Canada's Housing Bubble

Jeremy Torobin Globe and Mail Dec. 10 2009

Saying low rates won't last, Mark Carney's Bank of Canada says growing household debt now biggest risk to country's financial system

Ottawa -- The Bank of Canada warned Thursday that growing household debt is now the biggest risk to the country's financial system, and repeated a plea for borrowers and lenders to remember that the current era of super-low interest rates won't last.

While saying market conditions and the global economy have improved, and that Canada's exposure to a near-term negative shock has “declined modestly” in the past six months, the central bank used its semi-annual review of the financial system to highlight risks posed by homeowners taking on mortgages they may not be able to handle when borrowing costs rise.

“Households need to assess their ability to service these debt obligations over their entire maturity, taking into account likely changes in both income and interest rates,” the central bank said.

“Financial institutions need to carefully consider the aggregate risk to their entire portfolio of household exposures when evaluating even an insured mortgage, since a household defaulting on an insured mortgage would likely be unable to meet its other debt obligations.”

The nascent economic recovery makes it less likely that “substantial credit losses” on Canadian households loan portfolios could infect the rest of the financial system, and the potential for “system-wide stress” as a result is a “relatively low-probability” risk, the bank said. Still, it noted that household debt remains “a key vulnerability over time,” especially with the ratio of debt to income reaching a record 1.42 in the second quarter of this year.

“Although Canadian household debt as a share of personal disposable income is lower than in the United States and the United Kingdom, its upward trend implies that households have a growing vulnerability to additional adverse shocks,” the bank said.

At the same time, historically low interest rates have helped Canadians cut the amount of income that they need to devote to servicing debt, the bank said.

But to illustrate the point that household debt could become a bigger risk when policy makers lift their main interest rate from the record-low 0.25 per cent, the bank's report included a simulation to show how the share of households with a high debt-service ratio would rise should borrowing costs go up after the middle of 2010.

According to the bank's exercise, the share of households with a debt-service ratio higher than 40 per cent of income would rise to 8.5 per cent by the second quarter of 2012, assuming the central bank's rate is 3.2 per cent, and to 9.6 per cent assuming the central bank's rate is 4.5 per cent. That proportion of households with more than 40 per cent debt-service costs compares with 6.1 per cent over the past decade and a record of 7.4 per cent set in 2000.

That said, the central bank said Canadian banks currently have more than enough capital on hand to absorb potential losses, suggesting that even the worst-case scenario in the stress test would fall short of risking a collapse of the financial system.

Thursday's report by no means represents the first time Bank of Canada Governor Mark Carney and his rate-setting committee have commented on the need for “prudence” in the housing market, but it marks the first time the central bank has attempted to quantify the risks based on interest rates reaching specific levels. In its last review published in June, policy makers used a model based on a more severe recession and a resulting increase in unemployment.

“Probably what we'll see going forward is a bigger effort among lenders, the Department of Finance, the Bank of Canada and consumer groups, just to emphasize the fact that, yes, this is a unique opportunity, but one must look at this in a prudent way,” said Michael Gregory, a senior economist at BMO Nesbitt Burns. “Rates are going to go up, and not only should you think about how you manage now, but how you're going to manage in five years' time.”