RBC on "Canada's Debt Threat"
JULY 27, 2011
Readers may be interested in an RBC Global Asset Management report released yesterday:
Canada's Debt Threat- Eric Lascelles, Chief Economist
It's an interesting read that sheds some light on the state of consumer finances here in Canada. As always, I find lots to agree with and lots to disagree with. Let's have a look at some of the key quotes:
"At the top of the list (of economic risks) is Canada’s towering household debt burden. This is a fascinating subject in that 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. The subject is also timely: the imminent arrival of higher interest rates will soon put debt affordability to the test."
It is refreshing to see economists recognize that the worst of the recession was fended off by robust spending on the part of the Canadian consumer. As other developed economies saw their consumers retrench and start paying off debt, ours 'mercifully' kept their wallets open. Granted, the bulk of the economic recovery is now driven by business investment, it would be a mistake to discount the impact that consumer spending, largely driven by low interest rates and the spin-off wealth effect from rising home equity, has had in buoying the Canadian economy.
The base instinct to fear for the sustainability of Canadian household finances is understandable. Canadians have partaken in a torrid love affair with credit, seduced by easy access to low borrowing rates. The stock of household credit has grown by over a third since the start of the credit crunch – averaging a meaty 8.1% growth per year. In contrast, personal disposable income has grown at just 4.0% per year. Credit cannot expand at twice the rate of income indefinitely.
No it can not! And unfortunately, it has not been just since the start of the credit crunch...
This enthusiastic borrowing has served to pickle Canadians ever more deeply in a brine of debt. Canada’s household debt-to-income ratio has now soured to a record high of 147%, and continues to rise...This puts Canada abreast of the U.S. – slightly higher, actually – and in stalking territory of the U.K. To make matters worse, American and British debt burdens are ebbing, while Canada’s continues to mount.
...So far, however, Canadian household debt has been remarkably manageable. As a proxy for household stress, both mortgage and credit card delinquency rates are within range of their historical norms. Mortgage delinquencies are running at 0.43%, versus a long-term average of 0.42% and a subdued pre-crunch level of 0.24%. Credit card delinquencies are pegged at 4.33%, versus a long-term average of 3.69% and a pre-crunch level of 3.01%. Some deterioration is evident, but there is nothing shocking here.
I've shown the delinquency rates across the provinces here before. It does mask some worrisome trends, particularly the very significant surge in delinquencies in Alberta and BC. While 'shocking' may not be the right word, it is more than a bit concerning that during times of exceptionally low interest rates and generally rising house prices (which we know help reduce delinquencies), mortgage in arrears data shows a generally climbing trend.
...the Canadian debt-service ratio – the fraction of household income dedicated toward servicing the interest on household debt – is at a pedestrian 7.6%, still below the historical norm of 8.1%
The same goes for the personal bankruptcy rate. This strongly suggests that households are actually feeling pretty good despite high debt-to-income ratios. Perhaps this shouldn’t be so surprising. While Canada is conventionally compared to the U.S. and U.K., others such as the Netherlands, Denmark and Norway maintain substantially higher household debt-to-income ratios.
It seems there is no single level that can be viewed as an iron-clad threshold. The sustainable level is simply the level that people can afford. This depends on the stability of employment, the age of the population, the purpose of the borrowing and the cost of credit.
All good points. It highlights the fact that there is a huge difference between recognizing that a trend is unsustainable and predicting exactly when the trend will turn. The sad reality is that we cannot entirely discount the possibility that this credit bubble could continue to inflate for another few years. Though that will only make the necessary deleveraging that much more painful, the ability and willingness of elected governments to 'kick the can down the road' cannot be understated.
I would point out that while the debt service ratio looks good, what is really needed is an analysis of the historic debt service ratio by age group. I believe that the data suggests that the 'debt pyramid' in Canada is highly skewed by the younger generation. It would be very interesting to see the historic debt service ratio for the under 40 crowd. I believe that the debt bubble is concentrated in this age group. It's those holding the most debt at the bottom of the pyramid that pose the problem, and I would again suggest that measures like the debt service ratio miss the increasingly vulnerable position of the younger generation compared to the past.
