest. But America learned that picking winners and losers is a tough game before a crash takes hold. “It’s only when the tide goes out that you learn who’s been swimming naked” Warren Buffett says.

What now?

We can’t predict when slowly falling home prices might turn into a crash. But let me share a few lessons America learned from our housing bust.

1. Housing markets are regional. Attitudes toward housing aren’t.

Canadian market watchers often say a housing bust will be contained to a few regional markets. Vancouver and Toronto come up most often.

Americans had faith in a similar theory. In 2005, Federal Reserve chairman Alan Greenspan said that while “we don’t perceive that there is a national bubble … it’s hard not to see that there are a lot of local bubbles.”

We learned the hard way that he was wrong, because the theory is wrong. The worst of America’s housing bubble was concentrated in a few cities — Las Vegas, Miami, Sacramento, Phoenix — and they were hit the hardest when the bubble burst. But the crash changed the way all Americans thought about housing. Home prices lost value from coast to coast once Americans realized that a home isn’t a safe investment, but just a place to live and a potential liability. It was a paradigm shift in attitudes across the country.

2. Pain in the housing market spreads quickly.

A home is most people’s largest asset, and it’s usually leveraged. A small decline can be devastating on household wealth. Rebuilding that lost wealth after a housing crash takes time, and the increased saving diverts spending that would have otherwise gone toward going out to the movies, buying a new car, or taking a vacation. A housing bust is almost never contained to the housing market. It affects the entire economy.

3. There is never one cockroach in the kitchen.

We originally called our housing problems the “subprime crisis” because we thought the whole problem was centered on low-quality mortgages. We were wrong. As the tide went out we learned that Americans were addicted to all forms of debt — credit cards, auto loans, and anything else we could finance.

Canada appears to be in a similar situation. Debt among Canadian households as a share of disposable income is now at a similar level that prevailed in America in 2007, and double the level seen in the 1980s. A good portion of that debt is consumer credit, not just mortgages. It’s not so much the housing bubble but the debt bubble in general that poses a risk.

It gets better

The most important lesson America learned from our housing crash is: This too will pass. And then it gets better. Our housing burst caused Americans to live within their means again. It forced us to think more rationally about our future. For those prepared with gumption and a level head, it was an outstanding time to be an investor, as panic caused a once-in-a-lifetime buying opportunity. Warren Buffett says the key to investing success is to “be greedy when others are fearful, and fearful when others are greedy.” Many investors who know that saying miss the subtle lesson: When things look the scariest is when the future is actually the brightest.

America endured. So will Canada.

Heads-up, Canadian investors: The U.S. stock markets are home to some of the best businesses in the world. The Motley Fool Canada has created a new (free) special report identifying three U.S. companies that are worthy of your hard-earned investment dollars. Simply click here to download your (again, free) copy right now.

The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.

Follow us on Twitter and Facebook for the latest in Foolish investing.

This post was authored by Fool.com contributor Morgan Housel.

Fool contributor Morgan Housel does not own shares of any companies mentioned.  The Motley Fool has no positions in the stocks mentioned above.


This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

More on Investing

Woman has an idea

3 Things About goeasy Stock Every Smart Investor Knows

Here are three things about goeasy stock that every smart investor knows or needs to know.

Read more »

Target. Stand out from the crowd
Dividend Stocks

1 Dividend Stock Down 30% to Buy Right Now

Keyera is an energy infrastructure company that pays shareholders a forward yield of almost 6%. Is KEY stock a good…

Read more »

oil and natural gas
Dividend Stocks

Suncor Stock Is Rallying: Should You Invest?

Energy stocks like Suncor Energy Inc (TSX:SU) are rising with oil pries.

Read more »

A stock price graph showing growth over time

3 Growth Stocks That Could More Than Double Their Revenue by 2025

Three outperforming stocks with rising revenues are profitable options for growth investors.

Read more »

tsx today
Stock Market

TSX Today: What to Watch for in Stocks on Monday, April 15

TSX investors may want to remain cautious, as any major update related to the ongoing Iran-Israel conflict could increase market…

Read more »

A worker gives a business presentation.
Dividend Stocks

TSX Communications in April 2024: The Best Stocks to Buy Right Now

Here are two of the best TSX communication stocks you can buy in April 2024 and hold for years to…

Read more »

Man holding magnifying glass over a document
Tech Stocks

Watching This 1 Key Metric Could Help You Beat the Stock Market

One key metric that Buffett looks at is the return on equity. Here's why you should watch it.

Read more »

Man considering whether to sell or buy
Dividend Stocks

Royal Bank of Canada Stock: Buy, Sell, or Hold?

Royal Bank of Canada (TSX:RY) has a high dividend yield. Should you buy it?

Read more »