Carney warns on debt, again

Canadian household indebtedness, as measured by the ratio of household debt to personal disposable income, currently stands at 153% and is expected to continue to rise. The fact that the lion’s share of this burden consists of residential mortgage debt, fuelled by low interest rates, means Canadians are vulnerable to a debt shock down the road.

The Bank of Canada Review, a collection of the central bank’s recent research on household indebtedness, rang alarm bells Thursday, warning these levels of indebtedness are unsustainable and will make households—indeed, the entire financial system—more vulnerable to house price declines.

“Rising house prices can facilitate the accumulation of debt,” said the central bank report. “Households could therefore experience a significant shock if house prices were to reverse.”

In addition to house prices, the Bank said consumer credit, especially among younger Canadians, has also been a contributing factor. The report said that increased borrowing by younger Canadians reflects a buy-now-worry-later attitude perpetuated by “new lending practices or financial innovations” that have made it easy to access credit.

Financial experts in Canada assert Canadians need to be concerned, but shouldn’t lose sleep over these debt levels.

Sal Guatieri, vice-president, senior economist, BMO Capital Markets, says these signs have been visible for some time and that Canada is still not at the tipping point the U.S. and the U.K. were a few years ago.

“What’s insightful in this report is that some of this debt is attributable to rising house prices and a portion of that run-up in debt has been used to finance consumption and home renovations,” he said. “Both those elements mean that households are somewhat vulnerable to a pullback in spending if house prices decline much like we saw in the U.S.”

And that is because falling house prices pretty much eliminate the option of extracting home equity.

That said, Canada is by no means in the danger zone. Yet.

“Canadian household haven’t reached the debt wall, but it does mean that they will have to pull back their rate of borrowing,” said Guatieri. “They have already done so for consumer loans now they’ll have to do the same for residential mortgages.”

It is widely believed that the quality of Canadian debt is far superior to that of the U.S. The Bank of Canada Review argues that “in the United States, the subprime market had grown to account for about 14% of outstanding mortgages before the finan­cial crisis, compared with about 3% in Canada.”

In other words, Canada doesn’t suffer from the same weak credit quality, a by-product of loose lending standards, which brought down the U.S. housing market a few years ago.

Beth Hamilton-Keen, member of CFA Institute’s Board of Governors, says that while the cautionary tale remains valid, the Bank of Canada Review reveals little that is new.

Banks have made borrowing easy in the interest of profitability; it is up to consumers to steer clear of that trap, she added.

“It’s one thing to engage in debt—it is a consumption-now decision—but where’s the exit?” asked Hamilton-Keen. “It has become a lot more socially acceptable to have debt than [a couple of] generations before us, but [given] the cost of maintaining that, you really need to consider when you will pay it off.”

The Bank’s report shows indebtedness peaks in the 31–35 age range and then gradually declines with age. But while mort­gage credit, the primary source of changes in total debt, is particularly significant for younger households, secured personal lines of credit are responsible for growth in total consumer credit across all age groups.

Sooner or later, it will all catch up with Canadian consumers and there will be pain to bear.

“We’ve gotten quite complacent with these low [interest] rates, there’s no near-term threat of consumers changing their ‘we’ll-deal-with-that-later’ approach,” said Hamilton-Keen. “When interest rates begin to change, though not a near-term threat, a rate increase by a couple of percentage points will be a tipping point.”

Those who opted for a variable mortgage, she said, are more vulnerable to rate fluctuations.

The temptation right now is not to lock in because it doesn’t look like interest rates are going to go up and there’s a discount for staying variable; everything is pointing towards keeping consumers exposed to interest rate change when it does eventually happen.”

The Bank of Canada has kept its benchmark at 1% since September 2010. However, Governor Mark Carney and Finance Minister Jim Flaherty have been cautioning against borrowing beyond sustainable levels as interest rates will eventually begin to rise again.