Housing Market Risks Remain Top Threat to Canada’s Financial System

No similarity to U.S. subprime crisis, says Bank of Canada
December 15, 2015 Updated: December 18, 2015

OTTAWA—Housing sector risks have worsened, but the good news is the overall risk level to Canada’s financial system is roughly unchanged in the last six months, according to the Bank of Canada’s semiannual financial system review (FSR) released on Tues. Dec. 15.

The FSR is not meant to predict or project what might happen; instead it is an evaluation of the threats to Canada’s financial system. It discusses potential triggers that could turn vulnerabilities in the financial system, like high household indebtedness, into full-blown risks.

The biggest risk to the financial system is a severe recession, which leads to widespread job losses affecting people’s ability to pay their mortgages. This would then lead to a broad decline in house prices. As in June’s FSR, this risk would have a very high impact on the financial system, but chances are low that it happens. The two vulnerabilities at play here are the elevated levels of homeowners’ indebtedness and the rapid growth in home prices in Toronto and Vancouver.

While these vulnerabilities have gotten worse, the economy overall is seeing better days than it did in the first half of the year. Therefore, the likelihood of a trigger event—a recession—is lower.

The proportion of households with debt exceeding 350 percent of their gross income doubled from 4 percent before the financial crisis to 8 percent.

Canadian household indebtedness reached a new peak, according to a Statistics Canada release on Monday, Dec. 14. For the third quarter of 2015, the debt-to-income ratio hit 163.7 percent from 162.7 percent in the second quarter. This means that for every dollar of income a Canadian earns, on average, he or she has nearly $1.64 of debt.

Debt is also becoming more concentrated in the hands of younger households, who have less capacity to deal with losing their job or higher interest rates. The FSR points out that the proportion of households with debt exceeding 350 percent of their gross income doubled from 4 percent before the financial crisis to 8 percent.

The BoC estimates close to $400 billion of debt is in the hands of these most leveraged of households. “Compared with less-indebted borrowers, highly indebted borrowers tend to be younger and have lower incomes,” according to the FSR.

But the BoC is quick to point out that this is nothing like the makings of the U.S. subprime crisis. “There is no similarity to what we saw back then, as we have a much stronger underwriting culture,” said Bank of Canada governor Stephen Poloz in a press conference after the release of the FSR.

Canada doesn’t have the complex securitization of mortgages, which amplified and spread the problem globally, and as senior deputy governor Carolyn Wilkins pointed out, there’s more equity in Canadian homes today than there was in the U.S. pre-crisis, and 30 percent of Canadians have no debt at all.


Vancouver and Toronto

With Vancouver and Toronto seeing home price appreciation of roughly 15 and 10 percent respectively, combined with the aforementioned excessive leverage, this gives rise to the possibility of losses to both lenders and mortgage insurers in the case of a downturn in prices.

The home price appreciation in Canada is largely concentrated in those two centres, while the resource-heavy regions have seen sales fall sharply and prices start to decline slightly. According to October data from the Canadian Real Estate Association, benchmark prices in Calgary are about flat in the last six months, while Regina is down 3.2 percent.

On Dec. 11, Finance Canada took aim at Vancouver and Toronto. The measures announced, which take effect Feb. 15, 2016, will require the minimum down payment for new insured mortgages to increase from 5 percent to 10 percent for the portion of the home price above $500,000. The FSR does not account for the new measures in its assessment. The Bank of Canada was consulted on the policy action.

“These measures are a constructive response and should help to gradually reduce the extent of these vulnerabilities,” according to the FSR. The BoC believes the impact of the measures should be strongest in Vancouver and Toronto. The increase in down payments will increase homeowners’ equity for the riskiest type of mortgages in Canada. With greater homeowner equity, the risk of mortgage default is reduced.

“By next year we’re hoping that the constructive evolution we talked about will be more firmly in place. And that would see the housing market cruising into a slower growth path, which is more in line with income,” Poloz said.

Housing has been the main driver of growth in Canada since the financial crisis. The BoC is expecting that main driver to switch to non-resource exports and for the housing market to cool off, but not crash.

Key to a sound financial system is healthy banks. Recent reforms such as larger capital and liquidity buffer requirements make banks able to better withstand losses and bouts of lack of access to funding. The Bank believes the Canadian financial system is resilient and Finance Canada’s new rules will help mitigate housing risks in 2016.


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