Are Canadians building debt bubble?

By Mark Noble | December 18, 2009 | Last updated on December 18, 2009
4 min read

While Canadians are in better financial shape than majority of the developed world, we are using low rates to quickly ratchet up debt. And economists say it’s not necessarily a bad thing.

Overextended household balance sheets – especially in the U.S. and U.K. – were ultimately the root cause of the global financial meltdown. Canadians with government-imposed mortgage insurance and a generally higher level of savings were able to avoid the catastrophic collapse in real estate prices experienced in the U.S.

However, Canadians are now ratcheting up their debt levels as evidenced by the rapid-run up in property prices in urban housing markets. Bank of Canada governor Mark Carney recently expressed concerns that Canada is building a home grown debt-bubble set to burst when interest rates rise.

He suggested Canadians are not adequately preparing themselves for a environment of rising rates within the next 18 months.

A new report by CIBC World Markets presents a partial rebuttal to Carney’s comments.

“Make no mistake: Canada is not doomed to see a U.S.-style housing and mortgage blow-up,” says CIBC’s chief economist Avery Shenfeld in the bank’s latest Economic Insights report. “There are three lines of defense for those with high debt service ratios that the BoC analysis ignored.”

Shenfeld adds, “One, some mortgage holders will have substantial home equity, even allowing for a house price slide, and [these homeowners] could downsize. Two, others have high debt payments because they are making accelerated pay-downs of principal, which they could stop. Three, history suggests that many will jump into fixed mortgages in time to avoid the full brunt of the variable rate shock. The result is that the number of Canadians truly at risk could be substantially less than the (Bank of Canada’s) estimate.”

Setting themselves up for trouble

Some Canadians are clearly going to be over their heads.

At just under $350,000, the report estimates that the current average Canadian house price is roughly 7% higher than they should be, based on market fundamentals such as interest rates, income growth, rents and demographics. Prices are most overvalued in western Canada.

In addition, the report highlights that mortgage credit is now rising at a year-over-year rate of more than 7% and the household debt-to-income ratio rose to a new all-time high of more than 140%. Not only was this past recession arguably the worst in the post-war era, it’s also the only recession during this period when real household credit continued to expand through a recession.

“Given that the current overvaluation is occurring in a context of historically low interest rates, what we are most likely witnessing is a temporary period of exuberance that is ‘borrowing’ activity from the future, as households take advantage of lower rates and accelerate their borrowing and home purchasing activities,” says Benjamin Tal, senior economist at CIBC. “The reality is that in the past, interest rates have played only a minor role in driving mortgage default rates,” he adds.

Tal adds that rising unemployment is much stronger risk to the health of debt servicing.

“Historically, it’s clear that mortgage arrears rates are highly correlated with the unemployment rate, with little or no correlation with changes in interest rates. The same goes for the economy in general. Over the past three decades, personal bankruptcies have risen twice as fast in an environment of falling interest rates than in an environment of rising rates,” Tal says. “The logic here is obvious. Interest rates rise when the economy recovers, and the benefits to employment and incomes of an improving economy easily offset the sting of higher interest rates on debt service costs.”

While concerned about the undue risks Canadians may be taking with their money, Sal Guatieri, a senior economist at BMO Capital Markets, says domestic demand created by the housing boom is sustaining a fragile economic recovery.

“The strong domestic demand will offset the demands on the external side, keeping our economy moving forward. Rising debts do make Canadians more vulnerable to an economic shock, which could occur as either a spike in interest rates or a new economic recession,” he says. “We expect interest rates to rise in the middle of next year but do so gradually, not aggressively. I think the Bank of Canada realizes that if it raises rates too fast, some vulnerable households will just pull back too quickly and that will tip the economy into recession.”

With few other sectors of the economy firing on all cylinders, Guatieri says even with rising rates, an inflationary cycle is unlikely.

“There is a lot of slack in the economy — unemployment remains high, so the Bank of Canada has time to renormalize policy. Inflation should not be a problem for several years,” he says. “We’re certainly monitoring the Canadian housing market because it plays an integral role in the total Canadian economic outlook. The housing market is likely overvalued &151; we estimate about 1/3 or 30% overvalued in relation to incomes and rents. That means the market is susceptible to a correction if interest rates rise too quickly.”

Canadian borrowers do have to account for whether they can still comfortably carry their debt-loads if either home prices drop or interest rates rise 1% to 2%.

“Canadians should be careful not to take on too much debt and if they can, they should use their interest rate savings to pay down their mortgage. When it comes to refinancing four or five years down the road it will almost certainly be at higher interest rates,” Guatieri says.


Mark Noble