The great secret of household debt and home prices over the last three decades is that the secular shift towards lower interest rates was the main driver for an equal but opposite shift towards higher indebtedness and rising home prices... Although home prices today average 6.5 times per capita personal income, versus just 3.8 times in 1980, monthly mortgage payments are actually more affordable today. Every percentage point drop in interest rates has enabled around a 10% increase in home prices. The cost of borrowing has made all the difference.
Absolutely lower interest rates have enabled people to 'afford' to take on more credit. That part is obvious. However, there are other factors at play that I believe are ephemeral. Most notable is the unprecedented willingness of consumers to take on such debt. Canadians, and particularly the younger generations, are staggeringly comfortable with debt. This is a relatively new phenomenon and one that I will suggest will not last. Furthermore, there are important questions that are not addressed: How have consumers been able to access such massive amounts of credit, and will these credit spigots remain open as they have over the past decade?
To answer this, one has to look at CMHC's role in providing the necessary credit through a reduction in down payment requirements, an expansion in amortization lengths, and most significantly, a removal of regional mortgage insurance ceilings that limited borrowers to a certain size of mortgage. And as this mortgage debt has buoyed house prices, the equity position of many owners was buoyed substantially, enabling them to borrow cheaply against that equity. The resulting boom in lines of credit has been staggering...
The reality, as we've seen in the US, is that once consumer perception of debt changes, it matters very little what interest rates are. Demand for credit decelerates. Furthermore, with CMHC facing increasing media scrutiny, I would not be surprised to see another round of policy changes aimed at CMHC.
Finally, focusing entirely on interest rates to explain both house prices and debt levels misses the fact that for a full four year period, house prices and interest rates moved in the same general direction. I would suggest that there are more factors at work than just falling interest rates.
So far, our analysis has been confined mostly to averages. But the average household never goes bankrupt, never defaults on a loan and its primary breadwinner never becomes unemployed. It is individual households that suffer these indignities...
Thirty percent of Canadian households are debt-free. Another 35% have minimal debt of $50,000 or less. This is heartening. It is only the remaining third that carry a large burden of debt (Exhibit 5). Of these, there are many households whose debt easily runs three, four, and five times their annual income. These households are not necessarily as profligate as they may initially seem: a household with an average income that purchased an average-priced home would instantly incur a debt-to-income ratio of around 350%, on top of whatever student, vehicle, and credit card loans were previously outstanding. It is not hard to achieve a household debt-to-income ratio of 400% today.
I'm not sure this is quite as 'heartening' as what the author suggests. We know that household debt is averaging roughly $100,000 in Canada. Once again the law of averages wreaks havoc on stats like this. If we assume that the average debt held by the middle group is roughly $25,000, it would mean that the average debt level of the bottom group is $261,000. Even if we assume that the middle group is carrying an average debt load of $50,000 (which clearly it isn't), the bottom group has to be carrying debt loads in excess of $235,000 (AVERAGE!) to make these numbers work. Given that household income in Canada is still roughly $70,000, this implies a debt to income ratio of between 3 and 4 (300% to 400%) as an average for the entire group. And remember that within this group, the law of averages is once again at work, meaning the bottom 10% of households would almost certainly have debt to income ratios of 500-600%.
Again, I'm not entirely sure that this is comforting.
There is much more to the article, including an interesting discussion about the affordability picture in Canada, which the author believes is "the metric that matters." I'd like to discuss that concept in a second article later today.
Cheers,
Ben
Posted in:
47 Comments
Don't you feel like you're preaching to the deaf here?
I'm not an economist, but what are your thoughts on the approach of the BoC wrt interest rates? I seems to me that while the notion of keeping interest rates low might be sound theory in relation to the global situation, the Governor should be giving more credence to the, maybe unique to Canada, situation with the level of debt Canadians are taking due to the long period of negligible interest rates?
My feeling is once the dam breaches, we could be in for our own Canada Special economic crisis.
Saint, the BoC has to concern itself with the effect of interest rates on the value of the dollar. It is a complicated a problem with no easy answer. Right now, talk is the best strategy.
