Mortgage Watch

The shock was how quickly the tables turned.

House prices across Canada have dropped 11 per cent since hitting a peak of $316,896 in May 2008, down to $280,880 in November, according to latest figures from the Canadian Real Estate Association.

The drop is weighed heavily by cities such as Vancouver, Canada's most expensive housing market, where prices have also fallen almost 13 per cent since May.

Across Canada, prices have dropped 10 per cent since November 2007, when the average home cost $311,485. Sales slipped 42 per cent year-over-year.

With consumer confidence at 25-year lows and the economy in recession, potential home buyers are staying on the sidelines until prospects brighten. Banks are also more reluctant to lend money to finance home purchases in markets where prices have been falling.

"It was back to reality in 2008, " said CIBC World Markets economist Benjamin Tal.

"The realization was that house prices can fall, and will fall."

Tal said we moved from a seller's market to a buyer's market "in a matter of months."

"This was a transitional year. A reflection of not a subprime-type meltdown, not of a bubble, but rather of recessionary conditions," said Tal.

The puncturing of the real estate bubble in 2008 has happened before. In the early 1990s, property values fell between 10 per cent and 20 per cent in many Canadian markets. In the 1980-81 recession, interest rates of more than 20 per cent in Canada squeezed inflation out of the economy but also caused thousands of homeowners to lose their houses because they couldn't afford their new payments when they refinanced their mortgages.

In both cases, recessions were followed by a runup in house prices when economic recovery came.

Tal expects national house prices to drop about 10 per cent in the next 12 months as the recession deepens in Canada. He said prices will drop the most in Western Canada, because that is where they had the biggest run up in the housing boom, which has lasted nearly a decade.

"The decline is going to be significant, but it's not going to be a freefall," Tal said.

"The U.S., minus subprime, equals Canada."

Canada's falling housing market is often compared to the United States, where prices nationally have fallen by 20 per cent since their peak in mid-2006, and up to 40 per cent in some cities.

The market crashed as a result of a risky and reckless mortgage practices, which led to billions of dollars in defaults, and turn caused millions of Americans to lose their homes. A second wave of those mortgage renewals is expected to hit in 2009, causing prices to fall further and defaults to rise.

While many real estate experts say Canada does not have the same problem with risky lending practices, Merrill Lynch Canada economist David Wolf maintains Canada is following the same path as the U.S., but with a two-year lag.

He said while Canadian mortgage defaults might seem low at 0.29 per cent of about 3.9 million mortgages as of September, it's a 17 per cent year-over-year increase. It's also larger than the 0.18 per cent of mortgage defaults in Canada in 1990, "right around the peak in house prices and just after the cyclical trough in unemployment."

He also cited a Bank of Canada study released a year ago that said mortgage default rates would rise to 2.25 per cent under a "very extreme" scenario of a 23 per cent aggregate drop in house prices.

"In sum, the relatively low level of mortgage arrears in Canada is of no comfort to us," said Wolf, who in recent reports has turned bearish on the Canadian housing market.

Gregory Klump, chief economist at the Canadian Real Estate Association, said he has been struck by how quickly sales have dropped in Canada in recent months, noting that 2007 was the strongest sales year on record.

He said many buyers are nervous about the current economy, but he is also seeing the impact of "very cautious" lenders.

Klump said he is hearing more stories than ever before of people with pre-approved mortgages that don't get the money from the bank when it comes time to try and close the deal.

"The last time I heard about such things happening ... would have been at the last housing recession," Klump said.

The Bank of Canada warned recently that, in a worse-case scenario, mortgage and consumer debt defaults could rise "significantly" if the global financial crisis deteriorates. It said the number of "vulnerable households" - the three per cent with a debt-to-income ratio above 40 per cent - could double by the end of next year.

The Canadian Association of Accredited Mortgage Professionals predicts mortgage approval activity to fall nearly 12 per cent to $193 billion in 2008, compared to $218 billion in 2007. Approvals are forecast to fall another 10 per cent to $174 billion in 2009 and another 1.6 per cent in 2010 to $171 billion. That follows a growth rate of about 11.5 per cent annually for the three years ended August 2008.

Scotiabank economist Adrienne Warren said she too expects the housing market in Canada to soften next year, particularly in the next six months as the recession creates higher unemployment.

"I think it's the type of environment where we won't see a lot of activity from buyers or sellers," said Warren.

She said the housing boom had to end eventually, after lasting more than a decade. The normal cycle is usually about six or seven years, she said.

Warren said she doesn't anticipate another boom once the market recovers, which she predicts will be in the last half of 2009.

"Partly as a consequence of financial instability, next year will be a trying one for many Canadians," he said in a speech. "While the Canadian household sector remains relatively healthy, its resilience will be tested during the recession."

But Carney said measures taken in Canada and around the world were working their way through the system and would pull the economy out of the "full-blown financial crisis" it is in.

"Policy-makers have had to respond with bold measures. These will work, although it will take time for confidence to return and for capital to flow once again."

The focus on the Canadian central bank was sharper on Wednesday after the U.S. Federal Reserve lowered its benchmark rate to near zero on Tuesday.

The Bank of Canada has obviously studied nonconventional measures other than rate cuts, Carney said. The bank's overnight target rate is at 1.50 percent so it still has a little room left for cuts.

"We continue to do contingency plans at the bank," he told a business audience in Toronto. "We're very up to speed on scenarios ... but it's premature to talk about that."

