“The greater the complacency, the more brutal the reckoning”

Household debt hits new record

Remember back in 2009 when articles like these were so prevalent?

Perhaps Canadians are inherently more conservative than Americans and that has kept the market steadier…”

Canadians have less debt than Americans and a better chance of getting personal and business credit from our much-healthier banking system.”

Canadians are more conservative by nature…”

Oh for the good old days when the ‘conservative Canadian consumer’ mantra was being bandied about as the major reason why Canada’s economy and housing sector will fare well in the coming years.

Today we learn that Canada’s consumer debt levels are now above those of our ‘reckless’ American cousins.  When adjusted for changes in income tax laws, our current debt levels are arguably above those of Americans at the height of their own credit bubble.

 

While assets and net worth continue to grow also, their values are floating on a sea of credit.  It’s been my position that peak credit is very close at hand. The lee side of that credit mountain looks vastly different from the summit.  Once demand for credit hits a wall, as it now must, credit-dependent assets like real estate crumble.  The broader economy contracts as consumer spending is choked off.  Unemployment rises.

That is unless the Bank of Canada can somehow orchestrate a soft landing in credit demand whereby consumers gradually come to the realization that they’re overextended and demand for credit gradually weakens.  Mass psychology being what it is, it’s very difficult to see that happening.

RBC had this to say:

“The household debt-to-personal disposable income (PDI) ratio, however, rose to a new record high of 149.9% in the third quarter from 145.2% in the second quarter”

(Other sources had the PDI ratio at 148.1%)

“The recovery was largely driven by the strength in asset values (real estate in particular) since the beginning of 2009 that was supported by historically low interest rates. These gains, however, have been accompanied by increases in debt, and as a result, household debt levels are at all-time highs.”

RBC concludes that since assets are rising on aggregate faster than debt levels that somehow this is not particularly troublesome.  I’m not sure how they can argue that.  The trend is clearly not sustainable.

As TD noted in their economic commentary:

“While household net worth continues to improve, it is growing at half the pace experienced in the three years prior to the recession. All the signs are pointing to a continued moderation in the rate at which households can accumulate assets. Unless households cool their pace of debt accumulation significantly in the near-term, the ability to grow their net worth will be constrained by the level of indebtedness.”

“As households have to devote a greater share of their income to their monthly debt
payments, bolstering their asset position through increasing savings will be a bit more of a challenge in the future, and liability growth is likely to continue to outpace asset growth for some time, weighing on net worth growth.”

Carney chimes in

Earlier today Mark Carney delivered a speech to the Economic Club of Canada.  In it, he mused about the current state of the global economy, the impacts of QE2 on Canada, and the implications of extended low interest rate policies on households.

Some key quotes:

“Encouraged in part by low interest rates, Canadian household credit has expanded rapidly during the recession and throughout the recovery. As a consequence, the proportion of households with stretched financial positions has grown significantly.”

“Without a significant change in behaviour, the proportion of households that would be susceptible to serious financial stress from an adverse shock will continue to grow.”

“These are extraordinary times. A massive deleveraging has barely begun across the industrialised world.”

“More broadly, market participants should resist complacency and constantly reassess risks. Low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce: the greater the complacency, the more brutal the reckoning.”

I do think Carney’s hands are tied over the short term.  It’s pretty obvious that the dream scenario for Carney would be to talk down consumer debt levels through this type of banter while still being able to keep interest rates low so businesses can invest and spur on employment growth. Unfortunately it’s not happening.

People will awaken to the fact that their debt levels are setting them up for financial pain in the future.  When they eschew debt, likely en masse, it sets the stage for deflation in credit-sensitive assets.  It also chokes off consumer spending, which currently accounts for 65% of GDP, and causes higher unemployment.  This is our future.  Exactly when people finally return to their senses is the only question.  I can’t help but think that it’s closer that many realize.

