Canadian Household Debt

A look through the headline data

A colleague of mine recently visited Toronto for the first time in over a decade and was overwhelmed by the number of cranes he saw in the downtown core. Like some visitors, he concluded that Canada’s real estate market must be frothy. While this anecdotal evidence, which I like to call ‘the crane-effect’, is a few screws short of a crane, he’s not the only one making the argument for an impending collapse in Canadian real estate. Vijay Mohan, a San Francisco based hedge fund manager, is so convinced Canadian banks are undercapitalized and real estate is unaffordable that he’s committed his entire fund to shorting Canada. Perhaps inspired by other doom-and-gloom hedge fund managers who built their reputation on the misfortune of others, Mohan’s thesis lacks depth. To that end, let’s take a minute to examine credit growth and other drivers of demand for real estate in Canada – none of whose cities made the Knight Frank 20 most expensive cities list.

Adjusted Debt-to-Income Still High – The data point most analysts are concerned about in Canada is the ratio of household debt to personal disposable income that now stands at 165%, higher than the pre-crisis peak in the US. As David Rosenberg pointed out last fall, this is a bit of an apples to pears comparison given Canadian healthcare costs of $5,948 per person aren’t added back to disposable income. This healthcare spend amounts to roughly 18% of household income, incidentally not far off estimates of US healthcare spending of 19%. Adjusting the debt-to-income ratio by healthcare costs and differences in index composition yields a result that is within 10% of the US ratio; roughly 140%.

Low Rates Contributing to Affordability – The impact of lower interest rates to household debt isn’t to be underestimated. The Bank of Canada’s affordability index (AFF), which factors mortgage rates and payments vs. disposable income shows an affordability metric that has steadily improved since the early 90s, even in the time period since the crisis.

Credit Growth Is Worrying… Similarly, credit metrics show Canada to be an outlier in terms of credit availability growth against global peers, as the ratio of bank credit to deposits has grown meaningfully since the crisis.

Measures of private sector debt and total debt (Government + Bank + Corporate) show a similar picture, with Canada’s debt growth as a percentage of GDP in the double digit territory.

…But How is Credit Dispersed in Canada – Still, the key to understanding if/when household debt growth becomes a problem is properly identifying its sub-components. A closer look at the composition of that debt indicates a significant leaning to mortgage debt, as one would expect. A Bank of Canada report last year indicates roughly 2/3rds of household debt comes from mortgages, with a significant proportion of that increase coming from 31 to 45 year olds, who have grown their mortgage debt-load by an average of $40,000 over the last decade. That same age category shows a greater willingness to take on mortgage debt as incomes rise, consistent with life-cycle spending theory and research conducted at Statistics Canada.

Mortgage Debt Leaning to Higher Income Earners – Statscan data shows that individuals with greater than $100,000 of household income represent 37% of debtors, but 56% of all household debt ($172,400 per borrower). As higher incomes are generally associated with greater assets, it may follow that the debt carrying capacity of this portion of the population is higher.

Yet another method of evaluating debt dispersion in Canada is through the Gini coefficient of household debt – a higher value indicates a relatively small proportion of borrowers hold a large proportion of debt. In 2009, the household debt coefficient was 0.611, compared with 0.372 for household income within the same group. In other words, household debt is not uniform, but concentrated amongst higher net worth individuals. General comparisons to the pre-crisis US consumer miss this point, and also fail to recognize that the subprime mortgage market in Canada accounts for just 3% of mortgages compared to 14% in the US.

US Debt-to-Assets Converging to Canadian Level – Anecdotally, a recent report on multi-millionaires suggests Toronto has more multi-millionaires than Rome, Sydney, Chicago and Los Angeles. Looking at the data, the ratio of debt-to-assets in Canada is 17.6%, compared to 16.9% in the US; a much smaller difference than the debt-to-income ratio. Furthermore, the US number has actually dropped meaningfully in recent years, from its peak of 21% in 2008.

House Prices Continue to Rise – Following a slight dip in house prices over the winter, prices have begun their steady ascent higher in recent months according to MLS data. The MLS monthly report also shows that months-in-inventory has been edging lower and is now a full third lower than the peak during the crisis. Further, though some have reported huge increases to listings, the listings-to-sales ratio has actually held steady at 50% over the last year. None of this says much about sustainability – but at first blush it certainly doesn’t paint the picture of panic Mohan is banking on.

To be fair, Mohan believes a hike in rates will cause deeply stretched Canadian households to buckle under the increased interest burden. His thesis is that the slightest hike in rates will trigger defaults and ultimately insolvency in the banking sector. Rate hikes affect two distinct set of investors: Those who own property and those who have yet to buy. An examination of the latter by TD Economics indicates the tightening in mortgage rules over the past few years has had the equivalent effect of a 1.9% increase in interest rates. Yet house prices haven’t collapsed.

What of the consumer who already owns his home? CMHC data indicates 68% of Canadians are homeowners, compared to 62% in the early 80s. Of the $566bn in mortgages the CMHC insures, 75% of them have an LTV less than 80%, with the average LTV of the whole book sitting at just 55%. Further, 75% of those borrowers are actually ahead of their payment schedule, whilst CMHC’s default claims have dropped in recent years to a low of 0.1%.

It’s anyone’s best guess how the above set of mortgagees will respond to a 50 basis point hike in interest rates. Still, it seems improbable that the investor I’ve described above is the precursor to a collapse in the Canadian banking system as Mohan suggests; these aren’t bartenders and gardeners buying their third investment property.

The Foreign Investment Proposition – Estimates of foreign investor activity vary considerably, with anecdotes and first-hand realtor accounts really all we have to go on at the moment. As such, making a quantitative argument for the counterfactual is difficult, so I’ll merely point to the Australian experience, where a loosening of foreign ownership laws in 2008 saw a spike of foreign investment that was 30% higher than historical figures.

Although rental yields in Canada’s major cities are 1 to 2.5% lower than in NYC and Miami, vacancy rates are under 2%, roughly half that of US major cities. Further, stability of the currency and lower absolute prices per square foot continue to support the value proposition.

Concluding Remarks – I don’t have a model that predicts house prices, nor would I wholly trust it if it existed. The goal of this piece was to aggregate and comment on existing research to shed some light on Canadian household debt and its potential impact on housing prices. There is no doubt debt imbalances have grown in the Canadian household. That said, the notion that Canadian banks are on the verge of insolvency and worth shorting is more than a little far fetched in my opinion. But who knows – maybe Mohan’s right – maybe OSFI and the Bank of Canada will conspire to bankrupt Canadian households and banks.