Rebuilding the Middle Class: Part 1: Awash in a Sea of Debt
Room 32 of the B.C. Supreme Court in Vancouver is where dreams of owning a home go to die. It's the main foreclosure court in the Lower Mainland, where banks and other lenders ultimately turn when homeowners can't keep up with their MORTGAGE payments. The homes get seized, then sold off. "There are many tears on that carpet," says Andrew Bury, a partner at Gowlings and the top foreclosure lawyer in the city. But lately the cramped courtroom has come to represent something else entirely - the utter insanity of Canada's red hot HOUSING market.
Last week Bury was in court to seek approval for the sale of a one-storey foreclosed home in central Richmond for $670,000. That was already $40,000 more than the house had been valued at two months earlier. Then, as he always does, Bury asked whether any other bidders were interested in the 2,000-sq.-foot home. Ten hands shot up. What happened next left him stunned. After a secret auction, the winning couple offered a whopping $852,500. "That's an extreme case, but it's the kind of thing we're seeing all the time now," says Bury. "It's a feeding frenzy out there."
Forget all the talk about a double-dip RECESSION. In Canada, most signs point to a double-peak housing bubble. After barely pausing to acknowledge the financial crisis, Canada's residential REAL ESTATE market has roared back to life, reaching record highs in recent months. The rebound has once again touched off a furious debate about whether we're now in a housing bubble. But it's quickly becoming clear this is about a lot more than just people paying too much for homes. In the same way house prices have defied the moribund economy, Canadian families, already saddled with record levels of debt, have continued to pile on mortgage and consumer loans at a blistering pace. In the last 10 years the amount of consumer and mortgage debt hanging over our heads more than doubled to $1.4 trillion, with $100 billion of that taken on in the last year alone.
When it comes to housing bubbles, the people who usually worry the most are those in the market for a home, or those who have recently bought one. Yet there's mounting evidence that we should all be concerned about the serious problems brewing inside household finances. Not only are there scary similarities to America's doomed housing bubble of a few years ago. We're also starting to look like Americans in the way we're wilfully ignoring the dangers of carrying too much debt. And that could pose a serious threat to any middle class recovery, and to the entire economy, as we try to crawl out of this recession. "If interest rates go up just two or four per cent we could see a crisis," says Ian Lee, director of the MBA program at Carleton University's Sprott School of Business, and a former mortgage banker. "This thing could blow up and drive us back into a recession."
Yet for all the stern warnings about our personal debt levels, Canadians remain remarkably nonplussed. The purported reasons for our sense of immunity are many - that our banks are healthier, our mortgage rules tighter and our regulators more adept. But most of all we've convinced ourselves we're a nation of prudent savers and responsible borrowers. Our political leaders tell us this, as do the banks, business leaders and anyone else who benefits when consumers spend money they don't have. But our days of parsimony have long since passed. Where we used to save 20 per cent of each paycheque a couple of decades ago, in recent years the average middle class family has put away barely two per cent. We've taken our responsibilities as borrowers and put them on a 40-year layaway plan.We've rushed headlong toward a buy-now-pay-later economy. Now it's nearly time to pay up. And many just don't have the cash.
Even before the recession began, Canadians were up to our eyeballs in debt. Since then, we've slipped below the surface. Over the last two decades, mortgage debt in Canada has nearly quadrupled to almost $1 trillion. At the same time Canadians have fallen in love with plastic. Credit card balances are up fourfold in just 10 years to $54 billion. Credit card companies repeatedly point out 70 per cent of card users pay off their balance each month. But many borrowers simply shift money from one form of debt, like their Visas and Mastercards, to another, like personal lines of credit. In the early 1990s, lines of credit were rare. Only about $4 billion had been drawn down. Today that figure stands at $200 billion, a staggering 4,800 per cent increase.
