With Canada's economy facing a patchy recovery from the steep, COVID-19-induced recession, the country's housing market looks set to suffer sharp price declines and an overall challenging period into next year.

Although borrowing rates will likely remain historically low and recent data on a housing rebound have been encouraging, the combination of elevated unemployment this year and next, uncertainty about the pandemic's duration, stricter lending rules, and slower near-term flow of new immigrants will create headwinds for housing activity and prices. S&P Global Economics expects home prices (as measured by the MLS Home Price Index[MLS HPI]) will be down 8.7% year over year in the first quarter of 2021, before starting to recover as the labor market finds its footing and pandemic-related uncertainty fades. (1) Despite our expectation for lower house prices and elevated unemployment, we believe credit risk in the Canadian banks' mortgage exposures and in securities backed by residential mortgages will remain muted.

House Price Drop Is Expected To Match Average Of Past Two Recessions

Our forecast of a housing price drop is steeper than that witnessed during the 2008-2009 recession, when prices fell 6.9% in the first quarter of 2009, but not as severe as during the 1991-1992 economic slump, when prices declined 10.9% in the first quarter of 1991 (see chart 1). Our outlook is relatively sanguine considering the Canada Mortgage and Housing Corp. (CMHC) is forecasting a decline of 9%-18%.

Chart 1

Lower interest rates following the 2008-2009 recession contributed to house price increases. Since 2017, however, there has been a noticeable slowdown in mortgage credit growth and house prices due to a combination of macro-prudential policies, strengthened regulatory oversight, higher capital requirements, multiple rounds of tightening government-mandated mortgage rules, stress testing of borrowers, and stricter guidelines around mortgage underwriting. House prices, however, remained elevated in greater Toronto and Vancouver, which added to the market's vulnerability to a price correction (see chart 2). Home affordability indexes were already at historically high levels, and were also elevated compared with those of other advanced economies (see chart 3), as households amassed high debt (at a time of low repayment costs and steady income flows amid a stable labor market).

Chart 2

Chart 3

Although we anticipate the Bank of Canada (BoC) will keep the benchmark interest rate at 0.25% through late 2022, the pandemic and its deleterious effects on the broader economy will almost certainly affect the housing market. S&P Global Economics forecasts Canada's real GDP will contract 5.9% this year, and the economy will suffer its worst back-to-back quarterly contraction in the modern era (first and second quarters), reflecting a real GDP decline of more than 13% peak-to-trough.

Nevertheless, we do not anticipate a prolonged slump in house prices, given the nature of the economic downturn and our expectation that it will be sharp but short. Moreover, mortgage underwriting standards are stronger than they were entering the 2008-2009 recession, and homeownership among the economic strata hurt most by the current dislocation is comparatively low. In our forecast, we do not anticipate any significant increase in "forced selling" although this poses a key downside risk to our baseline outlook. The general full-recourse mortgage market, the waiving of capital gains tax on the sale of a first residential property, and relatively low loan-to-values (LTVs) of uninsured mortgages on banks' balance sheets incentivize borrowers to satisfy their mortgage obligations, or, where absolutely required, to sell and benefit from built-up equity.

That said, the path of the economic recovery remains uncertain, as does a rebound in employment, which could be slower than in our baseline forecast. An impending mortgage-deferral cliff--to the extent borrowers do not resume making payments or agree to further arrangements--stands out as a risk that could lead to forced selling. In addition, reduced immigration in coming quarters could put a damper on demand (although this could be partially offset by the pent-up demand from the re-entry of those who were previously priced out of the market).

We Expect The Banking Sector Will Withstand The Near-Term House Price Correction

Notwithstanding the relatively sharp but short-lived correction in house prices, the economic risk trend in our banking industry country risk assessment (BICRA) remains stable. Canadian banks benefit from very strong economic resilience, as demonstrated by the comprehensive monetary and fiscal stimulus measures taken by Canadian authorities. These measures will help to offset somewhat elevated credit risk resulting from high private sector debt levels in Canada.

