What will Carney do if Canadian household debt keeps rising?

Date: Friday, May 11th, 2012

By Melanie Epp

Mark Carney believes that record high household debt is the number one threat to the economy. He also believes that if he raises interest rates it would hurt economic recovery, but slow spending.

“In exceptional circumstances,” he says, “If there are issues that threaten financial stability, such as household debt … the bank could use monetary policy for that purpose.” And Carney believes that we are well on our way to these “exceptional circumstances.” As a proportion of disposable income, household debt reached almost 151% by the end of last year. Currently, it stands at 153%.

Very soon, that number is expected to reach 160% – a number similar to that of the US just before the 2008 financial crisis.

“We have never been as indebted as we are today as individuals,” says Carney. “We’ve done analysis which shows that about 10 per cent of Canadians are vulnerable if interest rates returned to more normal levels, which will happen.”

Why is debt growing?

Currently, income growth is currently well below the rate of inflation. Because income growth has slowed, more and more Canadians are borrowing money to buy homes, or are taking loans out on their homes.

Despite what Carney says, though, private sector analysts keep telling Canadians that the Bank of Canada is unlikely to hike rates for at least another year, so many aren’t feeling the pinch. As long as the rates remain low, Canadians feel like they can afford the homes they’ve bought. Sure, record high debt doesn’t seem like an issue as long as home prices keep rising and interest rates remain low, but Carney warns that they’re not going to be this way forever.

As they certainly will, what happens if house prices drop and interest rates rise? Not only will Canadians see the value of their homes plummet, but they’ll also have higher debt to manage – all while income growth remains modest at best. The outcome? Canadians just won’t be able to keep up.

But will home values plummet? It’s hard to imagine, since they’ve been on the rise for so long with no sign of stopping. During an interview on CBC Radio’s The House, Carney told Evan Solomon that there are “issues in some segments” of the housing market, but he didn’t go as far as to say that a housing bubble exists in Canada.

“There are issues particularly in some parts of the country, in the condo market, without questions, where activity has been particularly strong,” he says. “And in some of our major cities, without question, evaluations are extremely firm.”

In particular, unsustainable condo markets in both Toronto and Vancouver have economists worried. The average home price in Vancouver finally declined in March from $823,749 to $730,998. In Toronto, however, the average home price continued to rise from $499,354 in February to $503,998 in March. Across Canada, the average home price is five times that of income, says Carney. The norm is 3.5 times higher.

While Carney says that there are a number of defense mechanisms that can be used to protect against a housing bubble, he suggests that it is ultimately up to Canadians themselves.

“First and foremost, it’s the decisions of the individuals who take out the loans, and Canadians are a smart and prudent people,” he says.

The responsibility, though, doesn’t just lie with Canadians, though; the banks and institutions are also responsible. They need to wise up and stop lending to people who clearly can’t afford the debt. Rates will rise and when the time comes, Canadians need to make sure that they will be able to carry their debt load.

What happens if debt becomes an issue? Without a doubt, some Canadians will be in over their heads when interest rates rise. Others will manage but be forced to reduce spending, a move that will help further slow economic activity.

Meanwhile, private sector analysts tell a very different story about the housing market. They almost unanimously agree that when compared to cost of renting and income, housing prices are too high in Canada. They suggest that a correction is coming, which could result in prices dropping by as much as 10-25%. In over-inflated markets, like those found in Vancouver and Toronto, those corrections may be even higher.

It’s not as if they’re not trying to fix the problem. Jim Flaherty, Minister of Finance, has made three attempts to deflate the housing bubble in the past six years by tightening mortgage-lending rules. Canada Mortgage and Housing Corporation (CMHC) have also done their bit to amend the system, as has the Office of the Superintendent of Financial Institutions (OSFI). In the recent federal budget, Flaherty announced that the government would introduce legislation that will increase governance over CMHC. And it since has.

Just last week, the Globe and Mail reported that Ottawa is “beefing up its scrutiny of CMHC and the more than $500-billion in higher-risk mortgages in its care.” The Conservative government has given OSFI, Canada’s banking regulator, new authority over CMHC.

Initially, the purpose of CMHC was to provide social housing and to insure mortgages for those who were unable to make down payments so that more Canadians could buy homes. Until recently, the federal minister of Human Resources oversaw CMHC. In 2007, CMHC’s mortgage portfolio had a legal limit of $350-billion. Since then, that limit has been increased three times to its current cap of $600-billion – a number that it is fast approaching. If mortgages run over, it’s Canadian taxpayers who’ll have to foot the bill, which is a scary thought since the pool is currently full of high-risk borrowers.

The government is also banning banks from using mortgages that are insured by CMHC as collateral on covered bonds. The practice, it says, goes well beyond CMHC’s mandate. Ottawa says that the new rules will ensure that CMHC’s commercial activities “promote and contribute to the stability of the financial system.” Although the CMHC has become an important financial institution, it has not been subject to the rules of OSFI, says Flaherty. Now it will be.

It’s not just CMHC that’s being scrutinized. Mark Carney has also spoken directly to the banks, asking them to get on board by curbing their lending practices.

Although Carney is constantly warning Canadians about rate hikes, he says that they are a last resort, only to be used if debt threatens the financial stability of the country. Rate hikes will only be used as an option to complement other measures, he says. If debt does continue to rise, though, Carney will intervene. A new agreement, which came into effect last year, gives him the power to act whenever he needs to, if necessary.

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Melanie Epp

Melanie Epp

Melanie is a freelance writer based in Guelph, ON. A member of both PWAC and IFWTWA, she writes on a variety of subjects, including real estate, personal finance, and marketing. She is a regular contributor on Sympatico's YourMoney.ca.

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