Why household insolvencies are climbing in a strong economy

The rise in Canadian household insolvencies demonstrates the impact of interest rate increases on a population carrying large amounts of debt, a CIBC report says, with lessons for investors and policymakers.

Consumer insolvencies are up more than 9% year over year, and Canadians’ debt to income ratio ticked up to 175.9% in the third quarter.

It’s a strange time for household credit stress to climb, with unemployment near multi-decade lows until last month, CIBC Economics said in a report released Wednesday. Ontario has seen just as large a spike in insolvencies as Alberta, whose economy is in rougher shape.

The report also ruled out the housing boom as the problem’s source, even though almost two-thirds of households’ outstanding credit is in mortgages. That’s because the numbers show that households are  prioritizing mortgages but falling behind on other debt.

So which debt is causing problems? The report pointed to products where interest rates were reset with increases in prime tied to the Bank of Canada’s 2018 rate hikes.

Write-offs are up on unsecured lines of credit and home equity lines of credit, for example, but not on credit cards, whose rates aren’t influenced by monetary policy.

“Households have been shifting debt from credit cards to lines to save on interest costs but were then squeezed as rates on [unsecured lines] began to climb,” the report said.

It called non-mortgage consumer debt “the canary in the coal mine” for turning points in the credit cycle.

While insolvencies have risen, the report pointed out that the increase has come from proposals to restructure debt rather than more costly bankruptcies.

It also noted that more people seem to be seeking proposals before they start missing payments. This could be due to marketing for insolvency trustees that’s created more awareness of alternatives to struggling through missed payments.

The report also noted that big banks have seen rising loan-loss provisions.

Last week, the Office of the Superintendent of Financial Institutions said big banks need to set aside more capital to prepare for future economic turmoil, pointing to risks from elevated household debt.

A report from Moody’s warned about the risk consumer debt poses to Canadian banks.

“Employment remains strong, but bank asset quality will deteriorate from consumer insolvencies if there is a significant increase in unemployment,” Moody’s vice-president Jason Mercer said in a statement.

The CIBC report downplayed the risks to investors but stressed the lessons for central bankers. The economy, with its high levels of household debt, would be “much more sensitive to interest rate hikes than in the past,” it said — something the Bank of Canada has repeatedly warned about.

“If raising the overnight rate to only 1.75% could set off a climb in insolvencies, before any major job losses have been seen, it’s clear that taking rates to anywhere near what was historically neutral, or even where some models might currently put neutral, could prove to be overkill,” the report said.

“Monetary policy will have to look a bit dovish to be only neutral for the economy as a result.”