Still, we expect credit losses for Canadian banks will spike. Net charge-offs could almost double in 2021 with deferral programs and fiscal support as well as timing differences (the fiscal year for Canadian banks generally ends on Oct. 31) delaying the pandemic's impact into next year. Nonperforming assets could more than double to about 1.1% of total loans this year. That said, we expect that, among other factors, tightened mortgage underwriting practices and considerable equity within existing mortgages will limit credit losses in banks' mortgage books despite our forecast for a drop in house prices. For instance, the average LTV on the uninsured residential mortgages is approximately 55%, which we believe leaves a substantial cushion in the form of borrowers' equity to absorb potential corrections in house prices. We expect Canadian bank ratings will be able to absorb about 2x their peak annual credit losses of 6 basis points (bps) seen in 2010 and 2011, and over 3x their historical annual losses (3 bps, on average, since 1990) within the residential mortgage portfolios. However, we believe the expiry of mortgage payment deferrals and the possible phasing out of government support (including the Canada Emergency Response Benefit [CERB] program) this winter remains the biggest wild card for banks' credit performance, as some homeowners could become financially strained if the labor market is not already on a steady path of normalization by then. In addition, a weak rental market may also test the financial strength of investors to fulfill their mortgage obligations. The BoC estimates about 80% of non-institutional landlords in Canada have a mortgage.

Securities Collateralized By Residential Mortgages Should Withstand The Headwinds From A House Price Decline

Liquidity risk, which restricts the ability to lend, is largely mitigated by the government's COVID-19 emergency response plan: The C$150 billion Insured Mortgage Purchase Program provides long-term stable funding to banks and mortgage lenders to facilitate continued lending and add liquidity to Canada's mortgage market; the Office of the Superintendent of Financial Institutions lowered the domestic stability buffer by 1.25% of risk-weighted assets, which allowed Canada's large banks to free up $300 billion for liquidity and lending; and the BoC's liquidity tool kit allows an expanded set of eligible counterparties against a broader set of eligible collateral to have access to the bank's liquidity. Therefore, we do not foresee a marketwide liquidity stress that could exacerbate the balloon risk present in Canadian mortgages.

In terms of credit risk, under the government-sponsored National Housing Act Mortgage-Backed Securities program, most of the credit risk is borne by the government through mortgage insurance. In the covered bonds and private-label residential mortgage-backed securities (PLRMBS) space, collateralized by noninsured residential mortgages, originators face credit risk that is elevated with higher unemployment (S&P Global Ratings does not currently rate any of these securities).

In our view, given the dual-recourse nature of covered bonds, the stability of the Canadian covered bond issuers credit ratings, the credit quality and diversification of the revolving collateral pool (weighted-average LTV [67%]); credit score of more than 700 [88%]), we do not expect any credit-related challenges from the projected 8.7% house price decline. Across the outstanding PLRMBS, the concentration of obligors in the more populous provinces of Ontario and British Columbia--which have been heavily affected by COVID-19--and about 50%-68% of the collateral pool with LTVs between 70%-80% could pose unique challenges. This is somewhat mitigated by the credit quality of the obligors, which is fairly strong; weighted-average credit scores range from 738 to 793 with about 75% greater than 700. Nevertheless, prolonged unemployment and a slower-than-expected recovery will pose challenges to highly indebted borrowers. Our forecast unemployment rate, at 8.5% by the end of 2020 and 6.8% by end-2021.

Economic Hurdles To Overcome

While we forecast Canada's economy will bounce back next year, expanding 5.4%, the macro environment has a high degree of uncertainty, and we do not see real GDP regaining its prepandemic level until the fourth quarter of 2021 (see "Canada's Economy Faces A Patchy Recovery," published June 29, 2020).

Assuming any subsequent waves of COVID-19 are not overwhelming, we expect a recovery in two stages: a near-term bounce in aggregate demand and employment activity as lockdowns ease, followed by a more gradual and protracted improvement.

Meanwhile, the unprecedented government stimulus, intended to maintain employer-worker relationships, will likely bolster a labor market rebound. We forecast headline unemployment, which peaked at 13.7% in May, will come back down to 8.5% by the end of this year and 6.8% by end-2021 (see chart 4).

Chart 4

Job losses have reached historic levels, to be sure, but they may hurt the housing market less than would be expected since homeownership rates among young adults--and workers in the retail, restaurant, and other leisure sectors (those who have suffered disproportionately from the sudden economic stop)--are among the lowest of all sectors (see chart 5). However, high unemployment will weigh particularly heavily on housing demand in the oil-dependent provinces of Alberta, and Newfoundland and Labrador (where prices are already declining).