I've been wondering if Carney dropping the word 'eventually' in the last speech was as much of a hat tip as the media made it out to be. As I've said before, the BoC uses the stern lecture as its tool of choice for curbing consumer credit demand. I have a hard time believing they are in any hurry to raise rates, though they'd be happy if people believed they were.
I would imagine that if mortgage credit demand does not move more in line with income growth over the next few quarters, Carney will be putting the pressure on Flaherty to further stem the tide via policy changes rather than interest rate hikes, which, as you've suggested in the past, is too blunt a monetary tool.
Never forget, the market may change interest rates before the BoC does.
It's all about debt-service. Canadians are taking on more debt because they can afford to. Since interest rates are going to stay low by historical standards for quite some time, home prices may very well continue to climb.
Even the BoC is hinting that the neutral interest rate level may be 200 basis points below traditional levels over the long term. Mark Carney has made it clear that rates will rise gradually, allowing rising incomes over time to mitigate the affects of higher payments.
And where will these rising incomes come from?
You do realize that Canadian consumers are facing significant inflation in the price of goods and services, right? Take a gander at the latest stats from the Bureau of Labor Statistics on finished goods, to take but one example. Unless incomes rise significantly per year (or unless he stops eating, buying goods, putting gas in his car, etc), joe sixpack is going to lose ground.
The situation that the average consumer faces with respect to food prices is sobering enough on its own.
I'd really like to see an argument for rising incomes in REAL terms.
how are you going to have a rising income when anything you export will be more expensive than your larger neighbor. profits in Canada will shrink due to increased labor cost in production, lower profits will force down wage hikes.
I hope you understand that the US is probably going to start cutting social programs and when they do there will be absolutly no doubt that deflation has taken control.
We all saw the housing bubble grow and pop down there and are in complete denial about our situation. You have been given free money to inflate land values to a point where wages cannot sustain the price. Then inflation kicks in and tightens budgets forcing a contraction. Google Australia home prices and start understand ing that we are next.
mis-spoke.
sorry inflation in staples kick in but wages cannot follow because your trading markets are losing purchasing power due to devaluation and unemployment.
look around a greece right now.
look at England right now.
look at the US right now.
we are linked
Question (Seriously): What is the impact of more and more couples with dual income and women getting better and better salaries?
It's seems to me that debt ratios need to take this into account? What do you believe is the impact?
Already baked into the income stats. The income is reflected by household.
Ok but isn't this causing in part the housing bubble? I keep hearing houses are 11 times average income...while they were 3 times average during the past 40 years on average. Ok but today more and more houses are being paid with two incomes. it can also indicate a bubble is forming: don't expect houses to be paid by three incomes in the next 20 years.
1. CMHC has low LTV ratios
2. Canada doesn't have any panic financial weapons for people to trade - NO CDS, NO BONDS WITH TEASER's
3. Canada doesn't need the world, the world needs Canada. Canada has things our US friends don't OIL, POTASH, MUSTARD, COAL, GAS, etc.
4. Canada has a strong job picture inspite of the global meltdown
5. The world wants to hold CAD Assets
6. Canada is the SWISS FRANC of the west.
Go back to sleep, we are fine.
"Canada has things our US friends don't...COAL, GAS"
Your claim caught my eye, Sams. US is hands down the hydrocarbon king.
of course sams mango.
prices always go up and wages follow.
there is never a cycle of downward pressure
nobody as yet has said there is a problem with overpriced r/e.
r/e prices over the last 10 years are not from a credit expansion but our increased productivity and diversification.
the US will not have a contraction in its economy this year.
oil over $100 a barrel will not put the brakes on growth.
we are an island of the western world that has nothing to worry about.
of course your right, I should pull down the blinds and stop looking outside.
Hot off the press from the Canadian Bankers Association:
Mortgage default rates in Canada have fallen to 0.41%. (http://www.cba.ca/contents/files/statistics/stat_mortgage_db050_en.pdf)
Lets see now - Mortgage defaults are down, Bankruptcies are down, Unemployment is down.
Clearly this terrible debt-invested Canadian economy cannot last much longer - there must be a massive correction on the way - I can sense it.
