How Un-likely is a Canadian Financial Crisis?
A series of reports from respected and conservative economic analysts from around the world warn that the Canadian economy is at risk of a financial crisis similar to that experienced by the U.S. in 2008. These reports are covered in detail in our recent article “How Likely is a Canadian Financial Crisis?”
Respected economists and leaders from Canada’s major banks feel that the warnings are overblown. The CEO of Scotiabank, the Chief Economist for CIBC, and a January 2018 analysis from National Bank economics make the argument that the risks are much less likely to affect Canada. It is worth noting that these banks have loaned billions of dollars in mortgage financing so they are closely monitoring these risks and want to manage their shareholders’ concerns.
| Bank | Mortgage Balances |
|---|---|
| RBC Royal Bank | 233 billion |
| Scotiabank | 208 billion |
| CIBC | 203 billion |
| TD Canada Trust | 190 billion |
| BMO Bank of Montreal | 106 billion |
| National Bank | 67 billion |
| Total | 1 Trillion |
Source: BNN, Big banks keep growing mortgage books despite new stress tests, Mar 2, 2018
Is Canada at a High or Low Risk?
Our recent article “How Likely is a Canadian Financial Crisis?” details how reports from the Bank of Canada,the IMF, U.S. Fed, and BIS believe Canada has an elevated risk of a financial crisis.
At the core of these warnings is a belief that people’s loans should not exceed their ability to repay them. As interest rates rise, repayment of debt will become more costly and challenging so the only way for Canada to improve the situation in the face of rising rates, is to borrow less. Since most Canadian debt is to support home purchases, this means smaller home buying budgets.
The arguments that Canada is at low risk, or that the impact would not be great are anchored on the following key factors:
Consistent economic growth
Home prices are relatively reasonable
We aren't the only ones with record debt
Employment and incomes are growing
High home ownership rate
Growing population
Low mortgage arrears
When I began writing this article, the intention was to show why Canada will not experience a financial crisis or financial stress event. Upon completing it, I feel confident that a Banking Crisis is unlikely, but I am not reassured that the average Canadian is not at risk of a financial stress event.
Consistent economic growth
Economists have pointed out that Canadian GDP growth since early 2007 has surpassed that of all other G7 economies, therefore the Canadian financial system must have solid economic support. Canadian GDP growth has hovered between 1% and 3% for the past few years.
In the context of high consumer debt levels, household income growth is likely better than GDP growth to prove we Canadians can handle higher interest rates. Between 2005 and 2015 Canadian incomes only grew 10.8% (1% annually). Over the same timeframe interest paid on household debt grew by roughly 25% (2% annually) while interest rates were at historical lows. Since 2016, 5-year fixed mortgage rates have increased 40% from roughly 2.5% to 3.5% and half of Canadian of mortgages are coming due for renewal in 2018.
Nevertheless, the economists are correct. Even if Canadian households feel financially strapped, so long as the economy is growing and people have jobs, they will continue to make their mortgage payments and a crisis is avoided. If the interest rate increases from 2.5% to 3.5% on a $300,000 mortgage, the impact to the homeowner is about $1,800/year.
Home prices are relatively reasonable
National Bank compared Canadian Metro Areas to other cities around the world to point out that even though prices are steep, they are relatively affordable compared to a list composed mostly of Global Megacities. This argument holds water if Vancouver real estate is viewed as a commodity in a global real estate market where people buy and trade homes in all of the cities above and the locations are seen as interchangeable. If we accept his argument, then we are saying that our prices are driven by global demand for real estate investment and not local incomes seeking to buy a home for shelter. This strengthens the case for taxed on foreign buyers and ownership taxes or outright bans on foreign ownership, but there are many who argue that foreign buyers are not the key cause of high home prices.
There are still some other weaknesses to this argument:
Many of the cities compared are megacities that are not like our cities. Some fit the population of Canada within their borders, they have phenomenal transit systems, and are home to the largest global head offices. Tokyo has 38 million people, Beijing 25 million, New York houses 24 million, London has a touch under 14 million people.
The same organizations warning that Canada is at risk of a crisis have flagged Hong Kong and China for being at risk.
They fail to explain the relationship between prices in different cities. For example, why are Chicago and Miami half the price of Vancouver? Does including these cities in the sample imply that Vancouver prices could drop to the level of Chicago?
The influence of foreign capital may wane in Canada with the introduction of provincial foreign buyer taxes, and some people calling for outright bans on foreign investment in real estate.
Finally, it appears they have chosen to compare Canadian cities to mostly expensive cities in the world while ignoring the many less costly cities.
