Household Debt: Bank Of Canada Warns Home Equity Loans Pose Threat To Financial Security
OTTAWA - Canadians are becoming increasingly vulnerable to a housing correction, exposing them to a perfect storm of high debt and falling assets, the Bank of Canada warns.
In a book of four research papers released Thursday, the central bank suggests many Canadians have constructed their finances on a house of cards, with ever rising home values the key and vulnerable support.
The bank economists point out that home prices have risen sharply in the past dozen or so years along with debt, as households needed both bigger mortgages to buy homes and used equity from higher home values to finance other purchases.
"These facts are interrelated, since rising house prices can facilitate the accumulation of debt," the report notes. "Households therefore experience a significant shock if house prices were to reverse."
It adds that falling home prices could have a "relatively large impact on consumption" as equity disappears and the ability of householders to borrow is diminished.
It calculates that a 10 per cent drop in home prices could generate a one per cent decline in consumption, which would slow economic growth.
TD Bank chief economist Craig Alexander said the fact the central bank devoted it's winter review on a single topic — debt — demonstrates how seriously it takes the issue.
And he says the bank's example of a 10 per cent correction is not unrealistic given that it is the over-valuation figure the International Monetary Fund gives for Canadian housing stock. Alexander himself believes it could be as much as 15 per cent.
He agrees that the central bank has every reason to be worried, because a correction could knock the stuffing out of Canada's fragile recovery.
"When it comes to the housing market and personal debt, I'm not worried that a housing market correction will lead to a problem in the Canadian financial system," he said.
"I worry more about the economy. I worry that if you have a drop in home prices and you wind up with consumers struggling to deleverage, it will lead to an economic contraction."
The bank does not suggest a U.S.-style housing collapse for Canada is in the offing, nor does Alexander. A big part of the problem south of the border was due to easy credit conditions, something Canadian banks have avoided.
But the bank's economists are clearly concerned nevertheless about the pitfalls from the steady increase in household debt, which has risen as a percentage of income from 110 per cent in 1999 to 153 per cent currently.
And debt to household equity has risen as well even as home prices have soared.
Part of that is well grounded on growing incomes, it says, but part is also due to super-low interest rates and unrealistic expectations that home values will keep rising.
Of particular concern to the central bank is that much of the increase in household debt was not mortgages, but loans secured by home equity which Canadians in turn spent on consumer items and renovating their homes.
"These findings suggest that household indebtedness constitutes an important source of risk to household spending, since it makes households more vulnerable to substantial negative economic consequences in the event of a correction in house prices," one paper states.
The Bank of Canada papers were released hours after a new analysis by the TransUnion management firm found that non-mortgage borrowing had slowed sharply in the past year to a one per cent increase, the lowest since 2004.
While that represents only a small fraction of what Canadians owe, analysts have noted that overall debt accumulation has also been slowing of late and that expectations for home prices have moderated.
That's a good indicator that Canadians are starting to heed the message, said Alexander.
One paper issued by the central bank suggested that home prices have been influenced not only by low mortgage rates but also on expectations that values will keep rising. History shows that's a bad bet, the paper states.
"Over history, these other factors are associated with the medium-run tendency of house prices to rise faster than their long-run trend for a number of years and then subsequently adjust back to trend."
Those corrections could be as great as 20 to 30 per cent relative to the growth in the economy, it said.
The Bank of Canada also notes that increasing debt levels have made Canadians more vulnerable to bankruptcies and insolvencies. Since 2000, about 100,000 Canadians a year have filed for insolvency or bankruptcy, triple the number in the 1980s.