Chart 5

In addition, banks have offered loan deferrals to borrowers for mortgages and other retail loans. We understand many deferral programs for consumer credit have freed up cash, allowing households to continue paying off their mortgages.

A Closer Look At Sales And Prices Suggests Strong Pent-Up Demand

Both sellers and buyers stepped out of the resale market during the social restrictions in March and April, leaving the market with little churn. In May and June, as every province eased lockdowns (to varying degrees), a wave of pent-up demand was unleashed.

After tumbling to their weakest level on record in April, home sales jumped 56.9% month-over-month in May and another 63% month over month in June as buyers came back in a big way (see chart 6). Still, the gains have not fully retraced the activity lost from February through April.

Chart 6

Meanwhile, sellers also returned to the market en masse in May and June, as national new listings climbed even faster than sales, jumping 69% and 49.5% (month over month), respectively. The level of sales in June was almost back up to the February level. The sales-to-listings ratio of 64% in June (up from 58% in May) suggested a slight tilt in the supply/demand dynamics in favor of sellers.

Although signs of negative price pressures were visible in April and May, these came on a thin volume of sales, and may not be very reliable as a gauge of market conditions. The MLS average price fell 0.4% in June from February (pre-pandemic), while the MLS HPI--a better measure because it adjusts for compositional shifts--remained 1% higher. In fact, the MLS HPI was higher in May than it was at the start of the pandemic, despite dipping modestly during the month. This points to some price resilience.

The quality-adjusted MLS HPI was up 5.4% year over year in June (following a 5.3% gain in May)--softer than in April, but in line with the first-quarter average. (On a monthly basis, the index was up 0.5% in June.) Annual prices rose for the fifth straight month in Vancouver (+3.5%), and remained elevated in greater Toronto (+8.2%), Montreal (+11.8%), and Ottawa (+16.1%). Meanwhile, prices dropped by about 2.4%, on average, in Calgary and Edmonton.

S&P Global Ratings believes pent-up demand will fuel additional gains for at least another few months. The big question is what happens after this. Our expectation is that softer population growth, a slow recovery in jobs, potentially higher supply once the government-financial support and loan forbearance programs wind down, and stricter CMHC lending standards will moderate growth in mortgage origination and, by extension, sales and prices late this year and into 2021.

Risks Could Exacerbate A Housing Downturn

While income loss represents the biggest headwind for housing demand, there are other important factors that, if they deteriorate, could worsen a housing slump, including:

Declining immigration

New arrivals to Canada have steadily supported the housing market in recent years--especially in key "landing pad" cities. Remarkably, immigration has never been so concentrated in the cohort aged 25-44, which is crucial for household formation. Canada welcomed 340,000 new permanent residents in 2019 and the federal government was set to maintain higher target levels in 2020 before the pandemic hit. According to Oxford Economics, new permanent residents were up in January and February relative to recent historical levels but fell by more than 25% in March. With borders effectively closed and travel restrictions likely to remain in place in the near term, immigration flows will likely remain subdued over the next 12 months.

The mortgage-deferral cliff

The six-month deferral of mortgage payments until the fall has no doubt helped limit greater hardship for financially strapped households. According to CMHC, the average monthly mortgage payment of Canadian homeowners is $1,326. As of June 24, 2020, the Canadian Bankers Assn. reported that 743,000 mortgages (about 15% of the number of mortgages in bank portfolios) at its 13 member banks are in deferral. This means that cash freed up from deferrals is about $985 million per month, or $2.9 billion per quarter. However, the impending ending of this measure has the potential to derail the housing recovery that is underway.

The CMHC warned in May that "as much as one-fifth of all mortgages could be in arrears" if mortgage holders do not get their jobs back quickly. (2) At the end of the deferral period, mortgagees will have to repay interest accrued in that time. Although the government has extended the CERB (which gives financial support to employed and self-employed Canadians directly affected by COVID-19), homeowners holding deferred mortgages who rely on such income-support programs will be squeezed when the measures finally do end--especially if the job recovery is sluggish.

Declining tourism

A drop in visitors to Canada could, at the margin, hurt the housing market, especially for homes that were used primarily as short-term rental properties and may be put up for sale due to lack of revenue. One estimate by the National Bank of Canada suggests that if 25% of Airbnb rental properties were put on the market, they would boost listings 34% in the Toronto market, 27% in Montreal, and 12% in Vancouver, exacerbating sales-to-new-listing ratios.