I have to comment on the "Unemployment is down". In Canada, the number of the unemployed people is counted based on the number of the EI paid as they have no means to count the people that are not eligible to receive EI (either at all or have reached their time limit on EI) so as soon as they stop being the EI recipients (or newer were), they are not registered as unemployed. Lots of people that have newer found a job have miraculously became not counted anymore.
In US, EU and other countries the system is different as the state keeps some participation in the unemployed people's life and they are therefore can be counted.
So if the number of the EI people in Canada is falling, it only means that there are less fresh EI recipients comp. to few years ago. May be. I bet the count was done before RIM decided to let 2,000 people go.
You are quite correct that the latest unemployment numbers do not include the recent cuts at RIM. But for the record, the 2,000 RIM job terminations are for world-wide operations, not just Canada.
As for the veracity of the unemployment statistcs, as long as they calculated in the same manner consistently month after month, they are quite valid.
You probably meant:
"as long as they calculated in the same manner consistently month after month" they are always invalid?
I mean these numbers newer had nothing to do with the unemployment numbers but only with the current numbers of the EI recipients.
Arrears 2005 - 2008: 0.2x%
Arrears 2009 - 2011: 0.4x%
You call that down? Black is white indeed.
At 0.2% or 0.4%, either way, the mortgage default rate is very low and trending lower.
As stated in the RBC article above, the long-term average is 0.42%. So much for cherry-picking stats to suit your argument.
Calling a month-on-month drop from 0.45% to 0.41% a trend when similar undulations were everywhere in the past? Who's cherry-picking now?
Also, if you look at the actual numbers, the most recent decrease in the arrears rate was not due to any significant drop in the number of arrears but a jump in the total number of mortgages.
Take as second look at the chart. The default numbers were 0.45% in January, 0.43% in March and now are at 0.41% - that is a 5-month trend, not a month over month blip.
Also, when you wrote the following:
" the most recent decrease in the arrears rate was not due to any significant drop in the number of arrears but a jump in the total number of mortgages"
You're kidding right? You know what the word percentage means, don't you? Next thing you know, you'll be claiming that people are paying their mortgages with their credit cards - oops, somebody already beat you to that one.
Sure, your 0.45% to 0.41% trend is stronger than the 0.2x% to 0.4x% trend. Whatever.
You only know what the word percentage means, that's where it ends. You don't know how to, or perhaps you don't care about interpreting the meaning behind the percentage. If next month both the total number of mortgages and arrears doubles, the percentage will remain the same. However, the sudden doubling in the actual number of arrears would be concerning, as we would not expect new mortgages to go into default only after one month.
I assume that you also know what the definition of hypothetical means. Presenting an argument supposing a "sudden" event that hasn't occurred (or is ever likely to), is about as illogical a position that could ever be advanced.
It doesn't matter whether it actually occurred. It was just an example to illustrate a logical principle. I suppose in your eyes people like theoretical physicists are all idiots because they talk 'hypothetical' all the time. Realtors and appraisers are geniuses and gods. Whatever.
Wonder why mortgage default rates are down? Check Credit Card Statistics and Credit Card Delinquencies for your answer.
Pay with the right hand and borrow with the left.
"Canada has things our US friends don't .... GAS, etc."
I guess facts don't matter:
https://www.cia.gov/library/publications/the-world-factbook/rankorder/21...
https://www.cia.gov/library/publications/the-world-factbook/rankorder/21...
I can predict Sams response: The CIA lies!
Here's the chart for mortgages in arrears.
http://i53.tinypic.com/2ia4bo3.png
we are smarter than most
and there is the reason that canada is immune.
p.s. this is just a joke so lets all relax. :)
And Credit Card Delinquency and Loss Statistics Chart
http://i53.tinypic.com/ajm2dd.png
This is as of January 2011. I wonder what the next quarter results will look like.
a chart that loves heights
Here's a telling quote from the original RBC article that wasn't included in the above synopsis:
"Simplistic criticisms of Canada’s household debt-to income ratio also tend to neglect a very important offset: there are two sides to every balance sheet. Yes, Canadian households have debts valued at 1.5 times their annual disposable income. But they also have assets valuedat 7.5 times their annual disposable income. In other words, they have far more assets than debt, and this gap – their net wealth – continues to grow."