-Ben

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16 Responses to “The greater the complacency, the more brutal the reckoning”

  1. jesse says:

    Carney’s speech gave hints at what tools they will employ to help rein in asset price dependency:

    “The third line of defence is the development of and selected use of macro-prudential measures. In funding markets, the introduction of through-the-cycle margining can help curtail liquidity cycles.16 In broader asset markets, counter-cyclical capital buffers can be deployed to lean against excess credit creation.”

    I don’t know the timeline for the rollout of these proposals (which aren’t new BTW) but they may not align with the timeframe under which the Bank would need to act.

    I had thought the Bank may want to tighten CMHC lending practices again but it appears like that’s not on their radar. That’s a bit incongruent with the chartered banks’ recent pleas for the government to do something to curtail household lending. It sounds like Carney’s telling them to f%&$ off and figure it out.

    • Chad says:

      CMHC is not run by the Bank of Canada. It is a Crown corporation and is under the Minister of Human Resources and Skills Development Diane Finley portfolio.

      So Carney isn’t able to change the regulations and the head of the commercial banks are telling the Conservatives to tighten things up at the CMHC and protect people from themselves. All Carney can do is warn people then raise the rates to fight inflation.

      I doubt that the Conservatives will tighten the requirements because it will hurt house price and the economy in the sort term. They might take the short term pain if win a majority government so I guess hope for that(not sure what the Liberals would do, likely nothing without a majority but you never know) or we may have a crash just like the USA

      • jesse says:

        Funny you should mention that!

        Canada could tighten mortgage rules: Flaherty
        Monday, Dec. 13, 2010
        http://www.financialpost.com/news/Canada+could+tighten+mortgage+rules+Flaherty/3970508/story.html

        I think we all understand the limitations of authority given to Carney WRT CMHC. It does not mean he cannot suggest changes to government policy that align with, and ease the application of, the Bank of Canada’s mandate. I found it odd he didn’t mention further tightening of mortgage rules in his speech, instead hinting the previous application may have been enough. I suspect there is a timing issue involved; some of the government policies he would prefer won’t be ready quick enough.

        Carney was appointed Chairman of the Committee on the Global Financial System and his comments in his speech seem to hint at the items at the top of their agenda. As role of Chairman he cannot invoke the policies the committee recommends but certainly he has influence amongst policy makers in Canada and in other jurisdictions. The independence of the BoC is on what they can do, not on what they can say, though he has to be careful on both accounts.

  2. Sam says:

    You are funding debt at half the rate, so you have double the debt – why is that big deal? If 1000$ a month got me a place for 100k ten years ago and now it funds 200K, my debt is doubled but my monthly payment is still the same. Why does no one understand this concept on this blog? Now are you then saying “if rates go back to historical norms, then the monthly payments would sky rocket” Has not happened and it will not happen. The bank knows the marginal pain from rate increases, the party continues.

    • Lumpen says:

      The bank sets the target for the overnight rate – i.e., for the intrabank market. Individuals do not borrow at this rate. The BoC has less say on longer-term, i.e., mortgage rates. The banks’ funding costs are determined by the broader bond market for Canadian mortgage-backed paper. If investors want a higher yield, borrowers will pay a higher rate – it’s that easy.

      Can the BoC influence the yields – sure. They can soothe or spook investors. They could purchase the bonds themselves a la US Fed in an attempt to lower yields (note – this doesn’t always work out as expected – look at the 10yr and 30yr yields since QE2 – they’ve risen).

      As for your view that it is all about the monthly payment, not the aggregate transaction value. Forgive me while I throw out a pity statement – “yeah – and that worked out so well for the US/Ireland/etc.”

      More seriously however, you’re paying 29% more on $200k @ 5% than $100k @ 10% – both P & I here. Are you suggesting that no one should ever pay down their mortgage, and just fund the interest until they die?

      I do note, however, that if it really is all about the monthly nut – which it is for many people – then if you assumed that rates went from 5% to 7%, to have the same nut, the $200k borrowed would need to be $165k. 17% drop – not Las Vegas, but that’s on fundamentals. But certainly in line or slightly worse than central NY/SF. Markets tend to overshoot in both directions.

