A Look at the Bank of Canada’s Latest Household Finances and Financial Stability Review

If you want to look beyond the incendiary headlines about housing bubbles in Canada’s largest real estate markets, last week’s report by the Bank of Canada (BoC), called Household Finances and Financial Stability Review, is worth a read. The report highlights several areas of concern, but it does not suggest any imminent collapse in house prices.  

Here is a summary of the key points I took away from the report (with my comments added in italics):

• Our debt-to-disposable income ratio has been rising steadily for thirty years, but this run-up has occurred in two distinct phases. Up until the mid-1990s, the increase in mortgage debt was largely caused by higher house prices, but since then, borrowers have increasingly been using the equity in their homes to finance consumption. A classic case of living “beyond our means”.
• The instrument that facilitated this shift from borrow-to-buy-your house to borrow-to-fund-your-lifestyle was the secured home equity line of credit (HELOC). In 1995, HELOCs accounted for 11% of non-mortgage credit, and by the end of 2011 that number had grown to almost 50%. The higher house prices have risen, the more aggressively HELOCs have been marketed and the more common home-equity extraction has become. (Further proof that Finance Minister Flaherty’s decision to halt CMHC’s back-end insuring of HELOCs last year was prescient.)
• Debt levels are higher for every age-group cohort. Not even our aging population (which should have a moderating effect on overall debt growth because older people borrow less) has done much to offset the substantial rise in our debt levels.
• While lower interest rates have reduced the cost of borrowing for everyone, the report notes that “an easing of affordability would have a greater impact on the housing decisions of younger age groups”. (Example: Between the ages of thirty-one to thirty-five, a person born between 1964 and 1968 had an average debt of $75,000, while a person born between 1975 and 1979 had an average debt of almost $120,000.)
• This helps explain why we have seen a substantial increase in the home-ownership rate, which rose from 63.6% in 1996 to 68.4% in 2006 (and has increased further since then).

There is inherently more risk when low interest rates induce young borrowers to enter the housing market earlier than they otherwise would. The length of their borrowing life cycle means that young borrowers are far more likely to face higher interest rates with a still substantial debt load in the future. When BoC Governor Carney and Finance Minister Flaherty repeatedly remind Canadians that “interest rates will go up”, they are looking straight at today’s young buyers.

Those are some risks worth worrying about. But before we all start storing canned soup and building bunkers in the hinterland, the report also offers some encouraging points to keep in mind:

• While measures of house price affordability have been decreasing of late, the BoC’s report shows that affordability levels today are still below their thirty-year average: “Despite increases in house prices, generally favourable labour market conditions (gains in real income) and low interest rates have supported affordability and contributed to significant increases in home ownership and mortgage debt.

Interesting point from a Bank of Montreal report last week: While average house prices have risen more quickly than nominal GDP (a proxy for average income levels) over the last ten years, the reverse was true in the prior ten years (when nominal GDP rose faster than house prices). I was surprised to see that when you look back over twenty years, nominal GDP and house prices have both grown by an average of 4.7%. 

[Post script – Ben Rabidoux subsequently pointed out that this BMO statistic was flawed because it measured overall GDP growth and not GDP growth per capita. If GDP per capita is used then the number is not nearly as reassuring. Guess I should have gone with my first instinct (surprise) on that one!]      

• The BoC’s report makes clear that the U.S. housing bubble  was primarily caused by two factors:

1) A relaxation of mortgage underwriting standards. (At its peak, U.S. sub-prime borrowing accounted for 14% of outstanding mortgage borrowing versus 3% in Canada.)

2) Easier access to borrowing that was secured against home equity.

While I think we should be concerned about the effect that increased borrowing against home equity is having on our overall debt levels, the most widely reported statistic about Canadian debt-to-disposable income ratios being higher than they were in the U.S. at the peak of its housing bubble is actually quite misleading. A recent BMO report laid this comparison bare when it showed that Canadians can contribute much more of their disposable income to debt servicing because they do not have to cover substantial costs, such as healthcare, from their after-tax earnings (as Americans do). When BMO used a more apt comparison, debt-to-gross income, it showed that our debt levels are nowhere close to where U.S. levels peaked. Furthermore, even today, U.S. debt-to-gross income levels are substantially higher.

• The BoC’s report concludes that “the trend rise in Canadian house prices is associated with a growing population and income, which has increased demand, coupled with an upward-sloping long-run supply curve owing to the increasing scarcity of land for residential development, primarily in urban areas.”

In other words, the BoC still thinks our house price appreciation is supported by sound fundamentals.

Five-year Government of Canada bond yields continued to surge higher in the early part of last week, approaching the 1.50% level that many insiders expect will be the trigger point for widespread increases to five-year fixed-mortgage rates. Then momentum changed on Wednesday and yields dropped for each of the next three days, leaving us at 1.43% on Friday and 2 basis points lower for the week overall. While several promotional rates have been withdrawn, five-year fixed rates can still be found for a shade over 3%, and ten-year fixed rates are still being offered below 4%.

Variable-rate mortgages still aren’t being offered at discounts that I think would justify their risk/reward trade-off.

The bottom line: While there are apt comparisons to be made between Canadian and U.S. borrowing trends, I think articles that suggest we are on the brink of a U.S- style housing collapse should still be taken with a healthy dose of salt. In the absence of salt, read the BoC’s latest report.