No reason to fear for Canada’s fiscal future

We can expect Canada’s professional doomsayers to derive new fuel from Friday’s news that the burden of indebtedness carried by Canadian households has reached yet another record high. And they will certainly have a point, even if their predictions of collapse don’t stand up to scrutiny.

Still, the average amount of debt carried by a Canadian family is high - now 164.6 per cent of total take-home pay - and rising, although it’s expected to stabilize in another year or two. The new number is up from 160.9 per cent one year earlier.

By this measure, the debts of Canadians are already heavier than those of Americans on the eve of the U.S. financial collapse five years ago. And home prices, compared with their level in the year 2000, have now risen more in Canada than in the U.S. on the eve of its housing meltdown.

These are indications of real stresses in our finances. Consumers are nearly tapped out. At the same time, home prices in some of Canada’s big cities (Montreal less so than Vancouver or Toronto ) look overvalued.

But it is a huge leap from this picture to the smoking ruin we witnessed south of the border.

Benjamin Tal, an economist at CIBC World Markets, looked at this fear in a recent report and found that it’s based largely on misunderstandings.

First, let’s take that debt ratio. It’s widely cited, but in the opinion of Tal and many other economists it’s far from the holy grail of debt measurement. Tal calls it “more a headline grabber than a serious analytical tool.” Carlos Leitao, chief economist at Laurentian Bank Securities dismisses it too, saying “I don’t think it’s meaningful.”

Why? Because the weight of your debt payments depends on more than total debt. It also depends very heavily on interest rates. With rates low and expected to remain that way for maybe two or three years, the real measure of debt stress is how much of your income is swallowed by monthly payments. And this measure, Leitao points out, is about as low as it’s been in the past 15 years.

Of course, those payments will rise when interest rates finally go up, but not terribly fast, suspects Douglas Porter, deputy chief economist at BMO Capital Markets. That’s because in a fragile economic environment, the Bank of Canada will want to move upward at a measured pace. As well, Tal points out, nearly all Canadian homebuyers have been rushing to lock in mortgages with fixed rates, shielding them from unexpected increases.

And there’s something even more important than the sheer amount of debt we carry. It’s what bankers call the “quality” of debt. What they mean is that gimlet-eyed Canadian lenders simply won’t lend to someone without a demonstrated ability to pay off their loan, so the quality of debt here is high. That means the danger of mass defaults, which contributed a lot to the U.S. home-price collapse, is close to zero.

This wasn’t true in the U.S. a few years ago, where prior to the crash, regulators and bankers went a bit crazy and a stunning 20 per cent of all mortgages were subprime (meaning of low quality). Tal estimates this figure for Canada today to be about 7 per cent, up only two percentage points since 2005.

This is significant, Tal notes, because homes in U.S. cities with above-average numbers of subprime mortgages suffered twice the price drop found in cities with less-than-average subprime lending: “Eradicate subprime from the U.S. housing market and, instead of the most severe house-price meltdown since the Great Depression, you get a soft landing.”

That’s not to say that we’re home free in Canada. We’ve enjoyed just about as much debt-fuelled growth we can handle, so our economic growth will be at least a little weaker than normal for the next few years. And in some cities, home prices are quite likely to fall, which is normal in an overpriced market. But there’s a world of difference between a correction of five or 10 per cent and the U.S. collapse of 40 per cent seen in that country’s hardest-hit cities.

Unless there’s a new recession, which isn’t expected, there’s little reason to fear for Canada’s future.