Carney dished out implicit criticism of media coverage last week of a Bank of Canada report on the possibility of problems in the mortgage and household sectors.

He referred to one scenario the bank had examined in which nominal household income would fall by 2 percent a year for six quarters and Canada's banks would incur significant losses.

"However, it is important not to overplay this scenario, since it actually illustrates the strength of our system," he said.

Carney said annual growth in nominal income had never been negative during any quarter for at least 37 years, and Canada's banks would still have strong capital ratios.

"There are a number of reasons why the risk posed by household balance sheets is significantly lower in Canada than elsewhere, not the least of which is Canada's more conservative lending culture," he said.

Subprime mortgages account for less than 5 percent of mortgage lending, one third the U.S. level. And because Canada requires insurance on mortgages with small downpayments and Canada Mortgage Bonds carry a sovereign guarantee, there has been no negative feedback loop between the housing market and the financial sector, he said.

Though households' debt-to-income ratio was at a record 140 percent, the debt-service ratio had declined to below the historical average because of lower borrowing costs, and this gives "a measure of assurance that most households can comfortably manage their debts," Carney said.

Still, the bank will closely monitor the risk posed by household balance sheets and consider the possibility that some may be more sensitive to shocks to their income or wealth.

He said Canadian banks are in such a good position that they can expand lending faster than their international peers. Asked by a member of the audience if the Bank of Canada might take equity stakes in chartered banks -- as in the United States -- he said there was "no interest".

Credit conditions in Canada continue to be difficult at the moment, he said, but he added that "credit, on an aggregate level, is still growing" and that "our banks are well-capitalized."

Canadian homeowners are green with envy over the fact our neighbours to the south are allowed to deduct the interest paid on their mortgages from their taxes. Is it possible to do the same thing here?

I received an elegant little flyer in my mailbox the other day. It was a small glossy fold-over, and it had a quality look and feel to it. The only text on the front flap of the flyer asked me a provocative question: "Is your mortgage tax deductible?" The inside of the flyer told me that I could learn how to collect tax refunds from my mortgage. "Canadian homeowners are entitled to collect Tax Refunds from their mortgage payments under Canada Revenue Agency (CRA) guidelines for 'Cash Damming'.

By following CRA's specific guidelines for borrowing and investing, you will claim thousands of dollars in Tax Refunds every year from your mortgage loan." The small flyer mentioned "Tax Refund" five more times, and twice pointed out that I could use my Tax Refund to pay off my mortgage faster. That's pretty exciting,

The biggest single expense of many Canadian families is their mortgage payment, and we've all been making those mortgage payments with after-tax dollars. Many a Canadian has looked across the border in envy at the tax deductibility that Americans enjoy on their home mortgage interest. If it turns out that we can be getting Tax Refunds from our mortgage payments too, well, that's just a no-brainer.

As it happens, I am quite familiar with this topic and strategy, so I can spare you the inconvenience of having to leave the comfort of your home to discover how this works. In fact, I'm going to provide you with all the essential information that you really must know about Canadian mortgage deductibility and Tax Refunds, all in the very next paragraph! How can I possibly do that? By using an enhanced information conveyance technology I like to call No Baloney™.

Ready? Here's what you really need to know about Canadian mortgage deductibility and Tax Refunds: In Canada, when you borrow money to buy your home, you can't deduct the interest. When you borrow money to make certain investments, you may be able to deduct the interest. There. Now that we've covered all the really important stuff, let's review some of the details. First of all, nothing about buying your personal residence is tax-deductible. You don't get to deduct your mortgage interest, there are no special tricks that have escaped your notice, and you will not be getting "Tax Refunds" from your mortgage payments. Period.

That being said, when you borrow money to make investments which have a reasonable expectation of income, you may be able to deduct the interest on the debt. So if you use your home as collateral when you borrow money to invest, you may be able to deduct that interest expense from your income taxes. You could, therefore, have a mortgage with interest that is partially or entirely tax deductible.

However, it's very important to remember two things: (1) No matter how you twist it, turn it, or wordsmith-manoeuvre-it, the money you borrow to buy your principal residence is not tax-deductible; (2) The only way the interest on your home mortgage can be tax-deductible is if you borrow against the equity you already own in your home, and use that money to investment.

The reason it's so very important to be clear about this issue is that borrowing to buy a home is something that most people must do in order to buy a home, and as long as they can afford their mortgage payment, they're psychologically comfortable doing so. They generally don't worry that their money is at risk. In fact, they feel a sense of security about the equity they are building as they pay the mortgage down. Borrowing to invest, on the other hand, is not something that anyone needs to do, and most people are not psychologically comfortable with it. In order for borrowing to invest to make sense, the average long-term, after-tax return on the underlying investment has to be higher than the after-tax interest rate on the loan.

That invariably means taking on investment risk. And for most people, tolerating investment risk is already sufficiently challenging without the added stress of knowing that those investments were made with borrowed money. Think about the recent gyrations in the stock markets, and consider how using leverage might change your emotional response to the hysteria. Don't get me wrong - I'm not picking on leverage as a concept. Using "other people's money" is an age-old investment strategy, it absolutely has its place as a financial planning strategy, and I've used it myself.

What I am picking on is the packaging of leverage - a strategy that inherently adds risk to investing - as a clever and heretofore overlooked way to get tax benefits on your home mortgage. Let's be No Baloney™ clear: For some people, borrowing money to invest may be an appropriate investment strategy. But borrowing money and investing it because you can get a tax deduction on the interest expense is a ridiculous tax strategy.