06/12/2014 10:36 EDT | Updated 08/12/2014 05:59 EDT

Housing Crash Still Bank Of Canada's Top Worry

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OTTAWA - The Bank of Canada continues to sound the alarm about the country's housing market, adding the risk of failures in the Chinese financial system and higher long-term interest rates from the U.S. as possible triggers for a destructive crash.

The central bank's latest semi-annual review of the financial system concedes that the probability of a sharp housing correction, particularly in prices, is small — but the consequences would be large.

Read more: This Chart Just Might Show When Canada's Housing Market Will Go Bad

In particular, the bank worries that although the market appears to be headed for a soft landing, certain hot spots like Toronto's condominium market continue to race forward, and prices continue to rise.

"House prices have continued to rise since the December (report)," the bank's governing council points out. "Although the more moderate pace of price increases suggests a soft landing, they are still growing faster than disposable income," the report adds.

The report cites Toronto, Quebec, Winnipeg and Hamilton as cities where housing prices have increased.

The Bank has long flagged Canada's housing sector as a potential problem, not just for indebted households, but also for financial institutions and the economy writ large.

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In its latest financial review, the bank says the risk of a Chinese "hard landing" from vulnerabilities in the country's largely unregulated shadow banking system had increased, which would affect Canada's economy through lower demand and prices in the natural resources sector.

Although regarded as unlikely, a sharp increase in U.S. long-term interest rates, which affect Canadian rates, would also cause problems in the housing sector, it said.

"High household debt-to-asset ratios and debt-service ratios would increase the likelihood of bankruptcy if their debt burdens become unsustainable following an increase in interest rates or if their homeowner equity was eliminated by a decline in house prices," said the report, released on Thursday.

Particularly vulnerable to a housing correction may be smaller financial entities, such as credit unions, which may not have the resources of big banks to withstand a reversal.

"Many smaller entities, including some mortgage investment corporations and smaller credit unions, cater specifically to borrowers who do not qualify for insured mortgages. These may include low-income individuals, recent immigrants, rural residents whose income tends to be more volatile."

On Wednesday, the Paris-based Organization for Economic Co-operation and Development also warned about Canada's housing market and suggested the government should limit its vulnerability to defaults by reducing the guarantee on mortgage loans. Canada, through the Canadian Mortgage and Housing Corp., insures 100 per cent of high-risk mortgages issued by banks, whereas the OECD says most other industrialized nations guarantee only 10 to 30 per cent.

Recently, several large Canadian banks have lowered their five-year fixed rates below three per cent, although Finance Minister Joe Oliver said he does not see that as a major problem.

Although the Bank of Canada's latest report does not directly link low mortgage rates to the government insurance system, it does caution that it believes financial institutions are taking on more risk in search of higher profits in the low-interest environment.

Overall, it sees the risks to Canada's financial system as basically unchanged from December, the last time it reported on the issue, with three out of the four key vulnerabilities coming outside, including a sharp increase in long-term interest rates emanating from the U.S., stress from China and other emerging markets, and weakness in Europe. It judges the risks in China as having increased while those in the eurozone have lessened in the past six months.

With this report, the central bank is changing the way it reports on financial system risk by stressing each vulnerability separately without giving an overall rating. But governor Stephen Poloz said in an accompanying statement the bank's "level of comfort as policy-makers remains roughly what it was six months ago."

As well, the bank governor will give a news conference after each report, a move designed to give greater visibility to the financial system review. Previously, the governor's news conference only followed release of the quarterly monetary policy report.

As he has in the past, Poloz signalled that he believes the world has entered into a new normal in terms of growth and interest rates tending to be more temperate than was the case before the 2008-09 financial crisis.

"This combination of higher equity prices, lower bond yields and lower volatility may reflect, in part, growing market expectations of a post-crisis steady state that is characterized by reduced global potential growth and lower long-term equilibrium interest rates," the report says.

"It may also partly reflect lower risk premiums, driven by prolonged, exceptional monetary policy stimulus in these economies."

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