Lucky

Tom’s a lucky guy, even though he says he lives in a ‘wasteland burb’ of godless Toronto. “I got turned onto your blog by a colleague of mine and must say it’s a bit of an eye-opener.  Ever the skeptic, however, I’ve been scratching my head over your predictions that higher interest rates could doom those of us with high debt ratios.”

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Tom’s mortgage is $350,000 and he figures the house is worth $700,000 (paid $550,000 for it ‘a couple of years ago.’). His household income is $175,000 and the mortgage costs two grand a month on a fixed-five-year mortgage of 3.5%.

“Now let me assume a bad scenario – interest rates skyrocket to 10%. My biweekly payments increase by $600 biweekly, or approximately $1200 monthly.  End of the world?  Not really.  At our income, there are other sacrifices we could make – less frequent new cars, cut back vacations, etc., but in no way would it make us default on our mortgage.  Perhaps I’m living in a relatively sheltered area, but my coworkers are mostly in the same boat – most have combined family incomes of $150k-$250k and own homes valued between $500k and $800k.”

“It’s highly unlikely that rates would go as high as 10%, but even if they did, I couldn’t see a debt load of 150%, or even 200% in my case, become a real estate armageddon…  That said, I do realize that the economy may suffer as a result of less money finding its way to other areas (like those cars and vacations I mentioned), but if that happened, the rates would come down again, equalizing the whole story.. What am I missing?”

This is called the isolation effect. It’s when people feel they’re isolated from external factors by their own smarts, good fortune or unique circumstances. It explains why people in expensive houses keep on spending. Why a million delusional people in Vancouver think it’s different there. It’s why the affluent American middle class never bothered jumping off the Titanic when they had a chance. And it’s why so many commuters in $700,000 GTA houses will be so surprised.

Tom makes the mistake of thinking the only risk of rising interest rates in his hood is that legions of people would default on their mortgages, go under power of sale proceedings and screw up the resale market. This comes from equating what happened in the US to the Canadian scene. But a wave of foreclosures is not in the cards, no matter what happens to rates.

Of course Tom won’t quit paying his mortgage even if his monthly costs more than double. As he rightly says, he’ll just adjust his spending habits – and stop buying new cars or going on trips. Him and nine million other households. This causes consumer spending to slide, which is not sexy news in a country where 66% of the economy depends on it.

So, that leads to job loss. But already the unemployment rate is over 7% – which is just 2% away from the disaster now unfolding in the US. Fewer people working has a direct impact on even more spending, and it doesn’t take long for a vicious cycle to emerge. Consumer confidence takes a hit, and folks feeling less secure about the future are not prime candidates for real estate purchases.

So if rates did rise, housing would fall. Sales first, prices next. As sales volumes diminish and values stumble, more people decide to list their homes (it always happens), hoping to catch the top of the receding wave.

So, Wasteland Tom, the danger isn’t that you couldn’t afford a mortgage rate hike. You can. It’s not that the big-house folks around you would default. They won’t. The danger which higher rates would pose is to the value of your property in a slacking market. You’d be surprised how fast that $700,000 pile of bricks can once again be worth $550,000. Or less. Your loss of net worth would be $150,000 or more.

This is why a third of all US families with houses and mortgages are now under water. They continue to make their mortgage payments and carry on – because there’s no choice. Housing values fell so precipitously there’s no buyer willing to pay more than they owe, which means they’re trapped in an illiquid property.

But, of course, this can’t happen here, right? We’re isolated.

And it won’t. At least, not because mortgage rates go to 10%.

But that’s not the threat. In case you missed the news, Tommy, the IMF this week warns that Canada is part of a dangerous world. Unemployment next year will go up, and growth down. Even Brother Carney just upped the odds of a US recession. And every major bank economist is forecasting a tough 2012 for people with the bulk of their net worth in a house. Listings are rising and in some large or prime markets (Victoria, swaths of the GTA, SW Ontario, the Okanagan, Annapolis Valley) streets are littered with weathering For Sale signs.

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So, rich guy, it matters not how much your house is worth, how upscale the neighbourhood nor how many BMWs are parked on Brussels block-encrusted driveways. It’s irrelevant whether you can pay your mortgage twice over or not. You can’t beat the market. The value of your home will be determined by others, not you. It is the buyers who always end up setting prices, not the owners or the sellers.

You think you’re isolated? Then why read this pathetic blog?

Punked.