Absolute numbers tell only part of the story. To understand just how deep in hoc we are, you have to put that debt in perspective. One approach is to look at how much debt households are carrying relative to their personal disposable income. The results are shockingly American in scale. According to the BANK OF CANADA, the debt-to-income ratio of households in this country stood at 142 per cent in the second quarter of 2009. What that means is that for every dollar Canadians earned, they owed $1.42 in debt. That's up considerably from 116 per cent in 2005. And by some estimates, it's since blown past 145 per cent. By the bank's own estimate, that ratio will rise to 160 per cent in two years, roughly where it is for American households. Except Americans are paying down their debts. So sometime in the next year or two we will leapfrog past America's debt-laden households. What's more, in terms of household debt relative to GDP, Canadians and Americans are already nearly neck and neck. "No one knows what the magic number is before we start to feel serious repercussions," says Rock Lefebvre, a researcher with the Certified General Accountants Association of Canada. "But the numbers are getting dangerous."
Perhaps the most startling aspect of Canada's looming debt problem is how fast we're making it worse. Canada is virtually the only country where households have taken on more debt during this recession. While total household debt in foreclosure-ravaged America shrank 1.7 per cent over the last year, debt levels here jumped seven per cent. In particular, according to Statistics Canada, in November personal lines of credit surged 20 per cent from the year before, loans for home renovations were up 31 per cent, and balances of credit cards jumped another 6.9 per cent. But in dollar terms, most of the increase in household debt has come as the result of the huge mortgages people are taking out to buy homes at today's soaring prices. Over the past two difficult years of the economy, the total residential mortgage debt load in Canada ballooned 18 per cent. "We're the anomaly in global markets," says Derek Holt, an economist at Scotia Capital. "We continue to climb to new highs with house prices and we haven't seen any deleveraging among households. What's so special about Canada that we should be experiencing this while every other industrialized economy went down and stayed down?"
The debt bomb is arguably the biggest challenge facing the middle class as it tries to rebuild after the recession. Just how it plays out will depend a lot on what happens in the housing market. What we do know is that with mortgage rates at record lows - you can still get a variable mortgage for 2.25 per cent - prices and sales are surging. According to the Canadian Real Estate Association, the average national house price in December jumped 19 per cent from the year before to a record high of $337,410. Meanwhile, sales of existing homes leapt 72 per cent. As a result, housing affordability has begun to deteriorate fast. In a new report, the Frontier Centre for Public Policy, a Winnipeg think tank, looked at 28 housing markets in Canada and compared them to 244 metropolitan markets around the world. Vancouver emerged as the most expensive housing market in the world, with a median house price of $540,900, fully 9.3 times greater than the median income in the city. Vancouver beat out both London and New York City, but in Toronto and Montreal affordability has badly deteriorated, too.
For its part, the Bank of Canada has played down bubble worries. "Recent house price increases do not appear to be out of line with the underlying supply-demand fundamentals," David Wolf, an adviser to the bank, said recently. "We see the housing market requiring vigilance, not alarm."
At the same time, some economists believe the spike in prices is largely a side-effect of all the doom and gloom early last year. Shell-shocked buyers and sellers both retreated from the market, but those looking to acquire homes were lured back by ultra-low mortgage rates, only to find the sellers and new home builders weren't there to meet demand. That led to an imbalance - too many buyers chasing too few houses. "It's Economics 101," says Craig Alexander, deputy chief economist at TD Bank. As housing inventories get built back up and new homes are constructed, both of which is happening, Alexander expects prices to slow, though not contract.
But for others, Canada's housing market is an outright bubble waiting to pop. Holt at Scotiabank says the market must come down at least 10 per cent. David Rosenberg, the chief economist of Gluskin Sheff + Associates in Toronto, is even more bearish. Based on the price of homes in relation to incomes and rental rates, he predicted last month that prices are in for a 15 per cent to 35 per cent correction. The roaring market has even drawn attention from American economic commentators. From their point of view - which happens to be at the bottom of the crater that was America's over-leveraged economy - the way we're behaving now has put us into dangerous territory. "Let me be clear, strictly on the numbers: Canada is in for a housing bust worse than ours," financial writer Karl Denninger wrote on his blog, the Market Ticker, last month. "Beware, Canadians. You can argue over the timing of the outcome here, but if you think the 'bad event' won't happen and act on that belief, don't cry when a year or three down the road I start piping up with 'I told you so!' "
For months now the Bank of Canada has been warning Canadians not to get used to the abnormally low interest rates of the last year. In a year-end financial review, the bank said the improving economy has taken some of the immediate pressure off households. Unfortunately, skyrocketing debt levels pose a worsening problem. As interest rates begin to rise from their record lows, which they most certainly will do at some point, borrowing costs will rise too. The end result could be that hundreds of thousands of families will face a brutal cash crunch.
