Debt, debt, and more debt

The Bank of Canada today paints a troubling picture of what has become a vicious circle where consumer debt is concerned, and amid weak underwriting standards on some home equity lines of credit.

The central bank unveiled its Monetary Policy Report, which puts more flesh on the bare bones statement it unveiled yesterday when it held its benchmark overnight rate steady at 1 per cent, but signalled that it’s thinking about hiking interest rates again, given a better outlook for the economy.
As The Globe and Mail’s Jeremy Torobin reports, the report indeed projected better-than-expected economic growth, though it also cited the risks the recovery faces.
It also expanded on Governor Mark Carney’s warnings over household debt, which have climbed in Canada to record levels, citing a low savings rate, “large and persistent increases” in house prices, and strong levels of real estate investment.
“It is not surprising that households would seek to consume some fraction of their increase in housing wealth, either by extracting higher housing equity to spend or by consuming more out of current income because they feel wealthier; either of these would result in a lower measured personal savings rate,” the central bank’s study said.
“Empirical estimates of the total marginal propensity to consume out of housing wealth in Canada range from 6 per cent to 16 per cent over the long run, assuming that the increases in wealth are viewed as permanent. This housing wealth effect on consumption may have increased over time, as financial innovations have made it easier to borrow against increased home equity.”
The report also repeated Mr. Carney’s warning that consumers are expected to add to their already fat debt burden, which remains the biggest threat in Canada.
The Bank of Canada appears most concerned over the tremdendous growth in home equity lines of credit, or HELOCs, and mortgage refinancings, which surged to $64-billion in 2010 from $8-billion in 2001.
About half of that is being used either to spend or pay off other loans. Here’s where the vicious circle comes in:
“Surveys suggest that approximately half of this equity extraction is used either for current consumption or to pay off other debt, much of which will be higher-rate debt, itself used to finance past consumption. Overall, it is estimated that home-equity extraction has funded roughly 3 per cent of aggregate consumer spending in Canada in recent years, up from less than 1 per cent in 2001.”
And note this warning: “Home equity extracted through additional borrowing cannot fund higher consumption indefinitely. Once the proportion of homeowners that access higher housing wealth through HELOCs reaches its peak, the personal savings rate can be expected to rise. This implies a lower level of consumption relative to income. With less equity in their homes, households would also be more exposed to a decline in house prices, which could further dampen consumption.”
Mr. Carney expanded on that at a news conference, saying there’s good and bad where HELOCs are concerned, notably in swapping credit card debt for cheaper loans. The trouble, though, is when that goes too far. And in some cases, he added, some of it has been done “in a context of underwriting standards that are less than optimal,” which Canada’s banking regulator is addressing.
“More broadly, it’s part of the bigger picture of driving Canadian household debt levels to record levels and levels that we see over the course of our projection continuing to rise,” he said.
“There are good aspects of it, but it contributes to a broader issue where some Canadian households are becoming overstretched and Canadian households as a whole are being overstretched, which creates risk for the economy.”
Some economists believe the central bank may address the household debt issue through rate hikes. Finance Minister Jim Flaherty has already tightened mortgage rules, and is loath at this point to do it again.
“To be sure, the case for rate hikes is strong,” said Paul-André Pinsonneault and Krishen Rangasamy of National Bank.
“With the government deciding not to intervene to cool down the hot housing market and curb household leverage, the BoC will have to address on its own the ‘biggest domestic risk.’” And given that fiscal drag isn’t likely to be as large as first feared (based on the recent federal budget), the BoC has flexibility for rate action.”