TD has come out with a very fascinating report in which they’ve assessed the financial vulnerability of households across the country. It’s full of interesting data, though some of them certainly questionable. Perhaps most interestingly, they have made easily available a range of financial data going back over a decade. The trends certainly speak for themselves, and we’ll look at those in more detail in a moment.
In addition, they have created a new index designed to gauge financial vulnerability. The report reveals some fascinating trend, but also raises a few questions about the raw data itself.
Let’s dive in!
Household Financial Vulnerability Index
I applaud TD for attempting to quantify financial vulnerability by examining a number of related metrics. The specific metrics used in their new index can be found on page 2 of the report.
I do question why they would weight debt serviceability at 20% of the total index, particularly when the authors actually have calculated a much more meaningful adjusted debt service ratio that measures the effects of future Bank of Canada rate hikes. If the goal is to measure credit risk, it would make sense to look at household finances once interest rates normalize. Debt serviceability is simply the percentage of household income being used for principal and interest payments. It should be obvious that living through an expansion of debt during a period of unprecedented low interest rates will mask some of the underlying weaknesses.
For example, debt to income ratios have ballooned at the same time that the percentage of income directed to debt repayment has fallen. If we look simply at the amount of income directed towards debt repayment, things look relatively safe. But to use that as a measure of current credit risk, I would argue, is misleading.
I would also be inclined to weight the debt-to-asset ratio lower than 15% of the total index. If there’s one thing we’ve learned from watching credit bubbles implode in different parts of the world, it’s that asset prices (particularly leveraged assets like real estate…the bulk of the average Canadian’s net worth) always look great just before the party ends. I’d suggest that it is a ratio that masks the appearance of credit excesses, the very thing the index aims to measure.
All that being said, it is a step in the right direction. Here is the current index by province, with the Canadian average set at 1. Hence, a province with a number larger than 1 is more financially vulnerable than the average:
Note that BC leads the list….no shock….with Alberta and Ontario rounding out the ‘over achievers’.
The raw data
I will come back to the report itself in a later post, but for now I think it’s worthwhile to dig into the raw data and see some of the fascinating trends.
1) Debt income ratios ballooning
You’ll note that the debt-income ratio has expanded in every area of the country since the start of the new millennium.
Interestingly, TD used Ipsos Reid data in calculating their debt/income ratios rather than Stats Canada data. Stats Canada has calculated the average debt/income ratio at 148%, much higher than Ipsos Reid’s estimate of 127%. While the Stats Canada data is aggregate data and the IR data is broken down a little more, I still have a difficult time reconciling the differences in these two averages.
Furthermore, in discussing the limitations of the IR data, TD notes that, “There might be, for example, a tendency for households to over/under estimate the value of their homes”. Add to that the tendency to over/under state their incomes. In the name of being neutral I suppose we need to aknowledge that survey respondents could either overstate or understate their incomes and house value…..but suffice to say that I’d suggest it’s highly likely they would do one over the other.
On the national level, debt has really ballooned since 2005, consistent with my observations in my post on Canada’s credit bubble. Ontario has seen a particularly large increase in debt/income levels since 2008, with BC and Alberta seeing massive jumps since 2009 (though both were significantly stretched well before that).
2) Debt Service Ratio (DSR) artificially low, but still alarmingly high compared to US consumers
The debt service ratio (the percentage of income diverted towards interest and principal payments) is currently hovering around the lowest point point contained in the data set. The grey column on the right indicates what the debt service ratio would be if the Bank of Canada raises its overnight interest rate from the current 1% to 3%.
Despite the low current readings, we know that debt as a percentage of income has increased markedly. What’s up with that? Two factors actually:
- 1) A fairly continuous lowering of the Bank of Canada overnight rate upon which prime rate is set.
- 2) A broad loosening of mortgage insurance standards since 2005. Increased amortization length has decreased the total monthly debt burden, but greatly increased the total mortgage paid over the life of the loan.
Although I don’t foresee a rapid rise in interest rates, it is nonetheless safe to say that the two factors that have enabled the DSR to remain deceivingly low are now working in reverse now that new mortgage rules are on the way.
Of interest, the DSR in the US peaked around 14% of disposable personal income in 2007 compared to a current 18.6% reading in Canada. I have a difficult time accounting for such a massive disparity in the levels between the two countries given our relatively comparable debt/income ratios, but the specific data source used by TD in their calculations is not given. It could be that mortgage interest deductability in the US is considered in their calculations, but the Fed data suggests that they have used personal disposable income, which implies after taxes are considered. I’m somewhat stumped on this one.
3) Home price to income ratios……bubbly no matter how you slice it.
Behold! Note that Canadian home prices were last near their long-term average of 3-3.5 times income back in 2001.
From the report:
“The ratio of existing home prices to income – average resale prices from Multiple Listing Service (MLS) as a per cent of disposable income. This captures relative overvaluation in the housing market as well as the susceptibility of household balance sheets to a housing price correction.”
Based solely on long-term averages, the Atlantic provinces and Manitoba are closest to fair value, while BC, Ontario, Quebec, and Alberta are getting ridiculous (especially BC).
Not much more to comment on here except to point out that house prices in Canada continue to defy virtually all long-term measures of fundamental value. All the anecdotes in the world don’t stack up against the reality that when the average family can no longer afford the average home without sacrificing their long-term financial health, something will give.
It also bears noting that much of the significant overvaluation is centred in the larger cities. This was noted in the most recent Demographia survey which found that while the six largest cities in Canada were seriously unaffordable, when the 35 largest markets were considered together, the aggregate number indicated only moderate unaffordability.
4) Personal savings rate
The personal savings rate in Canada averaged 3.9% in 2010, low by historical comparisons, but arguably not shocking based on current interest rates.
Since 2000, the savings rate has eroded most significantly in Ontario (7.6% to 2.9%). Most surprisingly is BC’s large and sustained negative savings rate for over 10 years running!
A trusted reader made the following observations in an email exchange: “The ONLY way the denizens of BC can maintain a negative savings rate for that long is if they are spending the equity in their homes. That is, they are getting HELOCS and paying bills from the HELOC. Understand, eventually you can get to the point where you pay the credit card, the electric bill, the mortgage, and the car payment from the HELOC. That is sustainable until house prices stabilize (and in Vancouver they have and are headed down a bit) and then you can’t get an increased HELOC. Shortly after that, you have a personal credit crisis.”
“BC is headed for a credit crisis. A negative savings rate means more money is going out (of the household account) than is coming in from income.”
This is particularly troublesome for BC when one considers that new rules will be restricting HELOCs to no more than 85% of the total home value.
I hope to delve more into this data if I can find the time, but I’ll have to leave it here for now.