The rising indebtedness of Canadian households in recent years has increased the possibility that a significant proportion of households would be unable to make debt payments in the event of an adverse economic shock. This growing vulnerability has heightened the risk that a deterioration in the credit quality of household loans would amplify the impact of the shock on the financial system. The resulting increase in loan-loss provisions for financial institutions and the reduced quality of the remaining loans would lead to tighter credit conditions and, in turn, to mutually reinforcing declines in real activity and in the overall health of the financial sector.
The vulnerability to this risk remains elevated and is broadly unchanged since June. There are tentative signs that the sustained rise in the proportion of vulnerable households in recent years has moderated and credit growth has slowed noticeably over the past six months. Nonetheless, our simulation results suggest that household balance sheets remain vulnerable to adverse economic shocks...
While the growth of household credit has slowed since early 2011, it has continued to increase more rapidly than income. As a result, the debt-to-income ratio of the Canadian household sector increased to a historical high of 149 per cent in the second quarter (Chart 23) and has been higher than the ratio in the United States since the start of 2011.
If recent trends persist, the ratio of household debt to income will continue to rise
Despite the rebound in the growth rate of mortgage credit in October, the Bank expects a gradual moderation in the underlying trend in household debt accumulation over the medium term as activity in the housing market slows and as lower commodity prices and heightened volatility in financial markets weigh on the wealth and confidence of Canadian households. Since the growth of personal disposable income is also projected to be moderate, the gap between credit and income growth is expected to narrow but remain positive, implying that further increases in the aggregate household debt-to-income ratio are likely.
The overall financial situation of households remains strained
Data for both individual households and the sector as a whole indicate that the financial situation of the household sector remains vulnerable. In particular, both the share of indebted households that have a debt-service ratio exceeding 40 per cent and the proportion of debt owed by these households remain above the 2000–2010 average.
The aggregate credit-to-GDP gap for Canada has fallen from its cyclical peak but remains high by historical standards, owing to the growth in household credit. International evidence has shown that this indicator is a useful guide for identifying a potential buildup of imbalances in the banking sector.
Financial stress in the household sector has eased since the beginning of 2011, although it remains above pre-crisis levels: mortgage and consumer loans in arrears have moderated somewhat during 2011 but are nonetheless elevated. As well, the ratio of household debt to assets remains above its pre-crisis level, and household net worth declined modestly in the second quarter. Given negative returns across a broad range of assets since mid-year, net worth is expected to have declined further in the third quarter.
Households are vulnerable to adverse shocks to the labour and housing markets
Given the vulnerable state of their balance sheets, households would be less able to cope with the impact of significant adverse shocks. Two interrelated events to which Canadian household balance sheets are vulnerable are a significant decline in house prices and a sharp deterioration in labour market conditions.
Since high-ratio mortgages in Canada are insured, it is likely that a moderate fall in house prices would affect systemic risk primarily through the negative feedback loop with the real economy. In such a scenario, declines in house prices would lead to lower household net worth, reduced access to secured credit and lower employment in the housing-related sector. These factors would reduce consumer spending and increase strains on household balance sheets.
Some measures of housing affordability suggest continued imbalances, owing to the robust performance of this market. In particular, house prices remain very high relative to income. Since the adverse impact of elevated residential property prices on affordability has been largely offset by low interest rates, affordability would be considerably curtailed if interest rates were closer to historical norms.
Certain areas of the national housing market may be more vulnerable to price declines, particularly the multiple-unit segment of the market, which is showing signs of disequilibrium: the supply of completed but unoccupied condominiums is elevated, which suggests a heightened risk of a correction in this market.
A sharp and persistent increase in the unemployment rate would reduce aggregate income growth and make it more difficult for some households to make their debt payments. It would also have adverse knock-on effects on consumer confidence, the housing market and Canadian household net worth.
The elevated debt loads of the household sector require continued vigilance
The Government of Canada has taken important measures in recent years to strengthen underwriting practices for government-backed insured mortgages. The most recent set of measures was implemented in March and April 2011, when the maximum amortization period was reduced from 35 to 30 years, the maximum loan-to-value ratio when refinancing a mortgage was lowered from 90 per cent to 85 per cent, and government-backed insurance on lines of credit secured by houses was withdrawn. These measures represented the continuation of a series of actions taken by the Government of Canada since 2008 to foster stability in the domestic mortgage market, and should help to moderate the future growth in household debt. Nonetheless, continued vigilance is warranted, since adverse debt dynamics remain in place. The Bank is co-operating closely with other federal authorities to continuously assess the risks arising from the financial situation of the household sector.
Given the robust pace of mortgage credit growth in recent years, the Office of the Superintendent of Financial Institutions has conducted focused research on retail lending products over the past 18 months. An advisory was recently released noting that additional analysis is planned in the coming months. Where appropriate, this analysis will build on international mortgage underwriting principles being developed by the Financial Stability Board. OSFI has reiterated that mortgage lenders are expected to have an established policy for mortgage underwriting that is supported through appropriate risk-management practices and internal controls.
Key points and comments:
- Household balance sheets are likely to deteriorate further in coming months, and potentially years, with current controls in place.
- The Bank of Canada sees high house prices relative to incomes as unsustainable in the long run.
- OSFI is concerned about a disconnect between bank lending practices and long-term economic stability.
- Curbs on lending in terms of implementing risk management measures and countercyclical buffers on mortage loans are likely in the works.
- Usually announcements of further tightening of mortgage credit are announced in the first two months of the year to allow for proper implementation before the brunt of the peak of Canada's spring selling season.
If the Bank of Canada feels the need to lower interest rates in early 2012, this paper suggests that they are seriously considering additional curbs on mortgage lending to offset any additional monetary stimulus. This may mean, in particular overheated regional markets (like Vancouver's), that OSFI will start enforcing measures more closely tied to regional price-income metrics. This means Vancouver homeowners may find credit availability tougher than other regions of the country.
This is an important report. I have been surmising that further curbs in mortgage lending are coming, but am still unsure what form they will take. It is still possible that curbs going forward will start delving into the low-ratio mortgage market -- if prices do start falling banks who are lending on terms incompatible with government-backed mortgage insurance will create a significant liability for Her Majesty's Government.