A hodgepodge of factors contributed to the current state of Canadian real estate, which has seen an increasing number of affordability refugees fleeing from the hottest markets.

Bank of Nova Scotia vice president of economics Derek Holt stated that a combination of record-low interest rates and careless federal-level actions has led to unprecedented amounts of household debt and a price-growth juggernaut that now has the Liberal government “scrambling to undo it.”

“The rule shifts contributed, as did the long-term decline in rates both through global bond markets and Bank of Canada actions, among other factors,” Holt wrote in his report, as quoted by The Globe and Mail.

Holt added that any moderating effects of stricter federal and provincial policies have been offset by rock-bottom fixed and variable mortgage rates. The analyst further argued that B.C.’s 15 per cent tax on foreign buyers is emblematic of the simplistic approach that Canadian governments take in addressing the affordability crisis.

Such measures since 2008 “did not derail housing or mortgage markets,” Holt said. “Amidst endless fear mongering, tighter rules still gave way to record high household debt and house prices.”

“Much of that was because of the offset from lower interest rates, and here we are once again talking about the possibility that the Bank of Canada could cut rates and further feed market household imbalances assuming – as I do – that the mortgage book is still rate sensitive.”

One of Canada’s largest banks has opined on the impact the portfolio insurance changes will have on mortgage rates.

Starting November 30, lenders will only be allowed to purchase portfolio insurance for loans that cost less than $1 million, are owner occupied, have an amortization period no longer than 25 years, among other stipulations.

This could mean higher mortgage rates, according to TD Bank, which laid out three scenarios that could come to pass as a result of the rule change in its latest report, entitled New Mortgage Rules to Reinforce Soft Landing in Canadian Housing.

Lenders pass the higher cost of funds onto consumers in the form of higher mortgage rates. Under this scenario, mortgage interest rates could rise up to the full amount of 30 to 40 basis points.

Lenders absorb the higher cost of funds due to competition.

Lenders become more stringent on approval guidelines in order to continue to take advantage of the cost savings offered by portfolio insurance. As such, borrowers could potentially be held to a maximum amortization period of 25 years. 

Portfolio insurance helps lenders reduce the cost of raising capital and all monoline lenders utilize it to compete with the big banks.

And portfolio insurance is becoming more ubiquitous.

“Portfolio insurance accounted for 20% of all new mortgage insurance put in force with CMHC in the first half of 2015, but accounted for 40% during the second quarter of this year,” TD Bank said. “In particular, the increased use of portfolio insurance has helped alternative lenders offer competitive pricing on mortgages.”

The governor of the Bank of Canada spoke of the risk to the economy from the high level of household debts and the rising cost of homes when he announced a hold-steady on interest rates Wednesday.

Stephen Poloz said that the bank came close to making a further cut in interest rates but decided that additional stimulus was not required right now with other macroeconomic measures in play.

He referenced the federal government’s newly introduced rules on mortgages which he called a “welcome development” that should “mitigate financial vulnerabilities over time.”

The governor said that housing sales are expected to be reduced in the near term due to the new rules and that it may spur construction of smaller homes.

Although he did not rule out a further cut in interest rates down the line, especially as the bank’s outlook for the economy has been revised down for the coming two years; but he said that the balance of risk is still within the scope of current monetary policy.

It is no surprise to anyone that the Bank of Canada maintained its target overnight rate at 1/2 percent today, judging that the underlying trend in total CPI inflation will edge upward to 2 percent starting early next year. Temporary offsetting factors, such as the fall in commodity prices and the decline in the loonie are dissipating. Slack in the Canadian economy will continue to put downward pressure on inflation. The risks to the inflation outlook are deemed to be roughly balanced.

Consistent with private-sector economists’ expectations, the Bank is expecting a strong rebound the second half of this year as the negative effects of the oil production cuts and the wildfires conclude. Consumer spending in the second half will be boosted by the July introduction of the Child Benefit, government infrastructure spending and accommodative monetary and financial conditions. The non-resource sector in Canada is growing solidly, particularly in the service sector and business investment continues to underperform.

As widely expected, the Bank once again cut its growth forecast for the Canadian economy. The central bank has been repeatedly disappointed by the poor performance of Canadian exports, hoping that the decline in the Canadian dollar since oil prices plunged in mid-2014 would boost manufacturing exports. While recent export data are improving, the bank has revised down its growth expectation for exports in 2017 and 2018 owing to lower estimates of global demand and the “composition of US growth that appears less favourable to Canadian exports, and ongoing competitiveness challenges for Canadian firms.” The US economy is forecast to strengthen from a very weak first half reflecting strong consumer spending boosted by rising employment and strong consumer confidence. Business investment, however, will remain anemic, as evidenced not just in the US and Canada, but globally as well.

Growth this year in Canada was revised down to 1.1 percent (from 1.3 percent in July). As well, 2017 growth is now expected to be 2.0 percent (down from 2.2 percent). For 2018, the growth forecast remains at 2.1 percent. The Bank now believes the economy will reach full capacity utilization around mid-2018, significantly later than earlier expected.

