Canada's Housing Bubble

Sep 08, 2010 Paul Vieira Financial Post

Ottawa -- Any savings Canadians have realized through this period of near-zero interest rates have been all but wiped out by the large amount of debt households have taken on, new research shows.

As a result of the rush into home ownership over the past decade that saw housing prices soar, mortgage principal payments as a share of income are now double what they were in the early 1990s, when interest rates were in double-digit territory. But starting in the early 1990s, rates began a downward trend that lasted nearly two decades. This time around, rates are as low as they can go, so households are stuck with sizeable debt payments for the foreseeable future.

The conclusions are from reports done by Scotia Capital in highlighting the risk posed by household debt on the economy. In essence, it presents a dilemma for the Bank of Canada, which releases its latest interest-rate decision this morning.

The global recovery has quickly lost steam, leading some analysts to argue the central bank needs to pause until the economic dust, especially in the United States, settles.

Yet, Canadian households — whose debt-to-disposable income levels now exceed 140%, a record high — continue to take out loans at a robust rate, with central bank statistics suggesting household credit expanded at an annualized 7.1% pace for the three-month period ended July 31.

The Bank of Canada may have to raise rates further to get the message across to households accustomed to loading up on debt financing, and which now allocate roughly a fifth of their income toward debt servicing.

But the Bank of Canada can’t raise rates too much without completely choking off consumer spending, which makes up nearly two-thirds of gross domestic product.

“The markets have discounted the evidence of domestic imbalances too aggressively,” said Derek Holt, vice-president of economics at Scotia Capital. “There is a need to take away the punch bowl [of low interest rates] because it is distorting consumer choices in the marketplace.”

The need to contain household debt arises from a concern that another economic hiccup could trigger a series of defaults and delinquencies in the banking sector — and in effect making loans more expensive and pulling the Canadian economy down.

Bond rater DBRS said in a recent report that as of the end of 2009, total household liabilities in Canada stood at a historic high of 146.2% of disposable income, of which two-thirds was tied up in mortgage debt. This can be attributable to the increase in available credit in the financial system, and the greater use and comfort of consumers with personal debt.

Mr. Holt said this rush into real estate over the past decade, which saw house prices double, moved up the timing of consumer spending at the expense of future years. The key implication for the Bank of Canada, he said, is the central bank must be cognizant of “overly disrupting” domestic imbalances through rapid rate hikes.

With households already stuck with high principal payments, rising interest rates “will definitely have an impact on economic growth,” said Peter Bethlenfalvy, co-president at DBRS, adding the Bank of Canada would be right in raising rates Wednesday if it is troubled with household debt.

“We have to be cautious about debt levels, especially if they don’t go down with rising interest rates as that will cause problems down the road.”

Late last year, Mark Carney, the governor of the Bank of Canada, warned banks to exercise caution in lending to households, and analysts say consumer debt remains a key concern for central bank policy makers.

A pending slowdown in consumer spending, as debts get paid down, is perhaps why the Bank of Canada is anxious for the business sector to pick up the pace of investment. Corporate Canada did just that, with purchases of machinery and equipment growing at its fastest rate since 2005.

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