The Canadian Mortgage Conundrum

If we look back at recent history, we can all remember the global economic crisis of 2008. Of course, many of us know that this crisis was triggered by a bubble in residential housing propped up by the availability of sub-prime mortgages. The collapse of the housing market had such a widespread effect that there were even movies made about it (i.e., The Big Short).

However, since that gloomy time in 2008, the US housing market has done a satisfactory job of recovering. This is in large part due to the fact that American households were able to deleverage.

Deleveraging is when a company or individual attempts to decrease its total financial leverage. The most direct way for an entity to deleverage is to immediately pay off any existing debt on its balance sheet. If unable to do this, the company or individual may be in a position that increases its risk of default.

That is the exact position that a large portion of Canadian homeowners are in. At this point, even a seemingly insignificant change in rates could cause the first domino to fall, thus setting off a chain reaction.

To quote Frances Donald of Manulife Asset Management “The economy has never been as levered as it currently is, and the economy is far more interest-rate-sensitive than it has been in the past, to a degree that we don’t have certainty over how each interest rate hike is going to affect Canadian consumers.”

The high household debt is arguably a crucial reason the Bank of Canada hasn’t already increased borrowing costs more. According to Stephen Poloz, Governor of the Bank of Canada, as of February the household debt figure in Canada was C$2.1 Trillion ($1.6 Trillion USD). This included both mortgage and non-mortgage debt.

Due to high Canadian household debt, the economy is estimated to be roughly 50% more sensitive to rate hikes than any previous point in history.

Not only is household debt at an all-time high, Canada is entering a year where 47% or more of existing mortgages will need to be refinanced. In an average year, there are generally 25%-35% of mortgages up to be refinanced.

Additionally, these mortgages are going to be refinanced right in the middle of the biggest mortgage interest increase in over a decade.

Generally, mortgage lending institutions will use “stress tests” to help reduce their exposure to risky borrowers. However, with new “stress tests” being implemented, it is pushing some borrowers to alternative lenders that charge astronomical rates. Will Dunning is quoted as saying, “In that sense, the stress test is not reducing risk. It’s increasing risk”.

According to Statistics Canada, total payments on debt made by Canadian Households rose 6.7% in the fourth quarter from a year earlier, and the interest-paid component climbed 9.2%. Those were the biggest gains since the 2008 financial crisis. Debt payments by Canadians now represent roughly 14% of household disposable income.

canada household debt service_0

This high household debt ratio and diminishing ability to service outstanding debt is certainly reason for concern. The effects can already be been seen. Vivek Selot, an RBC analyst, stated that the percentage of credit card users who “roll” from early-stage delinquencies to 60-89 day delinquencies, reached the highest since 2008 for one credit card program.

To go along with what Vivek pointed out, first quarter retail sales probably posted the biggest quarterly drop since the 2008-09 recession.

more: Deleverage

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