 Housing Slowdown Highlighted

The Bank attributed the downward revision to the economic outlook in large measure to the federal government’s new initiatives “to promote stability in Canada’s housing market”. The Bank of Canada reported that these measures are “likely to restrain residential investment while dampening household vulnerabilities.”

According to today’s newly released Monetary Policy Report, the housing initiatives will dampen this year’s GDP growth by 10 basis points and by 30 basis points next year. Government sources say they expect the growth in housing resales to decline 8 percentage points in 2017 from the forecasted 6.0 percent growth pace this year. Private estimates of the negative impact of the new housing measures on overall economic growth vary, but most expect the contractionary effect to be roughly a 30-to-50 basis point reduction in growth over the next twelve months. Given that baseline potential growth is less than 2 percent, this is a very material dampener.

Many are speculating that the new federal housing initiatives open the door to BoC rate cuts next year. Clearly, Governor Poloz sees the enhanced mortgage stress tests as mitigating his concerns of overextended homebuyers–forcing all buyers to qualify at the posted mortgage rate, well above current contract rates. Nevertheless, I believe it would take a material negative shock to growth for the Bank to cut rates. That shock might come  from a larger-than-expected contraction in housing activity among other sources.

The finance minister of Canada’s priciest province for real estate expects new regulations will cool housing appreciation in Vancouver, where there’s already been a marked decline in sales and foreign investment.

“We’ll see a slowdown in the rate at which the value of housing goes up; we may see a modest correction,” British Columbia Finance Minister Michael de Jong saidMonday on Bloomberg TV Canada. “I think it will occur in a managed and orderly way.”

The federal government introduced new rules this month aimed at moderating housing in Toronto and Vancouver, where prices have doubled in the past decade. The moves include a new stress test for buyers and closing a tax loophole used by some offshore buyers. De Jong announced a foreign buyer levy in July, and in September the city of Vancouver said it’s planning a tax on vacant properties starting in January.

Vancouver home sales slipped in August and September, the first two months of data since the 15 percent land transfer tax on offshore buyers came into effect.

Still Rising

Although home sales in the province’s largest city fell 33 percent in September, the most since 2010, prices continued to rise compared with the prior year. The benchmark price of a home, a measure used by the local real estate board, is now C$931,900 ($710,000), up 29 percent from a year earlier.

Foreign investment made up 12 percent of the C$20.6 billion in home transactions in Vancouver from June 10 to Aug. 31, but plunged to less than 1 percent following the tax’s implementation, the British Columbia Ministry of Finance said last month.

The minister said Monday high housing prices are also caused by local demand and a dearth of supply in the city bordered by water and mountains. Applications to build 120,000 housing units are currently before the city seeking approval, he said.

“There’s another part to this equation that we can’t forget and that is supply of building housing,” de Jong said. “That’s something that the private sector has a big role to play and governments need to facilitate at all levels.”

“Let’s not delude ourselves into thinking that the answer to this lies purely within the maneuvering or manipulation of taxation levers,” he said in a separate interview in Bloomberg’s Toronto office.

The new rules will cool the markets in Toronto and Vancouver and improve credit quality, according to the agency.

“Fitch believes that the new measures may temper the housing market, especially in cities that are significantly overvalued,” Fitch said in a report, released Wednesday. “According to a Fitch study published earlier this year, home prices across Canada are estimated to be about 25% above their sustainable value with major regional variations.”

Fitch is supportive of the income tax rule change, which targets foreign owners of real estate.

Under those guidelines, foreign owners are no longer able to take advantage of capitals gains tax exemptions.

“The income tax rule change in particular should reduce housing demand from foreigners. In Vancouver, this will reinforce the effects of the 15% tax on foreign home purchases put in place by the British Columbia government in August,” Fitch said. “Data from the Real Estate Board of Greater Vancouver indicate that average sale prices of detached houses have already dropped by roughly 16%, led by higher priced properties.”

The agency also argued the new guidelines for insured mortgage portfolios could impact non-insured underwriting.

“While insured mortgage loans are prohibited from securing this subsector of the covered bond market, changes to insured mortgage loan underwriting requirements could influence non-insured mortgage loan underwriting requirements. Any tightening of non-insured mortgage loan underwriting requirements would further help to cool the housing market and also help to address the concern of heightened borrower leverage.

While economists are in agreement that federal-level steps such as Finance Minister Bill Morneau’s announcement of new mortgage measures last week are needed to address the affordability situation in the country’s hottest markets, the jury is still out on whether the current approach is too stringent or too timid.

“[Last week’s announcement] is the sixth time in eight years that the government has implemented stricter mortgage regulation, with activity declining 6 per cent on average in the four quarters subsequent to their implementation,” Toronto-Dominion Bank economist Diana Petramala told The Globe and Mail.

“The rules … could take a bigger bite out of activity next year given their breadth and the fact that they are being introduced at a time when many markets have become increasingly sensitive to any shocks.”

Capital Economics analyst (North America) Paul Ashworth warned that the effects of the new rules, which would mandate borrowers to qualify for the posted 5-year bank rate in mortgage insurance, would be far-reaching.

“The much more likely scenario is that the latest tightening of mortgage rules, announced last week, will trigger an even deeper slump in home sales, which will eventually lead to a sharp decline in prices,” Ashworth said.

