Stephen Jarislowsky, chairman of Montreal-based investment adviser Jarislowsky Fraser Ltd., said he is “convinced” there’s a bubble in Canada’s housing market, fueled by government measures that encouraged consumers to take on debt.

“They have basically encouraged people to buy houses based on cheap mortgages,” Jarislowsky, 84, said in a telephone interview from Montreal. “That has created the opposite effect of what was desirable.”

Canadian home prices and resales will grow to records this year, boosted by low interest rates, the Canadian Real Estate Association said in a report this week. Canadian new-home prices rose 0.4 percent in December from the previous month, the sixth straight gain, government figures showed yesterday.

“I am convinced there is a housing bubble in Canada,” said Jarislowsky, whose investment fund owns shares in Canada’s four biggest banks, including Toronto-based Royal Bank of Canada.

The comments by Jarislowsky, who is one of Canada’s wealthiest investors with a fortune worth C$1.85 billion ($1.8 billion) according to Canadian Business magazine, contrast with the view held by Finance Minister Jim Flaherty, who sees “no clear evidence” of a housing bubble, his spokesman, Chisholm Pothier, said this week. 

Government intervention in the mortgage insurance market is exposing Canadian taxpayers to enormous potential liabilities if Canada were to be hit with a mortgage default crisis similar to what occurred in the United States, according to a new peer-reviewed study released today by the Fraser Institute, Canada's leading public policy think-tank.

The report, Mortgage Finance Reform: Protecting Taxpayers from Liability, finds that the Canadian government is heavily exposed in the mortgage market because 43 per cent of all residential mortgages (including all loan-to-value mortgages over 80 per cent) are backed by the government through the federally owned Canada Mortgage and Housing Corporation (CMHC).

The report recommends that the federal government follow Australia's example by opening Canada's mortgage insurance market to full competition including the privatization of the CMHC.

"The CMHC dominates the Canadian mortgage insurance market because it enjoys regulatory advantages not available to private-sector companies. As a result, several private-sector mortgage companies have withdrawn from offering mortgage insurance in Canada," said Dr. Brett J. Skinner, Fraser Institute director of insurance policy research.

"The Canadian government should reduce taxpayer exposure by allowing the private sector to take responsibility for insuring and securitizing Canadian residential mortgages. This includes the complete privatization of the CMHC's mortgage insurance business."

The report points out that the Canadian model has the majority of risk concentrated with the Government of Canada, and therefore the taxpayer liability is much greater in Canada than in Australia. By privatizing the CMHC or removing its unfair regulatory advantages, the market would likely be more pluralistic with multiple mortgage insurance providers serving Canadians.

This would be similar to the Australian model of mortgage financing, which has been highly successful in achieving home ownership outcomes and has produced a stable mortgage market, but has minimized taxpayer liabilities during financial crises.

With interest rates at a record low, a growing number of people are looking to purchase a home. Every homebuyer faces the age-old question of whether to choose a fixed or variable rate mortgage.

"The question of whether to lock in to a longer-term fixed mortgage rate or stay in a variable rate has become an increasingly complex and important debate," said Doug Porter, Deputy Chief Economist, BMO Capital Markets.

"Short-term rates are at historic lows and pressure is likely to build for higher rates in the year ahead."
Research shows that over the past 30 years it has been more cost-effective for borrowers to have a variable rate mortgage 82 per cent of the time. However, under the current environment, Porter points out there are a number of factors to consider before assuming the variable rate is the hands-down winner:

-  Canada has been in a long-term declining rate environment since the
        early 1980s.
     -  The Bank of Canada's overnight rate is now as low as it can go, so
        there is no further downside for variable rates. The surprises can
        only be to the high side from here.
     -  Fixed rates were advantageous during only two recent periods - through
        the late 1970s and in the late 1980s; in both cases ahead of a period
        of rising interest rates, as is the case now.

The Case for Staying Fixed

A conventional fixed rate mortgage can mitigate a number of risks. Although inflation has not been a problem since 1991, there is a risk of an inflation flare-up as global central banks keep the pedal to the policy metal, and amid record government deficits.

The Bank of Canada could be forced to raise interest rates aggressively, driving variable mortgage rates higher, but leaving Canadians with fixed rates relatively unscathed. Plus, fixed rates are currently very attractive given that short-term rates are already as low as they can go.

The Case for Going Variable

The advantage to a variable rate mortgage is that it has been consistently less costly over time. As well, the current outlook for inflation remains benign, which will likely keep price pressures at bay well into 2011. The soaring Canadian dollar is putting additional downward pressure on prices, reducing the near-term need for the Bank of Canada to raise rates.

There is also some risk to locking in as fixed rates could fall if the economy performs worse than anticipated. Even as rates start to rise, Canadians can always lock into a fixed rate at a later date.

The decision depends on the individual. For those who do not have a lot of financial flexibility - such as first-time home buyers and those who would run into difficulty from an upswing in interest rates - the moderate extra cost of peace of mind you can get from a fixed rate may be a price worth paying.

There is also a reasonable scenario where fixed rates may actually prove to be a cheaper alternative at this point. That's particularly the case given some recent cuts in long-term fixed rates, such as BMO's current special rate of 4.09 per cent for a five-year fixed mortgage. BMO Economics' view is that variable rates will climb only moderately, but by enough to tilt the balance in favour of current fixed rates.

"The most important thing a current or first-time homeowner can do is talk to a knowledgeable mortgage expert about their situation and make decisions based on their particular circumstances," said Jane Yuen, Senior Manager, Mortgages, BMO Bank of Montreal. "So come in to a branch or contact a mortgage expert to decide on the type of mortgage that is best for you at this point in your life."