Source: The Canadian Press

A new report predicts that Canada’s housing market is poised for a collapse and is only waiting for the trigger of rising interest rates expected for later this year — a view that flies in the face of many other forecasts.

Capital Economics calculates Canadian home prices could fall by about 25% — and even as much as 35% — over the next three years once the Bank of Canada begins tightening monetary policy.

Most economists expect the central bank will begin doing just that in late spring or early summer, with the trendsetting rate rising from the current one per cent to over two per cent by the end of the year.

And the Bank of Canada is expected to keep hiking the policy rate next year until it returns to normal levels — about 3.5% — by the end of 2012.

That would have profound implications both for home values and the economy, says David Madani, Canadian chief economist of Capital Economics.

“Even small rises in official interest rates have been shown to have a big effect on homeowner confidence in other countries under similar circumstances,” Madani said Thursday.

“If the Bank of Canada does resume its monetary tightening this year, this could easily prove to be a tipping point for a house price collapse.”

The knock-on effects of homeowners seeing the value of their biggest asset crash could see consumer confidence and spending plunge, damaging the economy, he added.

And if prices fall 35%, the Canadian Mortgage and Housing Corp. that insures higher risk mortgages could suffer losses of $10 billion as about 10% of mortgages default.

Capital Economics is not the only, or first, private-sector group that has warned about Canada’s hot housing market, which defied all odds in rebounding strongly while the country was still in recession, thank’s to super-low interest rates.

But so far, all predictions of doom have been unfulfilled.

The Bank of Canada and the majority of private sector forecasters are instead calling for a “soft landing” in the housing market, where prices flatten or fall at most a few percentage points. That slowdown has already begun in terms of both resales, prices and building permits for new homes.

The CIBC, for one, estimates home prices are inflated by between five and 10% at most and judges most homeowners will be able to shoulder modest interest rate increases.

As well, Finance Minister Jim Flaherty has stressed he does not believe Canada has a housing bubble, while taking modest steps tighten rules for mortgage borrowing to prevent one from occurring.

Madani believes the confidence is misplaced, however. He says not only have prices risen as quickly as the U.S. before the collapse there, but Canadian prices are way out of whack with traditional markers, such as incomes and the cost of renting.

“A lot of the debate has focused on what affordability looks like today. They have not looked at longer term affordability,” Madani said.

“We conclude that housing prices have formed a bubble and are at risk of falling substantially over the next few years.”

Since 1999, home prices in Canada have risen by seven per cent each year to about $314,000 — or 125% — using an index that averages resale values of two-storey homes and two-bedroom condos. That puts home prices at about 5.5 times the average disposable income per worker of $58,347, well above the historical average of 3.5 times.

As well, the price ratio of ownership to the cost of renting has almost doubled in 10 years.

Add to those markets that excess supply of new housing units is high by historical norms, and home ownership is already at record levels, and the recipe for a major correction are in place.

Those conditions have been there for some time, however, dissenters note, which causes some private sector forecasts, such as Merrill Lynch Canada, to sound the alarm three years ago.

Ironically, Merrill Lynch’s current chief economist Sheryl King disagrees with her predecessor, and the Capital Economics analysis.

She says Canada does not have the same underlying issues as the U.S., even if the run-up in prices is similar. Particularly, lending practices are tighter in Canada, dampening speculation, and homeowners are not allowed to walk away from their homes without penalty.

“You need a rise in the unemployment rate and you need a wave of defaults from speculators,” she said. “But defaulting is not an option in Canada, and we have an unemployment rate that is headed lower, so I disagree.”