Canada’s credit bubble

Stats Canada has released some updated data tables for consumer and mortgage credit.  Let’s have some fun and look at the growth in credit vs. the growth in income and inflation over the same period.

Total inflation growth according to the Bank of Canada

Growth in labour income

Growth in consumer credit (not including mortgages)

Growth in mortgage credit

So we’ve seen an expansion in household debt that has massively dwarfed income growth and inflation and are now sitting at the highest level of debt to disposable income in our history.  How did we get here?

Some culprits

The Bank of Canada overnight rate upon which variable rate mortgages and lines of credit rates are based has cratered and remains well below historic averages.  It masks the reality of the underlying debt burden and exposes households to potential interest rate shocks.

This has been coupled with an ill-advised loosening of mortgage standards…

Note:  This dumb rule was changed later in 2008.  Maximum amortization is now 35 years, with minimum downpayment requirement of 5%……supposedly!  But there are ways around that…

So you could borrow the required down payment off a credit card, line of credit, or friend/family member and repay it after the sale closes and the funds are released.

Meanwhile savings, which would normally provide a cushion against rising interest rates, have dwindled, currently sitting at around 3%.

All of this is reflective of a secular shift towards consumerism and a widespread embracing of debt loads that would have been considered embarrassing by generations past.

The economic spin-offs involved in a credit binge:

The primary symptom of a credit bubble is an increase in consumer spending as a portion of GDP increases as it is funded increasingly through an expansion in consumer debt.  In the 25 years prior to 2005, Canadian consumer spending as a percentage of GDP ranged between 52.8% and 58.9%.  Today?

Now having a large percentage of GDP attributed to consumer spending is not necessarily alarming provided it is not accompanied by an increase in consumer debt.

Oh crap!  It’s not all consumer debt. But consumer debt averages over $25,000 per household, well into record territory.

The majority of household credit is mortgage credit.  It’s hard to tell whether the run-up in house prices was the cause of the increased credit or was a symptom of the increased credit, but needless to say, the two go hand in hand.

Rising home prices are highly correlated with HELOC growth.  CAAMP recently revealed that home equity extraction has boosted household income by nearly 9%.  Thus, in a circular feedback mechanism, rising home prices provide the fire for increased consumer spending via line of credit growth.  Employment is buoyed by the increased consumer spending and increased demand for housing.

How does this end?

Any honest and semi-coherent person has to acknowledge that this is not a sustainable trajectory.  Whether you want to label it a bubble is up to you.  But let’s at least agree that households cannot perpetually expand credit at a rate greater that the expansion of their income.  That much is factual.

But the question remains:  What will the normalization look like and how will it affect the broader Canadian economy?

That is the trillion dollar question.  Let me suggest once again that secular trends that change the perceptions of a large portion of the populace often shift suddenly and unexpectedly.  In my opinion, it is highly unlikely that we will see a gradual paying off of debt while the economy painlessly realigns itself with the reality of less aggregate demand.  That’s the soft landing thesis that is often suggested, though seldom observed in economics.

Rather, economic phenomena that deviate markedly from their long-term norms have a tendency of self-correcting, and in fact over-correcting in a relatively rapid manner.  In this case, it will likely become painfully evident to many people simultaneously that they have lived beyond their means and have saved too little.  That realization is unlikely to dawn on only a handful of households at a time.

I’ve suggested that this epiphany might come in the realization that their largest asset is not worth what they had hoped it would be.  A moderate fall in home prices followed by an extended period of flat growth (the dream scenario for the bull crowd) would still be enough to choke off HELOC growth and consumer spending by extension.   Remember that home equity extraction is highly correlated with home price increase.

But the moment of clarity may instead come in the form of a rise in interest rates beyond the token increases of the BoC (unlikely in the short term in my opinion), another global economic shock (China bubble popping is a far greater near-term economic threat), or it might just be that the economic ‘recovery’ illusion lifts and people see the underlying structural issues with our economy.  Or it could be that the endless stream of home buyers subsides as home ownership rates are already well into record territory.

The point is simply that the rapid expansion in credit has left the Canadian consumer and the broader economy at a heightened risk of an economic shock.  At best it has set the stage for near-term weakness in aggregate demand as consumers gradually pay down their debt.  At worst, it has set the stage for a significant mean-reversion that would have far-reaching economic consequences.  Regardless, I highly doubt this credit bubble will end in a benign manner.

