It’s clear that debt-to-income ratios cannot be left unchecked forever. Eventually consumers will have to reign in credit or the government will do it for them.
The repercussions are undeniable. Unabated debt can put Canada’s economy in peril. If macro shocks occur, high debt ratios mean people have less ability to weather income reductions or home price declines.
The nightmare scenario is runaway defaults. Defaults sparked by economic crises can create a “negative feedback loop” says BoC head, Mark Carney. That occurs when desperate home sellers drive down prices and beget more desperate home sellers.
The good news is that Canada’s regulators are keenly aware of these risks. The BoC, default insurers, and major lenders regularly collaborate on ways to control systemic risk. One important tool is “stress testing” which involves creating “what-if” scenarios using dire economic assumptions.
The BoC, for example, said yesterday that it uses an extreme scenario of 11% unemployment in some of its models. In that hypothetical case, it says defaults would top out at 1.4%. That is bad, but it is manageable. (Insurers stress test for defaults of 3% and up.) By comparison, the U.S. default rate is 8.70%.
If it gets to a point where additional mortgage restrictions are warranted, the government can take either a shotgun or rifle approach. Focusing the cure on problem borrowers, not the entire population, is the more sensible approach.
Blanket regulation, like across-the-board amortization reductions, handicap hundreds of thousands of well-qualified homeowners and lessors. These people may have very legitimate needs for the cash-flow flexibility that extended amortizations provide. Forcing strong borrowers to make less-optimal budgeting decisions serves few interests, and is not what government was intended for.
While we’re on the topic, it’s interesting that amortization changes have been getting so much media play lately. Amortizations alone are a terrible indicator of default risk. Default risk is multivariate, meaning other things come into play, like down payments, debt ratios, credit risk, etc.
An 800 Beacon borrower with 10% down and a 35-year amortization is significantly less risky than a 650 borrower with only 5% down and a 25-year amortization. Moreover, it’s statistically shown that people with high credit scores make more pre-payments. Pre-payments offset extended amortizations.
Targeted solutions work better because they weed out fringe borrowers with the highest probability of default. Solutions along these lines might include:
Requiring 2.5%-5% higher down payments for less credit-worthy or more leveraged borrowers
Raising minimum credit scores for 90-95% refinancing.
Implementing minimum liquid net worth requirements for LTVs over 90% (to cushion against negative equity scenarios)
Until such remedies are required, there are some immediate actions the government can take:
Monitor debt and home equity levels closely. You want to ensure people can ride out a 10%+ home price correction and withstand a 3% hike in mortgage rates. The borrower groups who are most at risk must be properly identified and tracked.
Encourage lender prudence. Frequent warnings encourage prudent lending. The last thing on earth a mortgage lender wants is a default problem, especially when it’s been warned about repeatedly.
What the government doesn’t need to do:
Be swayed by rhetoric. Bank executives who preach responsibility with 25-year amortizations, and then promote interest-only HELOCs (with infinite amortizations) and easy refinancing (with 125% collateral charges), should be taken with a chunk of salt, not a grain.
Make rules prematurely. Finance Minister Jim Flaherty stated yesterday, “There is no reason for extreme concern now.” He noted that Ottawa is regularly in discussions with banks about default rates. Defaults are not an issue at this time.Moreover, interest rate increases will have a chilling effect on highly-leveraged consumers. BOC Governor Mark Carney says rate increases and April’s mortgage rule changes are already “beginning to have an impact.” Another 1-2% hike in rates will, to a large degree, self-moderate debt levels, as well as any housing excesses.
New mortgage rules, if significant, premature and coupled with higher unemployment, could turn a natural and cyclical housing decline into a small-landslide.
As a side note: Canadian mortgage defaults are minute by all standards. They could easily rise in the face of falling home prices or significant unemployment. There is no question there. Yet, the fact remains that Canada’s full-recourse, government-backed, highly-regulated mortgage system is designed to keep them contained.
What lenders need to do (and are already doing):
Be vigilant. Borrowers who are maxing out their allowable debt ratios will become higher risks. Carney says debt ratios are “likely to deteriorate further” and interest rates could impose a “brutal reckoning” on consumers who over-leverage. The guy with 5% down, 44% TDS ratios, minimal savings, the minimum permissible credit score, and high credit utilization could be trouble in the making.