      Note – none of this is to say no one should ever own RE at today’s prices. I’ve reduced, but not eliminated, my exposure. But for me, I like the risk-reward elsewhere more.

      • Sam says:

        If homes were actually mark to market, then I believe people would care. But if you pay 200k and your’e job is fine and your home trades down to 50K, NO ONE CARES, they are not going to fire sale a home and move family. That would cause a real estate crash. Rental vacancy rates are low, rates are low.

        You need to focus on jobs and “debt servicing side” of the equation. Don’t focus on rates and prices, that is very 2002

        In addition, who is going to give 10x leverage to take any risk/reward bet? I can put 10k down and have a 100k of exposure. Leverage can kill, but that is all you are focused on. it can also make very very rich.

      • Lumpen says:

        If looking at fundamentals is “so 2002” then I’m quite happy to stay there. But I would hope you can help me understand your thought process.

        Your first post states:

        “The bank knows the marginal pain from rate increases, the party continues.”

        Sounds like Chuck Prince – as long as the music is playing, we’ll keep dancing. You then move on to the other side of the coin:

        “If homes were actually mark to market, then I believe people would care. ”

        So, tell me if I have this straight. People love it and are thrilled when prices go up, yet are indifferent when they go down? And how does this jive with your “it can also make very very rich” concept at the end?

        Let’s move on to your “jobs and debt servicing” side. I haven’t seen anything from Statcan that shows significant high-earning jobs being produced in large numbers over the last two years, so if you have a source, I would like to see it.

        I can offer this up:
        www40.statcan.gc.ca/l01/cst01/LABR73A-eng.htm

        The key takeaway:
        From 2005 through 2009, average weekly wages grew 2.8% (nominal). Clearly less than asset price inflation, and this RE performance supports the view that it really is all about the monthly nut.

        So, what happens when rates stop going down? Does RE then only grow at the wage growth rate? That’s going to make some people unhappy. We don’t even need to get into what will happen if rates rise. Debt service is hard when inflation isn’t helping out the income stream.

        This topic ties in nicely to cap rates, wouldn’t you say? Vancouver is under 2%, Toronto is around 4%. These are lower than Japan today. Once again, not saying that they can’t keep going up. But they’re not going up on fundamentals. Personally, I would have a hard time sleeping at night with a significant portion of my net worth in investments with that kind of profile. Leverage on an investment like this would just make me more nervous.

        I prefer equities with the leverage on their balance sheet – in my experience, they have much lower probabilities of an investor being called out of the game. The recourse nature of the RE debt is a definite downside, as unless each asset in a portfolio is ringfenced, one bad buy taints the whole basket. Lots of things can make you “very very rich” – to each their own. I’d rather have a base metal equity with reasonable cap structure go up 50% than a 10:1 levered asset go up 7% (90% funded at 4% with a 2% cap rate). Both are clearly not sustainable over a long time frame, but the cost of entry and exit is much lower outside the RE market.

        No one has to sell their house, if to use your extreme example, of $200k to $50k. The market moves whether they recognize their loss or not. It merely represents the amount they can receive _should_ they sell it. If you doubt the veracity of this concept, check out Vegas on Redfin – note the original purchase price vs. the current asking price. The RE of the listers’ neighbours are similarly depressed, even if they aren’t trying to sell.

      • Sam says:

        So, tell me if I have this straight. People love it and are thrilled when prices go up, yet are indifferent when they go down? And how does this jive with your “it can also make very very rich” concept at the end?

        Because when prices go up, your friendly RBC banker calls you and asks if you want to get your money out via a loan against your new higher priced property. When it goes down, no one calls you with a margin call? U follow that?

        Show me a long term graph of Canadian real estate where the trend is down, even vancouver has been growing at a steady 7 ish. Periods of low prices, high prices, etc, but the trend is up and contines.