-Ben

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27 Responses to Canada’s credit bubble

  1. Chris says:

    Wow, checkout the run-up on mortgage-backed securities. Up well over 200% from 2005.

  2. vreaa says:

    Great post. Thanks Ben.

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  4. mac says:

    I take it your next post will be on David Rosenberg’s letter of December 7th:

    http://tinyurl.com/354bunv

    “As it turns out, and despite my earlier doubts, the Bank turned out to be 100% correct in hiking rates early as to defuse what was possibly becoming a housing bubble in Canada. So far, it looks like it has let the air out of the balloon gently without having to burst it.”

    Yes. He just said “defuse what was possibly becoming a housing bubble in Canada.”

    He goes on to sound a lot like Mac, with my predictions that jobs are slowly coming back in the US and that Canada might just bet 6-18 months behind.

    “Not only that, but we are starting to finally see some signs that Canada is catching on to classic ‘supply side’ economics…”

    He comments on cap ex, the step before hiring, I believe:

    “The key factor behind this performance is business investment in machinery and equipment, which surged at a 28.7% annual rate and on the heels of a 32.7% run-up in the second quarter and a 17.8% boost in the first quarter. You have to go back at least 13 years to see the last time Canadian companies made this sort of spending commitment to the economy. ”

    I guess low interest rate policy is responsible for that. And there’s more good feelings from Papa Grizzly Bear:

    “While Canada has lagged the United States for much of the past decade in terms of productivity performance, it is looking increasingly as though we are on the precipice of an important reversal…. Our research shows that there is about a 4 to 5 quarter lag before stronger productivity growth begins to kick in …”

    Wow. Say it ain’t so. Maybe all of Canada can’t skate by this bursting housing bubble but it looks like some sectors of this dire collapse may be moderated by better job prospects and wages eventually catching up to our high house prices. Who knows? Prices could slide sideways for a while.

    I think David agrees with me that we are blessed with good government here in Canada, despite all the gnashing of teeth over Harper and despite the fact that he will never rule with a majority because Quebecers just don’t vote for “blokes” like him.

  5. Mot says:

    Excellent post today. I think that the story around the growth in income is much worse than the 17.8% growth inaggregate since 2005 tells.

    The debt crisis is both at the public and household levels so it’s useful to look at incomes on an individual basis and how that has grown since 2005.

    I don’t have perfect figures here but from what I’ve found online, the employed labour force in early 2005 was about 16.1 million. In 2009 it was about 18.4 million. So on a per capita employed basis (labour income / employed labour force), wages have barely moved over that period.

    This also explains the need for additional credit required beyond mortgages just to maintain (and improve) a family’s standard of living.

  6. John in Ottawa says:

    David Rosenberg is one smart dude. When Rosy talks, people listen!

    Sept 23, 2010: Bubble or Not, Canadian markets in for a rude awakening — Globe and Mail

    By my calculations, every basis point of the Canadian economic recovery was the result of the boom in the housing sector. That goose is no longer laying any golden eggs.

    People can argue endlessly about whether the Canadian housing market constitutes a bubble. The reality is that we will probably find out at some time in the next year, as all the speculative high-ratio loans come due at interest rates above where they stood at the time of origination, courtesy of the Bank of Canada’s tightening cycle, which may or may not have fully run its course.

    Even if this correction in housing is only a fraction as harsh as was the case south of the border, the economy, and the financial markets are likely in for a rude awakening in coming quarters as lower home prices cut into household wealth, confidence and spending plans.

    At the same time, housing deflation and a rising tide of mortgage delinquencies will bite into CMHC reserves and, at the margin, undercut the quality of Canadian banks’ seemingly pristine balance sheets, which hold $500-billion of residential real estate loans, equivalent to 30 per cent of total bank assets.

  7. mac says:

    Not clear on your comment, John. Are you saying he’s been wrong before or are you illustrating how much his opinions on the possibility of a housing bubble have now changed?

    • John in Ottawa says:

      I don’t think he is wrong and I don’t think his opinions on the credit/housing bubble have changed. He has simply said that Carney risked popping the bubble with his interest rate hikes.

      Carney walks the impossible line between further inflating the credit bubble and popping it. When the credit bubble pops, housing will pop with it.

