A warning for Canada's banks

Canada's federal financial regulator, OSFI, has warned the country's banks that it is planning to keep a closer eye on their mortgage lending practices.  There is no hard evidence that the banks are offering anything like the NINJA (no income, no job or assets) loans that crippled US lenders almost a decade ago.  However,  OSFI is concerned about rising risks in their mortgage books, as housing prices continue to advance strongly, especially in the greater Toronto and Vancouver areas.

The IMF, the OECD and others have been expressing concerns about the frothy state of the Canadian housing market for some time.  Responding to such concerns,  OSFI has a list of things it wants the banks to be careful about, including income verification, proper appraisal of properties being financed, loan-to-value ratios and such, This is all boilerplate stuff, and given the generally conservative nature of Canada's banks, it's unlikely that there have been too many lapses in this regard.

The bigger issue, as OSFI is certainly aware, is the systemic risk that continues to mount as interest rates remain low and house prices continue to rise. Each individual bank may have an acceptable level of risk in its own mortgage book, but in the event of a crisis -- presumably triggered by a rise in interest rates -- it can't be assumed that the system as a whole will remain sound. Interest rates have remained so low for so long, and house prices have risen so far beyond all past experience, that we are in uncharted territory here.

Canada's household debt-to-income ratio is at an all-time high of 164 percent, higher than the level seen in the US just before the financial crisis. Moreover, the number of super-indebted household is also at a record high. Surveys regularly report that a worrying percentage of households have virtually no leeway in their finances: miss one paycheque and they're immediately in trouble. The proliferation of payday lenders bears this out.

There's no real precedent out there to tell us how bad things will get, and how quickly, once interest rates begin to rise.  Of course, there's no sign of that happening any time soon -- but that simply means that the rise in house prices and in household borrowing is going to continue, making it ever more likely that the eventual correction will be painful.  OSFI may not be able to ease the pain for individual households that get overextended, but it can at least try to ensure that the stability of the financial system is not put at risk.