Concerns exist over growing debt levels and reliance on low interest rates

TORONTO, Dec. 18 /CNW/ - While Canadians are taking advantage of record low interest rates to buy homes and rack-up unprecedented debt levels, we are not headed for a U.S.-style meltdown, finds a new report from CIBC World Markets Inc.

The report, which includes an in-depth look at the Canadian housing and mortgage market, shares the Bank of Canada's concerns that Canadians need to be prudent about adding further to debt levels, but argues that there are a number of factors that will buffer Canadian homeowners from being saddled with mortgages they can't afford.

"Make no mistake: Canada is not doomed to see a U.S.-style housing and mortgage blow-up," says Chief Economist Avery Shenfeld in the bank's latest Economic Insights report. "There are three lines of defense for those with high debt service ratios that the BoC analysis ignored.

"One, some mortgage holders will have substantial home equity, even allowing for a house price slide, and could downsize. Two, others have high debt payments because they are making accelerated pay-downs of principal, which they could stop. Three, history suggests that many will jump into fixed mortgages in time to avoid the full brunt of the variable rate shock.

"The result is that the number of Canadians truly at risk could be substantially less than the (Bank of Canada's) estimate."

CIBC's in-depth look at the Canadian housing and mortgage market finds an unprecedented level of volatility over the last two years. After falling on hard times at the beginning of 2009, housing prices, resale activity and new housing starts have seen a remarkable turnaround with the sector now outpacing the rest of Canada's economic recovery.

This rapid uptick in housing activity, in the face of recessionary conditions elsewhere in the economy, has caused many to question whether house prices are rising too quickly given current economic fundamentals. At just under $350,000, the report estimates that the current average Canadian house price is roughly seven per cent over what would be consistent with current housing market fundamentals such as interest rates, income growth, rents and demographics. Prices are most overvalued in western Canada.

Mortgage credit is now rising at a year-over-year rate of more than seven per cent and this has helped push the household debt-to-income ratio to a new all-time high of more than 140 per cent, making this the first time in the post-war era when real household credit continued to expand through a recession.

"Given that the current overvaluation is occurring in a context of historically low interest rates, what we are most likely witnessing is a temporary period of exuberance that is "borrowing" activity from the future, as households take advantage of lower rates and accelerate their borrowing and home purchasing activities," says Benjamin Tal, senior economist at CIBC.

While the Bank of Canada is worried that Canadians are making themselves increasingly more vulnerable in terms of their ability to continue to service these new, higher debt loads, Mr. Tal notes that any analysis of the potential impact of higher rates on the household sector in general, and the housing market in particular, should be done with tomorrow's healthier economy in mind.

"The reality is that in the past, interest rates have played only a minor role in driving mortgage default rates," he adds. "Historically, it's clear that mortgage arrears rates are highly correlated with the unemployment rate, with little or no correlation with changes in interest rates. The same goes for the economy in general. Over the past three decades, personal bankruptcies have risen twice as fast in an environment of falling interest rates than in an environment of rising rates.

"The logic here is obvious. Interest rates rise when the economy recovers, and the benefits to employment and incomes of an improving economy easily offset the sting of higher interest rates on debt service costs."

In its latest "Financial System Review," the Bank of Canada estimated that at present, 5.9 per cent of all Canadian households are vulnerable to rising interest rates since their debt payments account for more than 40 per cent of their household gross income. The Bank also estimated that the share of households would climb to 8.5 per cent by 2012 if interest rates jump three percentage points.

Mr. Tal argues that focusing on borrowers' debt service ratio (DSR) with no reference to the underlying asset that they hold can be misleading. "Many households with a DSR greater than 40 per cent have already accumulated a significant amount of equity in their house, and therefore have the option to downsize and reduce their debt overhang if their mortgage payments stop becoming manageable."

The report notes that out of the five million Canadian households who hold a mortgage, only an estimated 350,000 have a mortgage with a loan-to-value (LTV) ratio greater than 80 per cent and a DSR greater than 40 per cent. Add this number to the small number of renters with DSRs over 40 per cent and the share of Canadian households that are "vulnerable" to a rate shock is less than four per cent, notably below the 5.9 per cent starting point estimated by the Bank of Canada.

Another factor that will lessen the potential for mortgage defaults is that most Canadian financial institutions issue variable rate mortgages only to customers that qualify for a 3-year fixed-term rate, which today is well above current variable rates. While all borrowers will face the impact of higher rates, most of them will therefore be able to absorb a three per cent rate hike and still remain within the qualification threshold.

"Only mortgages that were underwritten since early 2009 are vulnerable in this sense as their new mortgage rate (prime + 300 basis points) will end up being higher than their qualifying rate," adds Mr. Tal. "But even this small group will not have to face the full magnitude of the tightening by the Bank of Canada, as they will have the option to switch to fixed rates in the early stages of the monetary tightening. And if history is a guide, they will do it very quickly."

He notes that others in the supposedly "at risk" group have some protection from the initial impact of rising rates by already locking in a fixed rate mortgage. "Based on information obtained from CMHC, no less than 80 per cent of households who took a mortgage in 2009 with an LTV greater than 80 per cent and a DSR greater than 40 per cent have a fixed rate mortgage. In general, low income Canadians tend to rely more heavily on fixed rate mortgages - the complete opposite of the situation south of the border where low income Americans were heavy users of variable rate mortgages."

He adds that while even fixed-term mortgages will eventually be reset, the longer time frame for any hikes in their borrowing rates leaves them with more time to pay down principal and benefit from rising incomes before that hits.

At the same time, many Canadians have taken advantage of low mortgage rates to accelerate their mortgage payments. No less than 40 per cent of mortgage holders accelerate their payments by adding a full month of extra interest payments each year. On a $250,000 mortgage with five per cent rate amortized over 30 years these payments effectively cut the mortgage amortization period by five years. Translating years into basis points means that by simply switching from an accelerated payment plan to a regular one, these same borrowers can absorb the first 75 basis points on any rate increase by simply exercising their right to cease these prepayments.

"Add it all up, the level of vulnerability in the mortgage market is not as high as suggested by the Bank of Canada, and even the most vulnerable borrowers have some flexibility to absorb higher interest rates," concludes Mr. Tal. "There is nothing in Canada akin to the huge excesses in lending that led up to the housing and mortgage crisis experienced in the U.S. in the past few years."

Mr. Shenfeld thinks the issue is less about what has already been underwritten but is more about new mortgages issued in the quarters ahead while interest rates remain very low. He does not want to see the Bank of Canada use the blunt instrument of mortgage rate hikes to slow this growth. "The economy still needs help, the Canadian dollar would soar to the detriment of exports if the Bank of Canada moved ahead of the Fed, and premature hikes would expose households to a rate shock before they've seen the recovery's income gains.

"While other adjustments to practices by participants in the mortgage market could be examined as a means of enhancing prudence, one should be careful to avoid excessively denting the health and flexibility of the housing market as a whole."

After all, he notes, the lessons for the U.S. were not that an extended period of low rates caused a mortgage and housing blow-up. "While (former U.S. Federal Reserve Board Chairman Alan) Greenspan sometimes gets blamed for keeping rates too low for too long, the worst mortgage vintages were actually those dated well after rates had moved higher," adds Mr. Shenfeld. "It was a massive failure to supervise the worst excess of the American mortgage market that caused the trouble, and fortunately, those excesses are not yet in evidence in Canada."

The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/sdec09.pdf.

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