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Another Move to Deflate Canada’s Housing Bubble

Canada’s housing bubble was the biggest threat to the nation’s banks this year. The fear of crashing home prices after a decade-long boom has kept investors nervous; they’ve waited on the sidelines as the Toronto market went through a severe correction this spring.

Now that we are well in the middle of fall, there are no signs of widespread pain, distressed sales, or mortgage defaults, even after a 20% price correction and more than 30% plunge in sales in Toronto, Canada’s largest city.

And if you look at the share prices of Big Five banks, you will see that they have begun to rebound. Their share prices are up between 4-8% during the past one month.

Despite this relief rally, some analysts feel Canada’s housing market is not out of the woods yet.

According to Steve Eisman, a fund manager at Neuberger Berman Group LLC who was featured in Michael Lewis’s book The Big Short, Canada’s housing market is “ripe for a pretty severe correction.”

The reason of his pessimism about the Canadian housing market is a new set of mortgage regulations which the banking regulator is enforcing in January 2018.

As I pointed out in my recent article, these new rules will significantly reduce the demand for new mortgages, as the banks will be required to stress test home buyers with mortgage rates two percentage points higher than they negotiated with their lender.

In simple language, your mortgage will be approved if your income justifies payback ability for the mortgage rate at 5%, for example, against the 3% rate you are actually being charged. The change is designed to ensure lenders don’t face high levels of loan defaults from uninsured borrowers if interest rates rise.

Another change is about prohibiting co-lending or mortgage “bundling” arrangements that appear designed to circumvent regulatory requirements.

The co-lending prohibition, if adopted, is expected to have the greatest impact on mortgage companies, like alternative lender Home Capital Group Inc (TSX:HCG), which primarily provides loans to people who don’t qualify for funding from the big banks.

Mr. Eisman, in a Bloomberg interview, said these changes will have a negative effect on mortgage volume next year, which will translate into lower prices.

“Canada is not going to crash, but it hasn’t had a credit cycle in 25 years. I think they’re about to have one,” he warned in that interview.

Should you be worried?

I think the government is intervening too heavily in the housing market at a time when home prices have already corrected, and sales activity is considerably down after Ontario’s spring measures, which included a 15% tax on foreigners buying home in Ontario.

Broadening the stress test will likely further slow housing activity, depressing demand by 5-10% once these rules are implemented, according to Brian DePratto, an economist at Toronto-Dominion Bank. Price growth will also suffer, with the changes expected to exert a drag of between 2% and 4% over 2018.

The bottom line

If that scenario plays out the way many analysts are expecting, then I see some non-bank financial institutions, such as Home Capital Group and First National Financial Corp. (TSX:FN) taking some of the hit from a slowing housing activity in 2018.

The reason is that these alternative lenders mostly cater to uninsured borrowers who are unable to get qualified from normal banks.

Canadian Imperial Bank of Commerce (TSX:CM)(NYSE:CM) stock, which was the hardest hit among the top Canadian banks due to its higher exposure to the overheated housing market, may continue to lag in this rally for financials.

But despite this negative move for the housing market, I don’t see Canadian real estate prices collapsing. Strong population growth, shortage of housing supply, and immigrant inflows are some of the growth drivers that will continue to support the housing market activity.

Any weakness in the banking stocks should be taken as an opportunity to add to your positions.

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Fool contributor Haris Anwar has no position in any stocks mentioned.

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