Canada's Housing Bubble

Analysis of the real estate bubble in Canada --

Record household debt could be Canada's undoing, economist says Print E-mail

Jul 29, 2011 John Morrissy Financial Post

OTTAWA— The very thing that lifted the economy from the depths of the recession — Canadians’ passion for owning a home — could also be its undoing, warns the chief economist for RBC Global Asset Management.

Central to Eric Lascelles’ concern is that the availability of cheap credit has driven household debt levels to record highs and soon-to-be-rising interest rates will bear a “palpable” impact on individuals as well as the broader economy.

“The very source of Canada’s relative success during the worst of the credit crunch — a banking sector that kept on lending and households that kept on buying — could yet spell its undoing if newly enlarged household debt loads prove too onerous to bear,” Mr. Lascelles says in a report issued Tuesday.

Further, he adds: “There is a popular misconception that the Bank of Canada cannot afford to raise interest rates because this would prove too damaging for mortgage holders. The opposite is in fact true. The reality is that the Bank of Canada cannot afford to delay raising interest rates, for precisely the same reason. The longer the bank delays, the more marginal borrowers will enter the market and be walloped when rates rise, and the further home prices will go above their equilibrium levels, only to tumble later.”

Once the Bank of Canada raises its key lending rate from the current “astonishingly cheap” one per cent, rising costs of servicing mortgage and other debts will sap consumer spending. Housing prices will fall as lower-tier buyers are forced out of the market by diminished affordability.

The strength that the housing market now provides the economy will morph into an “outright drag” on Canada’s overall growth rate, or gross domestic product, Mr. Lascelles concludes.

In terms of market implications, Mr. Lascelles says RBC remains “cautiously constructive” on Canadian equities and estimates that the banking and resource sectors will remain mostly untouched.

“However, it is undeniable that certain sectors — those catering to consumers and housing, in particular — could lose some of their mojo.”

The good news, considering previous stern warnings about the impact of elevated household debt — including those from Bank of Canada governor Mark Carney — is that “this is unlikely to be an outright recessionary event, nor does it fully compromise the ongoing economic recovery.”

As well, Mr. Lascelles’ research shows that despite the high average levels of household debt measured against income, currently at a record high 147%, only a relatively small portion of Canadians appear vulnerable to the most severe impact of rising rates.

Many Canadians still have spare spending capacity to allocate to rising mortgage costs and many are paying more on their monthly payments than the minimum required, leaving room for a reduction if needed.

As well, two-thirds of Canadian mortgage holders have fixed-income mortgages. Assuming an average five-year term, most of these homeowners will actually enjoy a reduction of rates when their mortgages roll over, Mr. Lascelles says. Beyond 2015, most will face higher rates, but by that time the impact will be mitigated by three years of rising household incomes.

The risk is greater and more immediate for holders of variable-rate mortgages. But even here, the majority bought before rates dropped this low, so rising rates would simply return them to levels they found affordable in the past.

Yet while many Canadians’ debt levels remain manageable, there are hints that household finances for certain at-risk groups, including seniors and those with low incomes, are becoming less favourable.

“The risk is clearly greatest of all for those who have just purchased a home,” Mr. Lascelles said. “They are on average earlier in their career, and their income has not yet fully blossomed. They often begin with little equity in their dwelling, having neither contributed much equity up front, nor made many mortgage payments, nor enjoyed the fruit of rising home prices. Their debt load is likely at its lifetime peak.”

Thus, the outcome of rising rates “will be quite painful for a small subset of households, but does not represent a systemic risk” similar to the devastation on the U.S. economy of its housing collapse.

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