“[It] could be very bad for the housing market. It is possible that lenders will simply decide to forego mortgage securitization and use their own balance sheets to continue offering ridiculously low interest rates and long amortization periods on what would then be uninsured mortgages,” he added.

Meanwhile, Emanuella Enenajor of Bank of America Merrill Lynch argued that the new measures miss the point as “aggressive lending” is not the problem right now, with earlier regulatory changes having taken care of less-than-optimal borrowers already.

“It’s still too early to tell how impactful these rules will be on housing activity, but for now, we see only a temporary, modest slowing of the housing sector for a few reasons,” Enenajor stated.

The revisions to mortgage rules announced last week would have better served the Canadian housing sector by being implemented in small stages, not as a sudden regulatory upheaval.

B.C. Real Estate Association chief economist Cameron Muir noted that the new measures introduced by Finance Minister Bill Morneau last week would—instead of cooling the markets as intended—drive off would-be buyers and slow down construction, CBC News reported.

“Introducing these measures as a single measure, a one-time shock to the economy, doesn’t seem to help affordability,” Muir cautioned.

The economist added that the mortgage market’s dynamism would be hit hard as potential buyers would be forced to stay in their current residences. Supply would thus be scarce by the time millennials have saved up enough to offset the larger down payments.

The prediction echoed that of Addenda Capital Inc. co-chief investment officer Jean-Francois Pepin, who warned last week that contrary to the expectations of lowered home prices as a result of the new rules, mortgage origination itself might be cooled down by the regulatory changes.

“If it slows down the housing market, it’s going to slow down the quantity of mortgages that will end up being on banks’ books, which means there’s a smaller pool that’s available to be securitized,” Pepin said in an interview.

The stricter rules—which would take effect on October 17—would mandate a more stringent “stress test” for first-time buyers who have CMHC-insured mortgages, evaluating their ability to repay under the big banks’ posted five-year rate.

The new federal rules governing Canadian mortgage will hit millennials’ home buying plans the hardest, according to the B.C. Real Estate Association (BCREA).

With the regulatory changes coming into effect on October 17, the BCREA warned that most young professionals and starting families will face greater challenges in getting their homes as they can lose fully 20 per cent of their purchasing power, HuffPost Business Canada reported.

BCREA outline a hypothetical scenario with a household that earns $80,000. Under the current rules, the family can purchase a home worth $505,000 home with a down payment of 5 per cent.

However, the stricter rules will force the household to settle for a residential property valued at $405,000 at most, as the regulatory changes mandate all insured mortgages with less than 20 per cent down payment to qualify at a higher rate bracket.

And while the new regulations might be able to reduce the economic risks that Canada faces in the event of a downturn or an interest rate hike, economist Brendon Ogmundson argued that the country’s real estate segment should brace itself for significant shockwaves (especially price pressures) in the near future.

“I think that the downside risk to tightening credit like this, at least in the next 12 to 18 months, is sharper, lower demand, potentially lower prices, as well as a decline in construction activity,” Ogmundson said.

Introduced by Finance Minister Bill Morneau last week, the tightened rules also included provisions for a new risk-sharing model that will compel banks to assume greater costs—which in turn can trickle down to consumers, according to market observers.

“[The new rules] would require mortgage lenders to manage a portion of loan losses on insured mortgages that default, rather than transferring virtually all the risk onto the taxpayer via the government guarantee for mortgage insurers,” Morneau told reporters on October 3.

It may be the most overlooked aspect of the Ministry of Finance’s most recent rule change announcement, but one economist who expects banks will soon shoulder more mortgage risk believes it will have a major impact on consumers.

“I believe that the ultimate proposal for lenders to take on the burden of more risk could … have a far reaching impact; this is something that CMHC proposed a number of months ago, almost a year ago, and it does appear that it’s going to happen,” Dr. Sherry Cooper, chief economist with Dominion Lending Centres, told MortgageBrokerNews.ca. “And it means the banks will probably have to cover 5-10% of the potential loss in their mortgage book.

“The risk of their mortgage book moves up, that means they have to hold more capital against their mortgage lending which makes the cost of capital more expensive and you better believe they’re going to try to pass that off to the consumer.”

In addition to its recent changes to mortgage insurance rules, the Department announced a consultation process that could lead to lender risk sharing. As it stands, banks don’t have any skin in the game.

“Today, the Government announced that it would launch a public consultation process this fall to seek information and feedback on how modifying the distribution of risk in the housing finance framework by introducing a modest level of lender risk sharing for government-backed insured mortgages could enhance the current system,” the Department of Finance said in its technical briefing of the changes. “Canada’s system of 100 per cent government-backed mortgage default insurance is unique compared to approaches in other countries.

“A lender risk sharing policy would aim to rebalance risk in the housing finance system so that lenders retain a meaningful, but manageable, level of exposure to mortgage default risk.”

The Globe and Mail reported Thursday that while banks have claimed publicly there is no need for risk sharing, bank executives have privately expressed support for the potential measure.

“Philosophically, people aren’t all that fussed,” one executive told the Globe.