Well the numbers about the debts and assets explain everything. The low rates of the Mortgage defaults and Bankruptcies are very consistent with the "But they also have assets valued at 7.5 times their annual disposable income." when 70% of the people are home owners with the bubbled equity.
These numbers probably mean that many people simply use the HELOC to pay the mortgages and to support their failing businesses, and as long as there is no significant decline, they are OK. As long as they do not need to pay out HELOC.
They should have included HELOC amounts in the same article to see the full picture, where are the money coming from.
That's because they've avoided using MTM (mark-to-market) to value foreclosed homes.
Ben, that should explain how the CMHC plans to write down those 2011 planned mortgage securities to $310 billion this year. They've been hiding losses to look solvent.
An yet another interesting quote from said RBC article:
"The Canadian landscape is littered with unfulfilled prophecies of imminent housing collapse. It goes without saying that a housing correction has not yet occurred. How has this been avoided? To understand, it is best to think about housing affordability in the very way that buyers do. This is not in terms of a home’s absolute price tag, but in terms of whether a household can make the monthly payment fit into their budget. Thanks mainly to low borrowing costs, they usually can."
ah,
so all we have to do is keep interest rates low forever. There are no drawbacks to that scheme, of course. The job of the government is to create volumes of fiat currency, devalue everyone's savings, and hand out money to the banks for free. Not only will this achieve important social ends (income equality, etc), but banks are cleared to ignore restrictive and dated practices such as risk analysis.
Everyone wins.
Is this the same RBC who in 2008 purchased credit default swaps with MBIA on sub-prime mortages? Don't believe all that you read from bank reports because they're already on the other side betting this market is going to fail anytime soon...
Read on...
http://i54.tinypic.com/mr8mqt.png
http://i52.tinypic.com/33urgup.png
http://i54.tinypic.com/20jitm1.png
"Simplistic criticisms of Canada’s household debt-to income ratio also tend to neglect a very important offset: there are two sides to every balance sheet. Yes, Canadian households have debts valued at 1.5 times their annual disposable income. But they also have assets valuedat 7.5 times their annual disposable income. In other words, they have far more assets than debt, and this gap – their net wealth – continues to grow."
Could it be that asset value... and net wealth... include inflated home values? We know home prices continue to rise, beyond any human logic.
Thoughts?
What other assets would Canadians own at a 70% home ownership rate? Oh ya, the other 30% is stocks and mutual funds.
RBC says: "Credit cannot expand at twice the rate of income indefinitely."
Ben Rabidoux replies, "No it can not! And unfortunately, it has not been just since the start of the credit crunch..."
What's missing in this analysis? Easy - the cost of credit. Even though nominal credit volumes are currently outstripping income gains on a percentage basis, the cost of credit is so low, that income gains are easily accomodating the increase in debt service.
The consumer is not acting recklessly or irrationally at all - they are acting perfectly rational. They are increasing credit volumes because it is affordable. Until interest rates rise sufficiently to alter the equation, or credit volumes rise enough to absorb the slack, or the rise in incomes can no longer keep up to the pace of credit expansion, it will continue.
"The consumer is not acting recklessly or irrationally at all - they are acting perfectly rational."
It would only be "rational" if all of the consumers were able to lock into the interest rates for the full duration of the debt. i.e. - 2.35% mortgages locked for 30 years and not 5 year terms during which interest rate can fluctuate. Thus, there is nothing rational about this.
In any case, how long can these rates be this low. Normally functioning economies need higher roi than the meager 2.xx% otherwise you have irrational skewing of the risk and miss allocation of credit.
Market tops typically take about 3 to 7 times longer to occur than market bottoms. This puts RE bears in a long painful process of trying to call market tops. Kind of like stopping a rocket, the reverse of the falling knife. Tops tend to move sideways for quite along period of time before trending down again.
