Bank of Canada signals debt risks as some Canadians pay too much to enter booming real estate market
The Bank of Canada has a clear message to Canadians: Interest rates are guaranteed to rise, but house prices are not.
With the pandemic’s low interest rates pushing over-indebted borrowers to rack up mortgage debt, the central bank has ranked household indebtedness and accelerating house prices among the biggest threats to the economy in the medium term. .
The average price of homes in the country jumped more than 30% during the health crisis, with prices rising at a faster rate in suburbs of Toronto and small towns in Ontario. The bank itself has played a role in the demand for real estate by keeping interest rates at record highs over the past year and promising not to increase them for a while.
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“Some people may think that the kind of price increase we’ve seen recently will continue. That would be a mistake, ”Bank of Canada Governor Tiff Macklem said at a press conference on Thursday. “Interest rates are very low. This means that there is more potential for them to go up.
In its latest financial system review, the central bank warned that household vulnerabilities have intensified with deteriorating loan quality and increasing speculative buying. The bank found that the share of heavily indebted households taking out mortgages is increasing significantly and now accounts for 22% of all new mortgages.
That’s higher than during the 2016-17 housing boom, when rising mortgage debt triggered tighter lending rules in Ottawa. Additionally, heavily indebted borrowers make down payments that are less than 20% of the property’s purchase price. The bank said this combination was “associated with a greater risk of late payment of debt.”
“Some of the vulnerabilities we had before the crisis have returned and at the top of the list are housing and household debt vulnerabilities and they have intensified,” Macklem said. “The message to Canadians is not to extrapolate from the current rapid increases that we have seen in prices. Don’t expect these to continue indefinitely.
Despite the increased risks in the housing market, the central bank said systemic risks to the financial sector remain low. Canadian banks are well capitalized, in part thanks to reforms undertaken in the aftermath of the 2008 financial crisis, and have performed well throughout the pandemic.
As part of its review of the financial system, the central bank performed a “reverse stress test” to determine what type of economic downturn would be necessary to put the Canadian banking system at risk. He determined that “the Canadian economy is expected to take a severe shock – more persistent than that experienced in early 2020 – before the capital cushion of systemically important domestic banks and their credit supply are compromised.”
Along with the report, the central bank introduced a “house price exuberance indicator” to detect periods of “extrapolative expectations”, or the expectation by buyers that house prices will continue to rise. Under the new measure, the Toronto area, Montreal and Hamilton are firmly in exuberant territory, with Ottawa approaching that level.
Only nine major markets were examined under the indicator of exuberance. The bank included Vancouver, Victoria, Calgary, Quebec and Winnipeg, but not other areas like Tillsonburg, Ontario. and Chilliwack BC, which saw some of the biggest price increases during the pandemic.
The bank said a misalignment of house prices and fundamentals could cause house prices to fall in the future, which could make it difficult for homeowners to make mortgage payments or let homeowners owe more than the value of their home.
Mr Macklem defended the central bank’s decision to keep interest rates close to zero for at least a year and reiterated that monetary policy applies to the entire economy, many parts of which remain depressed.
Economists have said the central bank is in a delicate position. “It’s a tough balance,” said Priscilla Thiagamoorthy, economist at BMO. “Interest rates affect more than housing. “
TD economist Ksenia Bushmeneva said Mr Macklem was right to be concerned and point out the risk of high household debt. “I feel like the governor sent a strong message to Canadians, but I think the [central] the bank has limited leeway to play a bigger role in cooling the housing market, ”she said.
Very little has been done to slow down the real estate boom. The Canadian banking regulator and the Department of Finance have toughened the mortgage stress test. Additionally, Ottawa and the City of Toronto have proposed empty house taxes to force homeowners to rent or sell their properties if they don’t use them.
Along with vulnerabilities in the housing market, the bank has flagged potential risks related to corporate debt and corporate insolvency as government support is withdrawn in the coming months.
Canadian businesses have fared surprisingly well from the pandemic, thanks to generous support from the government, the bank said. Overall corporate debt has declined and corporate insolvencies are 30% below pre-pandemic levels. However, the bank warned that could change as government support programs, such as wage and rental subsidies, come to an end.
Firms that depend on high yield debt markets to fund their operations could face particular problems if investor appetite for risky assets wanes. High yield bonds, also known as junk bonds, represent about 20% of the value of all corporate bonds in Canada. Most of them are issued by commodity companies.
“A change in investor sentiment could lead to a sharp revaluation of existing assets. … If this were to happen, it would become more expensive and more difficult to renew existing debt and issue new high yield bonds, ”the bank report says.
Although the bank concluded that the systemic risk to the Canadian financial system is low, there are places where vulnerabilities increase.
The main area of concern is the fixed income market, where changing patterns of bond holding create “liquidity” problems in times of crisis. (Liquidity refers to the ability of sellers to locate buyers and transact in a way that does not cause large price movements).
Non-bank financial institutions, including pension funds, mutual funds and insurance companies, have an increasing share of the bond market. Unlike banks, these asset managers do not have capital cushions in place, nor direct access to central bank funding, to meet sudden redemption requests. This means that in times of crisis, they may be forced to sell large numbers of bonds to raise cash, wreaking havoc in the fixed income market.
“There has been a gradual structural change, with the asset management industry requiring more liquidity, which could exceed the ability of banks to provide it in very stressful situations,” Macklem said.
This happened last March when investors panicked and demanded liquidity. The funds were hit by redemption requests and margin calls and were forced to sell their fixed income assets. At the same time, banks, which typically act as market makers willing to buy and sell bonds, have pulled out of the market to focus on lending to hard-hit companies. Bond markets almost seized up, even for the safest assets like Government of Canada bonds.
The central bank intervened with a series of market liquidity measures and by mid-April bond markets were largely back to normal. But the experience of last March showed just how vulnerable bond markets have become in times of crisis.
The bank said it is also monitoring financial risks related to climate change and cyber attacks, and that it sees the rapid development of the cryptocurrency market.
“Despite their growing popularity, these [cryptocurrency] markets are not systemically important in Canada, neither as an asset class nor as a payment instrument. But that could change if a big tech company – a so-called Big Tech [company] – with a large user base decided to issue a cryptocurrency which has become widely accepted as a means of payment, ”the bank said.
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