        LV and Redfin (no clue) but “Who needs these places?” That was not a real estate spec buy, it was a real estate spec “sell” by developers. People want to live in Canada. In fact look at Whistler, it is trading at below inception prices?? You had the 2010 Olympics, the largest housing boom in canadian history and still the prices don’t pick up – WHY?????

        No one needs that place, you can’t live and work in Whistler, no real engine. To Ski is expensive so many parents put kids in other sports. Not everything booms and busts, you need to better deep analysis instead of just general rants. That is my thoughts on Whistler and that Asians don’t really show up as big ski people but I am sure if it had a musical school, it would attract people.

        LV is a place where people go to commit sins and of pure excess, how would you expect it to behave in a downturn? upturn? Who needs to live in LV? Think about what you type and look into the reasons, don’t just simply follow the trends and graphs.

      • Lumpen says:

        You seem to have a focus as an investor. Please show me any two Vancouver properties on MLS that makes sense as an investment without capital appreciation (as an investor). I’ve periodically picked out 5 or 6 at random every couple of months, and I haven’t found any that work in the last 3 years. If the opportunity is there, this should be easy for you.

        Your margin call is when you can’t find a renter to cover your monthly nut. If you’re underwater, you’re on the hook for any deficit if the bank forecloses (other than AB). Then the portfolio starts to hemorrhage quickly as you backfill. As long as you have reasonable equity in reserve, you’re poorer, but covered. But for the aggressive, game over.

        You’re taking the focus on Vegas as a strawman. It’s easy to knock down, and nowhere did I suggest that such a fate is in store for any area in Canada. The reason I dragged it out is it’s a great place to see $600k condos list for $150k. Even if a given condo isn’t listed, but the comps are $150k, that’s what it’s worth – your “they don’t need to sell” argument is equally applicable there. Doesn’t change what a property is worth.

        Don’t disagree with the upward trend. And that’s why you wouldn’t find me shorting the RE market – catalyst hasn’t shown itself yet. It may never for all I know. But other asset classes will outperform a levered RE play at these levels.

        Can you support your position with any fundamental analysis?

        (Not an attack – just curious if you’re the equivalent of a technical trader as opposed to a fundamental investor. Both can make money and lose money, but don’t necessarily happen at the same time.)

  3. mac says:

    You nailed it. Carney wants to “talk down” consumer debt while keeping interest rates in tow with the US. Over here in Lotus Land, the minute there’s a suggestion that interest rates may stay low for more than 3 months, the crackhead, first-time buyers belly up to the bar and order another round.

    That explains the slight uptick in sales volumes in the last two months of fall and why all the agents are talking about pressure on buyers come spring. Out here, Harper will have to take an axe to loose monetary policy to deflate house prices. Nothing short of a shock will do.

    • jesse says:

      It may be as simple as running out of buyers. Carney stated levering up is a positive transient effect on GDP and consumer spending but even with perpetually low rates such behaviour is unsustainable.

  4. mac says:

    Ben,

    Now with Sam, you’ve got a real bull on your hands. Not a “balanced” observer like me. If he’s from Vancouver, you will soon see the difference.

    • Sam says:

      Mac, I have tried many times to point holes in the housing market in Canada. I live in NYC (big apple). But if i did live in the Vancouver, what would I “soon see”????

  5. mac says:

    Sam,

    OMG. Either I’m lost or you’re lost.

    1. Refin is redfin.com an online realty site not a place to live.
    2. My comment was to Ben, the blog author, who thinks I am a bull. I am merely pointing out that you are more likely a real bull, rather than me. You may even be the first bull to post on his blog.
    3. I agree with much of what you say.

  6. Anonymous says:

    I dont understand economy, all i know is reduce various fees and costs. If people paying more on phone and internet then their principle amount in mortgatge the end result will be – you know – crash.

    There is no room for people to reduce cost in their daily leaving, people are forced to take debt, who cares We love our corporations and government

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