Although I have nothing against Garth Turner as an opinion, he will not publish my posts because I have said his market timing is so bad its as good as Robert Prechtors. Told him in a post that he should buy a busted watch so he can be right twice a day. If you don't allow posts that counter your view, that is information suppression and in my opinion, a form of propaganda. On the other hand, let me be clear that I have no intentions of buying this RE market. That is because there is evidence, albeit relatively recent, of market topping. According to "Scientists at Rensselaer Polytechnic Institute have found that when just 10 percent of the population holds an unshakable belief, their belief will always be adopted by the majority of the society." Keep the word unshakeable as a premise to stick to when believing the RE market is coming into a correction period.
I have had disagreements with some on this blog about market timing. They proclaim that you cannot do it effectively. Au contraire I say. I only make statistics and charts of past data a far smaller part of my analysis for market tops or bottoms. What I use is psychological measurements and have found them to be far more useful, and profitable for that matter.
According to statistics, there is about a %70 ownership rate in this country. As for the remaining %30, there is no doubt a relatively high number of RE bulls that are feeling disappointed they did not buy RE earlier.
I did not buy. I do not regret not buying RE. There are still bulls abound for Canadian RE, far too many for me to consider buying into this market. In other words, most if not nearly all (outside of this blog and GT's blog etc) are huge RE bulls. That means most are on one side of the boat and will provide statistics and data supporting their case. I will remain on the other side until it gets a bit crowded for my comfort. Then and only then would I consider buying RE.
Unfortunately, because RE and markets in general take so very long to top out, those early callers like GT and Ben have to bear the brunt of heavy criticism from "the crowd" or mainstream with almost hyenas like laughter directed at them.
Although I wish early callers like Ben and GT would realize how long markets take to top out, I respect their willingness to shout from the empty side of the boat, the side I as well am on. In fact, perhaps I can be looked upon as the silent minority who should have the fortitude to speak louder. I do not because I understand the power of psychology and the long periods market tops keep the bulls confident.
The only thing one can do, if they believe a market correction like myself is imminent, is stay in cash. Which I keep building and is well positioned to put more than %50 down on a homes purchase, and still have plenty leftover.
Again I say, "Patience young man", is what my psychology is whispering.
Even with RE bulls around—the problem is RE liquidity and when the market turns many will be trapped and left underwater. One can not assume there will always be enough buyers in the market.
I too am a cash-hoarder patiently waiting...
Excellent comments! I couldn't agree more.
Appraiser , i don't quite see it that way
"
What's missing in this analysis? Easy - the cost of credit. Even though nominal credit volumes are currently outstripping income gains on a percentage basis, the cost of credit is so low, that income gains are easily accomodating the increase in debt service
"
lol,
if nominal credit is outstripping incomes forcing a borrower to obtain higher credit to purchase the same asset then you are in a ponzi scheme and it will end. Credit cannot go past a point where incomes support the purchase. Incomes because of free trade are not protected and due to this a credit bubble has been formed to keep up a fake demand. Every other country in the developed world is now deflating that I know of but us and that is because money is fleeing the US and seeking safety until an interest rate hike which will happen to bring back investment.
this is why the US lost its manufacturing and is losing it IT. Anything that can be actually built will go to the lowerst labor point if the same tech is used.
At least Canada has a rose coloured set of bubbles with slightly thicker skins than the global norm.
However, the inevitability of mathematics, gravity and the spectre of rising interest rates, involuntary or not suggest strongly that Canada deferred involvement in the collapse rather than avoiding it.
Did the report mention Canada basically has only one customer and that customer is bankrupt?
Sometimes people survive the initial blast but fall victim to aftermath. When combined with the frightful reality of global associations, ALL indication point to Canada's economic outcome becoming catastrophically impacted once the insanely over valued and hideously leveraged real estate situation becomes less of a dirty secret.
Interest rates have been known to shoot to 19% + from a standing start... I said "never" one time before... never again will I say it.
Canada's economy is a snowball in flight... with a brick and siding wall dead ahead.
Time to stop with the whitewash and prepare for reality which is always inevitable and most often bites if not faced up to. Time to stop being terminally polite perhaps?
http://beyondprophecy.blogspot.com/