But the bank points out that in most cases, these were not homeowners. The vast majority are renters and the unemployed who have taken on too much in the way of credit card debt and bank loans.5 ECONOMIC LANDMINES THAT COULD IMPACT CANADA IN 2012
1. RISING HOUSEHOLD DEBT
Canada's household debt burden climbed to yet another record high in the third-quarter, prompting Bank of Canada Governor Mark Carney to call it <a href="http://www.montrealgazette.com/business/Mark+Carney+again+sounds+alarm+rising+Canadian+household+debt/5856418/story.html" target="_hplink">"the greatest risk to the domestic economy</a>." At 150.8, <a href="http://www.reuters.com/article/2011/12/14/us-economy-debt-idUSTRE7BC2DY20111214" target="_hplink">Canada's debt-to-income ratio is now higher than in the U.S. or the U.K</a>. Meanwhile, household net worth fell, which, as many observers have warned, has made Canadians more vulnerable to adverse economic shocks.
2. SLUGGISH CONSUMER DEMAND
Though BMO's Doug Porter maintains that low interest rates and modest job growth should prevent household debt issue from becoming "a clear and present danger to the outlook in the year ahead," he predicts that the debt burden is likely to increase. Unlike in the U.S., Canada's consumer recession was "very mild," leaving scant room for growth in consumer spending, he says. "At best, we see consumer spending growing in line with income next year," he said. "We've actually pegged it a little bit below income growth next year ... at less than two per cent in 2012." (FREDERIC J. BROWN/AFP/Getty Images)
3. EUROZONE INSTABILITY
When TD cut its 2012 outlook for the Canadian economy earlier this week to 1.7 per cent, the bank cited a deepening fiscal crisis in the eurozone as one of the primary factors. More bearish than BMO, which on Thursday held its expectation for Canada's GDP growth next year at two per cent, TD is forecasting "a deterioration of financial conditions and a significant European recession in the first half of next year." "<a href="http://www.td.com/document/PDF/economics/qef/qefdec11_can.pdf" target="_hplink">A deepening recession in the region will exert a significant drag on the global economy</a>," the bank maintained. "Canada will be negatively impacted through weaker commodity prices, confidence and export growth. Labour markets will also soften as a result." (ERIC FEFERBERG/AFP/Getty Images)
4. CHINA LOSING STEAM
The signs are abundant that the world's largest economy is cooling. Mounting local government debt and slowdowns in everything from industrial production to <a href="http://www.cbc.ca/news/business/story/2011/12/09/china-economy-slows.html" target="_hplink">the housing market has led many to predict softer economic growth in 2012</a>. "<a href="http://www.npr.org/2011/12/13/143623874/after-boom-chinas-property-market-heads-lower" target="_hplink">Real estate is a locomotive industry that leads at least 58 other industries</a>," Cai Weimin, who runs a real estate think tank in Shanghai, told NPR. "Doomsday probably won't come true in 2012, but for the Chinese economy, 2012 will be a very tough year. (Aaron tam/AFP/Getty Images)
5. GROWING INCOME GAP
As Canada's rich-poor divide widens, some experts warn that the concentration of wealth at the top of the income distribution and stagnating wages for everyone else could be a drag on the economy. Though Canada's income gap is not as pronounced as in the U.S., Canadian Centre for Policy Alternatives economist Armine Yalnizyan argues that the growing divide is bad for business all the same. <a href="http://www.huffingtonpost.ca/news/mind-the-gap" target="_hplink"><strong>Mind The Gap: Our examination of Canada's growing income divide</strong></a> "<a href="http://www.canadianbusiness.com/article/39123--inequality-is-bad-for-business" target="_hplink">Real growth in purchasing power has been restricted to a small fraction of Canadian consumers</a> in what is already a small market," she maintained in an op-ed in Canadian Business magazine. "Throttling aggregate demand slows the economy for everyone." Anne Golden, president and CEO of the Conference Board of Canada, echoes this sentiment. "Growing inequality distorts consumer patterns," she told The Huffington Post in a recent interview. "Most businesses, except maybe for Porsche [dealerships], rely on rising purchasing power of the many, not the few, to deliver growth and profits." (ADRIAN DENNIS/AFP/Getty Images)