That's not idle speculation. The bank's researchers put households through a series of theoretical stress tests to see how they will fare should interest rates rise to between 3.2 per cent and 4.5 per cent by mid-2012. (The Bank of Canada's benchmark rate is just 0.25 per cent, and with many sectors of the economy like manufacturing still struggling, governor Mark Carney has vowed to keep it there until at least June.) When a household's debt-to-service ratio, a measure of monthly payments relative to income, breaks past the 40 per cent mark, it's considered to be "financially vulnerable" to financial shock. What the bank found in its review was that if rates rose to the higher level, 9.6 per cent of households would find themselves in that danger zone.
It's important to note that the Bank of Canada's scenario of a jump in rates to even as high as 4.5 per cent would still leave mortgage rates low by historical standards. Especially if, as many fear, the trillions of dollars in emergency liquidity that's been pumped into the economy sparks inflation. But according to Lee, the former mortgage banker turned Carleton University professor, given today's insanely low levels, rates don't need to jump that much to wreak havoc on Canada's debtor class. "I was in the industry when mortgage rates went through the roof and I was throwing middle class owners out of their homes," he says. "We've seen this movie before."
That was the message he shared with officials from the Finance Department in December. In a pre-budget consultation he called on Ottawa to clamp down on mortgage requirements by ratcheting up the minimum down payment from five per cent to 10 per cent, and capping amortizations at 30 years or less. The Harper government has already backpedalled once on its effort to liberalize the mortgage process when, in 2008, it shut the door on 40-year amortizations and no-money-down mortgages. Lee argues tightening the rules even more would simply return the mortgage sector to the way it was in the early 1990s. "Some people will be priced out of the market, but those people who are most at risk shouldn't be in the market in the first place," he says.
Flaherty has since hinted he might clamp down, but such a move would be unpopular and the industry is already resisting. In a recent speech, Royal Bank CEO Gord Nixon said consumer debt in Canada is "extremely different" than in the U.S. Bank of Montreal CEO Bill Downe has said the bank is "heavily engaged with the consumer about how much debt is too much." At the same time, CIBC put out a statement highlighting research from its economists that concluded: "Make no mistake: Canada is not doomed to see a U.S.-style housing and mortgage blow-up."
Then earlier this month the Canadian Association of Accredited Mortgage Professionals (CAAMP), a professional standards and lobbying group, attempted to throw cold water on the Bank of Canada's debt warnings. It released a report arguing the vast majority of first-time homebuyers last year opted for safer, fixed-term mortgages over riskier variable mortages, which are more exposed to short-term rate hikes. "The concern federal officials are voicing is that a lot of people are going to variable [rates]," says Jim Murphy, president of CAAMP. "We found that wasn't the case. The market is already working very well."
Newspapers eagerly took up the story, declaring Canadians to be "cautious," "prudent" and a people who "play it safe." But while the report fit perfectly into the narrative of Canadians as the epitome of diligence and responsibility, no one questioned its conclusion that out of 13.25 million homeowners in Canada, only 4,000 "might" be at risk.
Economists aren't buying it. "I have difficulty with the CAAMP report," says Scotiabank's Holt. "It's a very different picture than what I get from talking to people in the mortgage industry." Holt doesn't subscribe to the view that a rise in interest rates would trigger a debt crisis in Canada. But he also believes the risks are far greater than lobbyists are letting on. He says as many as 40 per cent of first-time buyers have opted for variable rate mortgages, while another 10 per cent chose fixed mortgages with just a one-year term. That means half of all new mortgages are heavily exposed to short-term rate changes. "I think their study grossly underestimates mortgage rate sensitivities," says Holt. "It doesn't even really matter if they went variable rate or fixed rate, because pretty much all of the mortgage market in Canada resets in the next five years."
