Hurricane Harvey's lesson for Canadian real estate: Don Pittis

This week, HurricaneHarvey offeredanother little lesson in market forces. It'sa lessonthat helps us think about Canadian real estate.

Market theory tells us that peoplewho wanted to protect their property from the hurricanes and floods that plague the Gulf Coast should have had insurance.

The fact is, only about 20 per cent in the Houston area did, says Robert Hunter, an insurance expert with a U.S. consumer research group.

"All these people taken out in boats, they have a second problem: They have no insurance," he said.

Financial risk-taking

Market theory also tells us that, like Texas homeowners, Canadians buying into the current housing market understand the risks they are taking.

If interest rates rise, they know they will have to find more cash to pay their monthly mortgage payments. The alternative isthey will lose their homes.

The example from Hurricane Harvey demonstrates the difficult choice forthe Office of the Superintendent of Financial Institutions, or OSFI,the Canadian regulator that has taken the lead in trying to take the froth out of Canada's housing market.

Public statements from Canada's biggest banks show they have come around to the idea that a market free-for-all may be dangerous for already overheated housing. Bank of Montreal chief economist Doug Porter has announced that Toronto was a bubble, and we've popped it.

OSFIisn't so sure. It hasfloated additional rule changesthat could go into effect later this year.

This week, a report from TD Economics chief economist Beata Carancigives a qualified stamp ofapproval to OSFIattempts to cool the market.

TD: Soft landing

As the title of the report, Navigating a Soft Landing, implies, TD expects the increasing layers of rules imposed by various levels of governmentto calm but not crash the market.

Not everyone in the Canadian real estate industry has been so accepting.

As CBC reported last month,some in the property business, includingGrant Thomas, founder and partner with The Mortgage Group, would be happy for the government to butt out.

"The government has been intrusive in our industry in the last three years, and they continue to be so at a rate that is probably unnecessary,"he said. "I'm not overjoyed whenever the government involves itself in business."

For OSFI, the problem appears to be that parts of the industry, anxious to keep the boom alive, areworking theirway around the regulator's first attempt to discipline the market.

Under the initial rulesthat kicked in last October, anyone who wanted to borrow more than 80 per cent of the purchase price of a home in other words, those with a down payment of less than 20 per cent would have to prove they could afford an increase in borrowing costs of two percentage points, a so-called stress test.

Those people, with what's called a highratio mortgage, must also buy mortgage insurance that protects their lender if the borrowerdefaults.

But there was more evidence this week that the first stress test is not working. A report from the Canada Mortgage and Housing Corporation out yesterday showsthe number of insured mortgages is declining following the rule changes in October.

Perhaps people with low down payments are putting off buying a house, but there are signs something else is happening.

Rather than paying the mortgage insurance and submitting to the stress test, some borrowers are topping up their down payments with loans fromunregulated lenders.

Such lendersinclude mortgage investment corporationsthat have traditionally offered second mortgages. Or they can be the bank of mom and dad.

That's why OSFInow wants to restrict official deals between regulated and unregulated lenders, called "bundling." The regulatoralso wants to apply the twoper cent stress test to borrowers who ostensibly have more than a 20 per cent down payment.

In Houstonit appears manyhomeowners were willing to take a risk on losing everything rather than buy expensive insurance. In Canada, the pressure to buy a dream home in an overheated market means some buyers are willing to squeeze every penny out of their finances without leaving a pad to protect themselves fromrising rates.

• Most Harvey flood victims uninsured, face big bills alone
• Could you handle a 2% mortgage rate hike? New rules coming

It may be that interest rates will never rise. Before Harvey, perhaps it was reasonable for homeowners to assume Houston would never flood. Now there are fears houses will be abandoned andparts of Houston will never recover.

In the Canadian case, a continued property boom followed by a sharp fall as pinched homeowners run for the exit could crack Canada's economic recovery.

The freemarket analysis would saythey take the risk, they pay the price. But when disaster strikes, it'snot just the individuals who take the risk that suffer.

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