We aren't the only ones with record debt
It is fair to point out that Canada is not alone in having high levels of debt. Although, it doesn’t sound terribly reassuring. It is reminiscent of a childhood argument that playing with matches is safe because other kids in the neighbourhood are doing it too. Many of the countries with higher debt than Canada have also been warned that they are vulnerable.
Employment and incomes are growing
We have one of the highest workforce participation rates among OECD countries so we have lots of incomes to make the mortgage payments. The difficulty with this argument is that the debt ratios are alarming after being adjusted for income.
High home ownership rate
Today, only 68% of Canadians own homes while some other countries have higher ownership rates. The implication of this comparison is that there is a potential for Canada to have 20% more homeowners. This explains why 40% of Canadians have taken on debt to buy homes but it doesn’t explain why the amount of debt should not be alarming or why a financial crisis is less likely. As well, experience from the U.S. shows home ownership doesn't predict market stability. Home ownership in the U.S. peaked at 69.2% in 2004 and dropped for 12 consecutive years to reach 62.9% in 2016.
Growing population
Canada has a 1.2% annual population growth because of an inflow of high skilled immigrants and Canada has a highly educated workforce. A well educated workforce should provide better incomes to pay off all the household debt. This is all true and these should lead to higher incomes but if you look at OECD average wages, Canada is only 11th of 35 countries, and one could argue that lower skilled Alberta oil patch wages are pulling up our national average. As well, even if Canadian incomes are higher, the debt ratios are alarming after being adjusted for income.
Low mortgage arrears
Avery Shenfeld, chief economist at CIBC World Markets said, "Mortgage arrears rates in Canada continue to dive," to support his view that a Canadian financial crisis is unlikely. It is true that very few Canadians are currently missing mortgage payments but arrears are generally not a good indicator of the risk of a crisis. Using U.S. arrears before the Great Recession as a guide, we can see that by the time mortgages started to fall into arrears, the crisis was in full swing.
Conclusion
Strong economic fundamentals, job growth, and continuous population growth from immigration are creating demand for housing. This continuous demand for housing has supported house prices and explains why Canadians have taken on so much mortgage debt. Canada’s debt relative to disposable income is lower than 20% of the other 35 OECD countries so our debt levels are conservative relative to Denmark, Netherlands, Norway, Australia, Switzerland, Sweden, and Ireland. Canadian housing sentiment if strong and more than 50% of Canadians surveyed in April 2017 believed home prices will never fall.
Cause for pessimism
A risk event is, by definition, never guaranteed to happen. Canada’s debt relative to disposable income is higher than 77% of the other 35 OECD countries and economists and rating agencies are warning us of Canada’s financial vulnerabilities and risks. The Canadian government has been proactive and has regularly enacted policies to incrementally reduce how much Canadians could borrow since 2008.
Scotiabank CEO, Brian Porter, recently said that Canada's banks now are holding more capital as a safety buffer than they were 10 years ago, and are in a better position to weather any future crises. As well, Scotiabank, TD Canada Trust, and Bank of Montreal, have expanded into the U.S., South America and Asia so a Canadian crisis may not hurt these banks as much as lenders without international operations. We should feel reassured that the federally regulated Canadian banks and lenders can weather a financial storm.
How confident do we feel that the 27% of Canadians who have mortgages on their homes can handle potential future interest rate increases? Let’s examine the vulnerability of Millennials and Baby Boomers.
Most Millennials (aged 22 to 37) began entering the job market and buying homes after the Great Recession and have never lived through a period of time with “neutral” interest rates. A Manulife survey conducted in 2016 found 33% of Millennials felt mortgage rates were too high. Since 2016, 5-year fixed mortgage rates have risen from 2.5% to almost 3.5% today and could reasonably be expected to reach 4.5% by the end of 2019. That represents an 80% increase in interest costs from 2016. Many Millennials still don’t believe rates can rise to that level and they may get a rude surprise when their mortgage comes due for renewal.
Some Baby Boomers have ignored their parents advice and, instead of paying off their mortgages, have been living off the equity in their homes. 10% of households over the age of 65 in 2016 had over $100,000 in debt. These older borrowers will be exposed to interest rate increases during retirement when their incomes tend to fall.
Most banks agree that higher interest rates are coming but they believe that Canadians can comfortably pay the higher interest costs.
Contradicting this perspective, a survey conducted in 2017 found 77% of respondents felt they would struggle to absorb an additional $130 per month in interest payments on debt.
None of us want to see retirees forced out of their homes by rising interest rates or young couples torn apart by financial hardship because they are house rich but cash poor. Let’s hope the economists at the Canadian banks are correct in their assessment of the risks and that they are considering the financial welfare of Canadians, not just the bank.
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