It's all about debt

Amid mounting fears over just how far and how fast the Bank of Canada might raise interest rates, the Canadian media are suddenly full of scare stories about the financial plight of the household sector. On Monday Statistics Canada released data on national wealth and financial flows for the first quarter of the year, which provided fresh insights into household balance sheets. And on the same day, Manulife Bank of Canada released a survey outlining some scary scenarios if mortgage rates continue to rise. 

In many respects the StatsCan data paint a positive picture of household finances. The net worth of the household sector rose by about 1.2 percent in the first quarter, with higher non-financial assets (mainly real property) offsetting falls in the value of financial assets. The aggregate value of residential real estate rose by more than 10 percent in from Q3/2021 to Q1/2022. The household savings rate rose to 8.1 percent in Q1, the highest level since 1995 if you ignore the bloated levels briefly recorded early in the COVID pandemic. Lastly, the ratio of household debt to disposable income edged down to 182.5 percent in Q1 from the record 185.0 percent posted in the previous quarter; it need hardly be stated that this is still an extremely high ratio by global standards. 

If there are positives to be taken from the data, why is the media coverage so bleak?  In part this relates to the media's voracious appetite for bad news, and in part it reflects the sheer speed with which a multi-year sellers' market has U-turned into a buyer's market.  It is also important to keep in mind that the data are highly aggregated: the "average" household may be in fine shape, but there are many that are not. Those that stretched their borrowing to the limit in order to get into last year's hot housing market and also opted for a floating rate mortgage are particularly vulnerable -- and according to the StatsCan data, 30 percent of outstanding mortgages are at floating rates. 

It may be argued that the rising aggregate value of household net worth means the problem is not a serious one. This again ignores the risks now being faced by the most heavily indebted households. It also fails to recognize the distinction between bankruptcy and insolvency. A household with substantial equity in its home many not be at risk of going bankrupt, but it may still lose the home if its cashflow becomes insufficient to service its mortgage debt.  

This brings us to the Manulife survey, which polled 2000 households across Canada in mid-April. Here are the key conclusions:

• Nearly 25% of homeowners say if interest rates increase further, they’d be forced to sell.
• 1 in 5 homeowners believe they can no longer afford the house they own.
• Nearly half of Canadians said they would struggle to handle unexpected expenses.
• NEARLY 40% of Canadians do not feel like their wages are keeping up with inflation.
• 80% of Canadians think there is an affordability crisis in Canada.

This is all quite remarkable, particularly as the Bank of Canada had only just started its tightening cycle when the survey was conducted. For anyone who carried a mortgage at a rate well above 10 percent in decades past, it's hard to grasp that current interest rates have pushed so many Canadian households so rapidly to the point of despair.  Interestingly, Manulife Bank itself -- in sharp contrast to the media latching on to the story -- is cautious in interpreting the data. Here is its "key takeaway" from the report:

With the shift in the housing market, rising interest rates and inflation concerns, it’s normal to worry about your long-term financial future. But feeling like you can’t afford your home doesn’t mean you’ll be forced to sell if interest rates continue to rise. Once you know more about how interest rates work, you’ll have a better idea of how this may impact you and will help you feel more in control when it comes time to make any major financial decisions.

That seems like excellent advice, though no doubt too late for many people. Experts have been fretting for years about what might happen when the Canadian housing market stopped racing ahead. We're starting to find out, and it doesn't look as if it will be very pretty to watch.