Spillover but no crisis

With Iceland in bankruptcy, Hungary and Ukraine requiring a lending hand from the International Monetary Fund, and dozens of U.S. financial institutions in hock, Canadian financial institutions so far have proven robust. Still, they are not immune to spillover effects, says the Bank of Canada.

Indeed, its Financial System Review, released yesterday, paints a picture of relative domestic stability up to now; but some market sectors face stress, particularly mortgage holders, should the U.S. recession deepen or lengthen into another year of economic retrenchment. There are other sectors that have been under pressure, including autos and forest products, and more manufacturers are likely to be squeezed as U.S. consumer spending falls off.

“The housing and mortgage market excesses seen in the United States and in several European countries do not have a counterpart in Canada,” the BOC asserts. “More generally, Canadian financial institutions have been sheltered from the worst of the problems, largely because of their lower leverage, lower exposure to asset-backed products, and more conservative lending practices.”

But Canadian financial institutions are not completely sheltered. Banks in Canada are still reluctant to lend to one another, and to act as market-makers to oil transactions beyond the overnight money markets. However, capital ratios have remained stable, and are in excess of what the regulators require. With Tier 1 assets at roughly 9.5% of capital, Canada’s banks have a 1% advantage over foreign banks. Also, while leverage ratios are higher than for U.S. commercial banks (19% versus 13%) they are much lower than in the Eurozone (31%) and the U.K. (26%), and for U.S. investment banks (also 26%). Still, the Bank notes recent discussions about procyclical capital requirements: forcing banks in prosperous times to loan less in order to create a buffer against times of financial stress.

Loan losses have been small and, moreover, Canadian banks have tended to keep mortgage loans on their own books, rather than securitizing them. Worldwide, banks have written down $700 US billion, while Canadian bank losses have been limited to $12 billion.

Household balance sheets, while in relatively good shape, are at risk, given historically high debt-to-income ratios. The prospect of a deep U.S. recession, the Bank warns, could exacerbate household indebtedness, though the banks have sufficient capital to withstand loan losses. Over the next year, nominal household income, depending on how deep the recession is, could fall by 2%, while debt might rise 6%. That would nearly double the number of households with a debt-service ratio of more than 40% of income, from 3.3% to 6.2%. In turn, loan losses could eat up 1% of total bank assets. Household loans account for 30% of total bank assets.

And the U.S. trade deficit, at some point, will see a weakened greenback, threatening to bring both writedowns and trading losses for Canadian financial institutions. Bank exposure to U.S. borrowers constitutes about 15% of total bank assets. However, the turns in the financial crisis have accelerated writedowns for life insurers. In addition, even though their equity holdings are small, at 6% of assets, segregated fund guarantees have forced a rise in capital reserves to hedge against maturity guarantees.

With every financial review, the Bank of Canada provides a summary of recent research. One paper, by Hajime Tomura, attempts to put together the link between house prices, consumer income and economic growth in a boom and bust cycle. It notes that rising housing prices reflect household expectations of greater future income. Over the past decade, Canada’s terms of trade have improved. The consequent rise in the value of domestic output, and with it, purchasing power for imported goods, has improved real household income, sustaining higher real home prices.

What happens when, faced with the prospect of a recession, households rein in expectations? Given these trends, real house prices could fall if Canadians no longer expect income growth, thanks to improved terms of trade. In other words, they are uncertain whether the terms of trade have permanently shifted, or will slip back. Tomura tries out two explanations for the role of the financial system in a boom and bust cycle.

If households save less because they expect future income growth, then there is a shortage of domestic credit. If international interest rates are high, then domestic ones will be, too. Real home prices become insensitive to future real house prices; with a correction of consumer expectations, real house prices need not fall. But, if international interest rates are low, mortgages increase as does the loan-to-value ratio. House prices increase, but so does consumer leverage, which makes a housing bust worse.

Tomura’s conclusion is that real interest rates and household expectations during a housing boom should be jointly monitored, to assess the risk of a future housing market crash.

(12/12/08)