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  9. Sam says:

    The problem with this analysis is that you have zero data on jobs and debt servicing. Nobody cares about how much debt you have, as long as you have a job that pays the servicing of it. U follow? The debt numbers can baloon and will continue to baloon. That is how the financial beast works. This can only end with end in jobs, and people can’t pay. Looks for those holes, don’t focus on what we already know. Show me a good study that shows what people are paying for debt historically – it’s lower, unemployment is fairly constant. If that breaks down, then sound the alarm bells.

    • “The problem with this analysis is that you have zero data on jobs and debt servicing.”

      The income numbers catch this. It’s aggregate income growth, which by nature will catch increases in jobs. Sorry, but it still doesn’t keep pace with debt growth. Not by a long shot!

      “Show me a good study that shows what people are paying for debt historically – it’s lower, unemployment is fairly constant.”

      Debt as a percentage of disposable income has never been higher. As you correctly suggest, the only thing masking the issue is the lowest debt servicing costs in several generations.

      As far as your employment argument goes, you need to understand that it is the credit bubble that artificially buoys the labour market.

      Read the last primer I wrote called ‘The Great Connection’.

  10. Sam says:

    The income can more than service the debt – two people, earning say 40k each get married, 90k gross. That can service the average house price just fine. You would not go to Muskoka and look at that on it’s own. The house prices are a reflection of money from Toronto. Vancouver these days is not really part of Canada is it? Suburb of Hong Kong. Now would vancouver prices look out of line in HK? Show me how the avg household income cannot service debt or is even close to going over the line? Simple bond math you are missing is convexity. It is very very important. the price of long duration assets (houses, etc) can move very quick with changes in rates. Do you really think Carney is going to raise rates and make the whole country suffer? He is sending warnings and not raising rates? He is doing this so corporate Canada can continue to borrow safely at low rates and business can get going, hire more people, keep the engine going. I am not saying house prices cannot come down, I am simply saying that your whole reasoing and arguments are false. Show me a real breakdown – Dubai, Greece – that is when a market breaks, people cannot pay. In Canada, they can. Give me 5 points that show people cannot pay?

  11. “Give me 5 points that show people cannot pay?”

    Red herring! Re read the post. I didn’t say people couldn’t pay at these artificially, historically low interest rates. I did say that the current trajectory is not sustainable. Surely you can see that. What that normalization looks like is the big question. My thesis is outlined for you. Let’s hear yours.

    “Do you really think Carney is going to raise rates and make the whole country suffer?”

    Carney only has influence on the overnight rate, and it’s unlikely he would leave it there if the bond market demanded an increasingly large premium. If bond yields continue to rise, that would be plenty to choke off the expansion in mortgage credit given that even variable rate mortgages must now be approved based on the current 5 year fixed rate, which reflects the bond market.

    That’s all it would take to kill off HELOC growth, which is largely dependent on house price appreciation. There are lots of ways to end a credit bubble with interest rates at zero. Just ask the US!

    • DaBull says:

      “Carney only has influence on the overnight rate, and it’s unlikely he would leave it there if the bond market demanded an increasingly large premium. If bond yields continue to rise, that would be plenty to choke off the expansion in mortgage credit given that even variable rate mortgages must now be approved based on the current 5 year fixed rate, which reflects the bond market.”

      If Canada’s central bank or any other affluent Country’s central bank has no influence over the long bond market then why has the long bonds yields been so low for so long in Japan. Long term bond yields (2+yrs) have been and are still extremely low in Japan. Even though Japan was down graded to AA status today, I will bet their long term bond yields won’t change much. You’re thinking on the long bond market is mistaken. Short term markets have quite a big influence on the long term markets, just look to Japan.

      http://noir.bloomberg.com/markets/rates/japan.html

      • “If Canada’s central bank or any other affluent Country’s central bank has no influence over the long bond market then why has the long bonds yields been so low for so long in Japan.”

        Japan has also been battling deflation. Inflation expectation is the primary determinant of long bond yield. The bond market accurately predicted that deflation would reign. If we flipped that question on its head we could ask why the long bond yields in the US have risen since the start of QE2. Riddle me that before you tell me my thinking on long bonds is mistaken.

      • DaBull says:

        Being that I can’t reply to your last post I will post it here.