Supply-demand imbalance

Supply and demand conditions had been tight since the beginning of the pandemic, but new listings surged in May and June as local governments relaxed some social distancing measures and delayed spring listings hit the market. While homebuyer demand is historically strong during the summer (and there is some pent-up demand), we expect it to remain softer this year due to health concerns and uncertainty around the labor market, which could lead potential homebuyers to postpone their purchase plans. We don't rule out some amount of forced selling due to the economic fallout of the pandemic, because once the government support programs wind down and mortgage deferrals end, some homeowners (particularly investors) may be compelled to sell. This could bring more supply to market around the end of this year. For now, Canada's housing market is largely "balanced"--defined as having a sales-to-new listing ratio of 40%-60%.

Why Not A U.S.-Style Slump?

Unlike in the U.S. in the years before the last recession, there's been no housing boom spurred by the relaxation of mortgage lending standards in Canada. In fact, growth in the Canadian market in the past 10 years has come despite a tightening of standards--including the shortening of the maximum amortization period, an increase in minimum down payments, and the raising of qualifying interest rates. In addition, the key markets of greater Toronto and Vancouver had already witnessed some price correction in 2017 after the macro prudential tightening measures were introduced.

The proportion of new loans to borrowers with low credit scores was also much lower compared with the U.S. average in 2004-2007. In addition, more than one-third of Canadian mortgages are insured, and strategic defaults as we saw in the U.S. during and after the previous recession are less likely in Canada, since most mortgage loans provide for recourse against borrowers. Although just 12 of the U.S.'s 50 states are "non-recourse" (which means borrowers who are underwater on their mortgages can simply walk away without significant ramifications), three of those are California, Nevada, and Arizona--all of which saw property price booms in the years preceding the 2007-2008 downturn.

For Canadian mortgages, those with LTVs above 80% require mortgage insurance. That, in turn, limits the risk of banks being exposed to borrowers who would be underwater if prices decline more significantly than we expect. Average LTVs for the mortgage portfolio across the banking sector are in the 50%-60% range, meaning homeowners have significant equity in their homes and prices would have a long way to fall before the average homeowner would be underwater.

At the same time, Canada's relatively strict zoning laws--including "greenbelt" provisions for areas around the country's largest cities that limit the availability of developable land--could lead to continued supply-demand imbalances.

Despite Near-Term Pain, Canada's Housing Market Will Prove Resilient

Notwithstanding our expectation of a sharp but short-lived correction of Canadian house prices, in the near term, we believe fundamentals support the resilience of the country's housing market. Several years of macro-prudential policy measures, tighter underwriting standards including stress testing of borrowers, coupled with generous fiscal support, and supportive supply-demand imbalances will likely help soften the dual shock of lower oil prices and a pandemic induced economic standstill, on Canada's housing market. However, the looming uncertainty over the path and timing of the recovery and elevated household indebtedness remain key downside risks to our housing price outlook. An impending mortgage-deferral cliff, when fiscal support measures expire and banks' payment deferral programs end, presents the most obvious and pressing risk to housing supply, and therefore prices. Structural changes, such as lower net migration or declining attractiveness of urban living, could pose demand-side risks over the medium term. For now, we believe Canada will avoid a U.S.-style housing slump, preserving equity Canadians have built up over the past decade.

Related Research

• Canada's Economy Faces A Patchy Recovery, June 29, 2020.
• Global Banks Outlook Midyear 2020: Temporary Shock, Profound Implications, July, 9, 2020
• Rating Component Scores For The Top 200 Banks Globally--July 2020, July 9, 2020
• Despite The Dual Shock Of Lower Oil Prices And A Pandemic, Canada's BICRA Economic And Industry Risk Trends Stay Stable, July 14, 2020
• Canadian Banks Are Set To Face COVID-19 Related Headwinds From A Position Of Strength, April 16, 2020

Endnotes

(1) We use the Oxford Economics model to generate the forecast.

(2) According to Oxford Economics, "deferrals are, unsurprisingly, concentrated in high loan-to-value mortgages and in regions hardest hit by the pandemic-induced economic shock. Nationally, 91% of mortgage deferrals have an LTV ratio above 85%, reflecting Canada's underlying household debt vulnerabilities. Deferrals in Ontario, Alberta, and Quebec—the provinces with the most COVID-19 cases—make up nearly three-quarters of total mortgage deferrals."