And in that way Canada's mortgage sector looks somewhat like America's did before the bust. No, we never had institutionalized mortgage fraud like they did in the States. Lending practices here were also tighter. But the ultimate reason so many American homeowners got into trouble was because one-third of them bought homes using mortgages with artificially low teaser rates. Once those low rates reset higher, even by just three or four percentage points, owners couldn't keep up with their payments. In Canada mortgage rates are artificially low because of the massive intervention by the central bank, and some day, probably within the next year, they too will reset higher.
But here's another more fundamental reason we're not all that different from Americans. Thanks to a loosening of mortgage rules over the last two decades and steadily lowering mortgage rates, 68.4 per cent of Canadians now own a home - roughly the same rate as in the U.S. The average national house price in Canada is about the same as what the U.S. experienced right before the bust. And yet incomes in Canada are, on average, lower than in the States. Economists offer theories for how Canada has achieved all this without taking on the same housing problems the U.S. did - it could be because of higher health care costs in the U.S., suggests one, or the cross-border comparisons could be distorted by the effects of averaging.
But it could also simply be that we're not as different from the Americans as we'd like to think when it comes to debt. "The Americans threw prudence out the window and drove off the cliff with their eyes wide open," says Lee. "We're just backing up to it."
There is good news in all of this - if you're a banker. When America's debt bomb blew up, it took many of Wall Street's biggest names with it. That's unlikely to happen here, says the Bank of Canada. While a crisis among indebted homeowners could lead to big losses for the banks, they remain far better capitalized than U.S. banks ever were, so the hit to their bottom lines should be muted. If the Bank of Canada's worst case scenario comes true, Canada's banks face losses of just 4.8 per cent as a share of their capital.
For households, though, the outlook is grim. Cracks have already begun to form in family finances. The fault lines can clearly be seen from the offices of the Credit Counselling Society of B.C. Over the past two years, the agency, which helps consumers resolve their debt woes, has seen more people coming in for help carrying more consumer debt - that is, non-mortgage debt - than ever before. "Five years ago it was common to see debt loads of $40,000, but this year we've seen people with $256,000," says Fernanda Capela, a counsellor. "$150,000 is very normal now." As Kyle Peters, another employee, notes, "Somewhere along the way we lost sight of the notion that if you don't have enough money to buy something, you shouldn't."
It's a lesson many have apparently forgotten. The recession has caught thousands of households off guard and sent the number of consumer bankruptcies and insolvencies soaring. In all of 2008, more than 115,000 Canadians were insolvent. By September of last year, we'd already blown past that number and when the final tally for 2009 is in, the number of Canadians who went broke could easily exceed 160,000. And that's with interest rates at nearly zero. At the same time, Bury, the Vancouver foreclosure lawyer, says foreclosures remain at elevated levels despite the economic recovery.
There are still many who dismiss fears of a crisis triggered by household over-indebtedness. They point to countries like Denmark, where households carry twice as much debt relative to their incomes as Canadians do. And this isn't the first time soaring household debt has set off alarm bells.
But the laws of financial gravity say debt levels can only reach so high before households are forced to deal with their addiction to borrowing and spending. In the U.S., deleveraging has come about through tremendous upheaval. Canada's banks won't blow up, and bankruptcy legislation makes it far harder for Canadians to walk away from their obligations. That could put Canada in an even tougher position because we'll have to bring our debts under control the slow, hard way - by dramatically cutting back on spending and paying down our loans. If the housing market does collapse, and people have to drag themselves out of debt, they won't be doing all the things, like buying cars and renovating kitchens, that have helped drive the recovery. In other words our "buy now, pay later" ethos could become one of "don't buy, just repay your debts." And that could leave the Canadian economy in a deep rut. As a new report from consultancy McKinsey states, Canadian households are highly likely to face imminent deleveraging and an unwinding of unsustainable debt that could "drag down growth rates for years to come."
There's one more lesson to take away from the U.S. experience. Once it was clear America was in dire straits, many asked: why didn't anyone see this coming? The easiest answer is that as long as everything kept humming along smoothly and everyone was benefiting from the borrow-and-spend culture, most people simply chose not to look. If we're going to avoid our own debt explosion, maybe it's time to open our eyes.
Maclean's February 8, 2010