Household balance sheets showing strain: BoC

While it was an overleveraged U.S. household that was a guiding factor to the current financial crisis, the destruction it has caused in the capital markets has transformed Canadian individual household debt levels from sound to potentially vulnerable, the Bank of Canada says.

According to the BoC’s Financial System Review, the decline in stock markets and home prices caused by the global financial crisis has decreased the debt-to-asset level of Canadian households. In fact, the Canadian household debt-to-asset ratio was at 17.8% in the first half of 2008 — before the market drop — already its highest level since 1991. Of course, as stock markets decline and real estate values drop, the amount of equity declines for most Canadians.

There is a real possibility that the number of Canadians who carry a debt-service ratio of 40% or more — the proportion of their income they use to pay down debt — could double within the next year if we go through a protracted recession.

“Significantly elevated credit risk in the household sector is unlikely to materialize independently of an external shock to incomes, such as would be generated by a deeper recession in the United States than currently expected and its spillover effects on Canada. Bank of Canada simulations indicate that such an outcome could cause the proportion of ‘vulnerable’ households (those with a debt-service ratio above 40%) to rise significantly from the current level of 3%,” the BoC writes.

Using a stress-testing simulation of the Canadian economy, that would see a prolonged recession in the United States, leading to a decline in household income by 2% per annum over the period of the third quarter of 2008 to the fourth quarter of 2009. The BoC says vulnerable households would double, from 3% to more than 6%.

While the number seems relatively modest, it would have a larger cascading impact. The BoC warns it would lead to “substantial losses” for the major Canadian banks dependent on consumer loans and “household indebtedness could act as a channel of contagion for an external shock and could affect the wider Canadian financial system through higher loan losses, while also causing a tightening of credit conditions.”

A major reason for this is, while vulnerable households represent a small fraction of Canadian households, they represent a proportionally much larger piece of Canada’s debt load. Typically, they carry about twice the proportional debt load of the percentage of the population they represent. A protracted downturn would drastically increase the amount of debt these households carry, doubling it from 6% to almost 13% over the same period. The BoC notes this is double the 1999-2007 historical average.

“Should this scenario materialize, the banking sector would suffer significant losses from the rising vulnerability in the household sector. For example, assuming 50% of households with a DSR above 40% go into default, and that loss-given-default is 100% on consumer loans,” the Bank writes, “the associated losses for the Canadian banking sector would be close to 1% of their total assets. The average Tier 1 ratio would fall from 9.7% to approximately 8.8%. This remains well above the OSFI benchmark of 7%.”

The bigger question is whether a protracted downturn will occur to create the environment highlighted by the BoC’s stress testing. The BoC seems uncertain on this, noting risks to the global economy posed by the downturn in the U.S. have indeed risen significantly in recent months, and created a much greater spillover effect into other industrialized nations.

“Credit conditions have tightened, not only in the United States, but also in other industrialized nations, threatening to aggravate the adverse feedback loop between the real economy and financial markets,” the Boc writes.

“While the extraordinary policy measures adopted by U.S., European, and Asian authorities should help to stabilize financial markets, there is a risk that they may not stimulate sufficient lending activity to support the economic growth rates envisaged in the base-case outlook for their economies. With the process of deleveraging far from complete, there is the possibility that the global economy could enter a prolonged downturn as constraints on the supply of credit persist.”

(12/11/08)