Asset prices can rise or fall but the debt endures

In Chapter Two of my book “When the Bubble Bursts: Surviving the Canadian Real Estate Crash” coming on March 21 (available for pre-order) I wrote about the “elephant in the room” that no one wants to discuss; not CEOs of Canadian banks; nor Finance Minister Joe Oliver and definitely not that loan officer providing financing at five times household income to a young couple about to buy a ‘starter’ home at a price that is double or triple 2000 levels.

But what if Canadians lose their appetite for adding more debt? What if the collateral that backs the existing debt shrinks in value?

As I wrote in the December 5th Weekend Note titled “It’s all about the debt,” some Canadian bank economists were pushing the concept that Canadians are comfortable carrying among the highest debt loads in the developed world. One such economist even put out the highly questionable theory that Canadians were paying down their debts at a rapid pace.

So it was refreshing to see a more accurate point of view expressed in a report by a Canadian bank as quoted in a March 5 Globe and Mail article by Tamsin McMahon, click here for article.

McMahon quotes a report that states the facts — Canadian household debt continues to surge ahead. Total household debt reached more than $1.8 trillion in January, up 4.6% from the previous January, led by mortgages that grew by more than 5%. This amount of debt is 80% higher than it was just a few years ago.

The article goes on to point out that Canada’s household debt-to-income ratio rose more than any other country outside of Greece (!!) between 2007 and 2014, according to the McKinsey Global Institute.

A Royal Bank economist points out that interest rates reached new low levels in January and managed to make it sound like a good thing. But why are rates falling to such low levels? How unusual is this new trend? After all, the recovery from the 2008-09 recession will soon be six years old and interest rates should be back to normal levels by now. If this were similar to past recessions the Bank of Canada would be trying to choke off an incipient surge of inflation and wages would be rising briskly. And rising wages make it easier to pay off household debt.

But this recovery is far from normal. For example, the Bank of Canada recently cut interest rates in a surprise move as the bank wished to take out insurance against the deflationary impact of the plunge in crude oil prices.

How does this relate to the ever-growing mountain of household debt? A quote from a former governor of the Bank of Canada illustrates the problem. As Mark Carney said to the same newspaper, ‘this cannot continue…while asset prices can rise or fall, debt endures.” (Globe and Mail September 30, 2010)

When Carney said that asset prices can rise or fall he was thinking of house prices as that is the collateral that backs most household debt. And when he says “debt endures” he means that debt doesn’t shrink at all with falling house prices. And similarly there could be other loans against other assets like oil and gas properties that are pledged as collateral and while the “asset prices” will decline the size of the debt stays the same.

Whether it’s a condo in Toronto, a house in Calgary or an oil and gas lease in Northern Alberta the banks will soon discover that the collateral isn’t worth as much as the loan officer estimated when he approved the loan. And we’re all going to learn in the next year or two if those banks were careful or reckless when they provided all that new debt to Canadian borrowers.

Deflation can make it difficult or even impossible to re-pay loans taken out during a housing bubble or an energy industry boom. Without rising wages and higher asset prices debts start to loom larger and larger. Individual Canadians and businesses would be well-advised to pay down their loans as quickly as possible, even if it means selling some assets. Otherwise, the debt endures.