        The minimal rise in long bond yields is from the deflation of the bond market bubble. Back in 2008 every boy and his dog was jumping out of equities and into the bond market. Now those same nervous nellies are feeling a lot more comfortable with the economic outlook and are now exiting the bond markets in droves and jumping back into equities. QE2 was put in place to smooth that transition out. Historically long bond yields are still extremely low. And, yes, there will be volatility in the bond market until the transition period ends. Which may be soon.

      • DaBull says:

        Sorry forgot to post the US 5 year historical yield.

        http://www.federalreserve.gov/releases/h15/data/Weekly_Friday_/H15_TCMNOM_Y5.txt

        or 10 year.

        http://www.federalreserve.gov/releases/h15/data/Weekly_Friday_/H15_TCMNOM_Y5.txt

        Sorry can’t find my link to the Bloomberg long US treasury charts. Those charts really say a thousand words, which in a nut shell is US long bonds yields are still historical extremely low.

  12. Sam says:

    The US market exploded because of CMHC types who could not post margin and thus faith was lost. CMHC is the only monoline insurer in Canada, it’s bonds trade very well and investors cannot get enough of them. So the next question is what is the average LTV on the bonds – 55%!!!! in Canada, nowwhere close to the 80% + in the US. I have tried over and over to point holes in the Canada market. Your post could be dated 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009, etc and your points and graphs could still have the same conclusion. This is nothing new what your data is showing. You cannot recycle the same points over and over. Show some real cracks? Find some holes, stories about people being foreclosed on? Banks saying “it’s ok you can’t pay, we can just add it to the back of the loan!” Sectors, jobs being wiped out that can then cause home prices to dwindle. Everyone one in Canada is bearish on housing, so it will probably go higher!

    I don’t need to give you a thesis. I am challanging yours and saying that your fancy graphs and ratio’s don’t mean anything until you can point out how the market can break.

    Btw, I live in the US and have seen first hand what has happened here. I see it happening in places like Whistler in Canada, where I get weekly foreclosure notices. That market is lower than where it started at inception. Dig deeper? Why is 1.5hours away in Vancouver booming and this lovely place in the gutter? Asians don’t ski is the root of it, they don’t need a place in Whistler, so the market is tanking. Each market has it’s local ups/downs. But to take general data in Canada to continue to press a dooms day Canadian outcome is hardly thoughful to your readers. Do some real deep dive analysis.

  13. “So the next question is what is the average LTV on the bonds – 55%!!!! in Canada, nowwhere close to the 80% + in the US. I have tried over and over to point holes in the Canada market.”

    I’d love to see that source. Given that the MBS market is now virtually the entire new mortgage market in Canada, and given that the average downpayment is less than 10% in Canada, I have a hard time believing that this is currently the case. Please prove me wrong.

    “Find some holes, stories about people being foreclosed on?”

    I’ve dealt with this before. Foreclosures are virtually non-existent in a rising market. The foreclosures are more closely correlated with house price decreases than with job loss or affordability erosion. The foreclosure rate in the US was benign until the crash happened. Foreclosure numbers have no predictive value in determining the future direction of a market. They are a lagging indicator.

    “Sectors, jobs being wiped out that can then cause home prices to dwindle. ”

    I would argue that you’ve got this backwards. Home price declines cause jobs to be wiped out. I’ve talked about this many times too.

    “I am challanging yours and saying that your fancy graphs and ratio’s don’t mean anything until you can point out how the market can break.”

    Seriously? I haven’t done this already?

    “But to take general data in Canada to continue to press a dooms day Canadian outcome is hardly thoughful to your readers.”

    I’m not pushing a doomsday outcome. You need to frequent this blog a bit more.

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  15. Gene Perez says:

    if you would of just taken Canada out of all those charts and just stuck in the U.S you would never know the difference other than the numbers its amazing how much things look just as bad as other places ,, not sure where we are going in the coming year… Santa Maria Homes For Sale

  16. Bruce says:

    Great point Gene, the attachment to the continuation of the past decade of the mass populous is understandable and disturbing. I did a talk a few weeks ago on a Canadian bubble not pointing out a doomsday scenario (but not ruling one out either) and exchanged the word Canada with US by quoting many of the points by Martinson. They can see the truth when it doesnt apply to them otherwise all logic is abondoned for hope.

    Sam the graphs arent fancy, their stats if you read many of Bens previous posts you will see that it’s pretty clear how the market will break. Further his analysis is the best I’ve seen for a real perspective on the Canadian market.

    Cheers
    Bruce

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