How likely is a Canadian Financial Crisis?
The following information comes from some of the most respected and conservative economic analysts in the world. The intent is not to scare the reader, but simply to give you pause. There is concrete evidence that the Canadian economy is at real risk of a financial crisis similar to that experienced by the U.S. in 2008.
I was cautioned by some friends and colleagues not to write this article because it is “bad for business” and they felt Mortgage Sandbox should be encouraging people to buy homes. I feel this article is important in the spirit of transparency. People should consider risks when borrowing money, but ultimately the only way to mitigate the risk of investing in a home is to buy it as a place to live. Even if you buy a condo and it drops in value between the purchase and the date when you want to trade-up, the price of the townhome you’re hoping to buy next will have dropped in value too. If buying a home primarily as an investment, the short term market outlook is an extremely important consideration.
The Great Recession in the U.S. caused unemployment to rise to 10%, hundreds of thousands of people to lost jobs, they then defaulted on mortgages, and lost their homes. Others ended up trapped in homes they were unable to sell because the mortgage was worth more than the house. The fact that the economists below feel that there is a moderate likelihood this could happen to Canada should be a cause of concern.
In the course of writing this article, I have confirmed some of the conclusions with economists at a well known think tank, a federal government agency, and a large Canadian bank.
Of course, there are also experts like the CEO of Scotiabank and the Chief Economist for CIBC, who feel that these risks are much less likely to affect Canada and we will explore their hypotheses in a future article. It is worth noting that these banks have very large mortgage portfolios so they are closely watching these risks and want to manage their shareholders’ concerns.
| Bank | Mortgage Balances |
|---|---|
| RBC Royal Bank | 233 billion |
| Scotiabank | 208 billion |
| CIBC | 203 billion |
| TD Canada Trust | 190 billion |
| BMO Bank of Montreal | 106 billion |
| Total | 940 billion |
Source: BNN, Big banks keep growing mortgage books despite new stress tests, Mar 2, 2018
Is Canada at a High or Low Risk?
In the Fall of 2017, the Bank of Canada issued a report where their analysts calculated there is a 35% to 55% chance of a “financial crisis” or a “high financial stress event” in the next 2 years. They are more than 50% confident in their assessment of the risk but essentially the Canadian economic future could be as precarious as a coin toss - a 50% chance of a very bad outcome for Canada.
In a 2013, the Bank of Canada published a paper that provides past examples of financial stress events. Keep in mind these impacted financial markets and often resulted in recessions, but they did not necessarily result in a significant house price drop. Past high financial stress event listed by the Bank of Canada were:
2007 - Lehman Brothers bankruptcy leads to Great Recession
2001 - Bursting of dot-com bubble
1998 - Long-Term Capital Management collapse
1994 - Mexican peso crisis
1992 - Black Wednesday, European exchange rate mechanism crisis
1989 - Toronto house price collapse
1987 - Black Monday, October 1987 stock market collapse
The elevated risk of a financial stress event is a likely explanation for the Bank of Canada’s caution in regard to raising rates too quickly in 2018. They are not just afraid of derailing the economy, they are afraid of causing the recession that we missed in 2008, and they aren’t talking up the risk because they don’t want to spook the market.
The Bank of Canada analysis is supported by an October 2017 International Monetary Fund (IMF) Report pointing to Canadian vulnerability, and also by the U.S. Federal Reserve who in a February 2018 presentation identified Canadian housing as so overheated that it exceeded their “Evidence of Exuberance Scale.” The IMF and U.S. Fed were looking at Canada as a whole. Vancouver and Toronto are well above the Canadian average.
On March 11th, the Bank of International Settlements (BIS) issued a warning that the “indicators” they use to predict financial crises are flashing red for Canada. They're also flashing for China and Hong Kong but this article is focused on Canada.
On the list below you can see Canada is the third country listed with two indicators in the red, the other two amber. By comparison, Germany, Italy, Spain, the US and the UK are all in the clear.
Based on BIS’ analysis Canada has a better than 50% chance of a financial crisis or a financial correction (BIS would call it a “stress event”).
They are concerned that we have a lot of debt relative to our income, that our regular debt payments are too high relative to our income, and that the situation will worsen as interest rates rise to their natural levels.
At the core of these warnings is a belief that people’s loans should not exceed their ability to repay them. As interest rates rise, repayment of debt will become more costly so the only way for Canada to improve the situation in the face of rising rates, is to borrow less. Since most Canadian debt is to support home purchases, this means smaller home buying budgets.
Cause for optimism
A risk event is, by definition, never guaranteed to happen. Right now economists and rating agencies are warning us of Canada’s financial vulnerabilities and risks, but the government began enacting policies to reduce how much Canadians could borrow since 2008.
2008: Reduced the maximum lifespan of a mortgage from 40 years to 35 years.
2010: Applied a stress test against the 5-year contract rate for mortgages with a down payment of less than 20%.
2011: Reduced the maximum lifespan of a mortgage from 35 years to 30 years.
2012: Reduced the maximum lifespan of a mortgage from 30 years to 25 years on mortgages with a down payment of less than 20%.
2016: Applied a stress test against the 5-year posted rate for mortgages with a down payment of less than 20%.
2016: Banned default insurance on refinances, mortgages greater than 25 years, and single-unit rentals.
2018: Applied a stress test to mortgages with a down payment of greater than 20%.
The July 2008 change was presented as part of a "responsible and measured approach by the Government to ensure Canada’s housing market remains strong and to reduce the risk of a U.S.-style housing bubble developing in Canada."
At the time, the benchmark price of a Greater Vancouver home was $555,800 and in February 2018 it stands at $1,710,800. The growth in Greater Toronto has been less dramatic rising from $364,100 in July 2008 to $751,700 in February 2018.
Although the government’s intervention hasn’t succeeded in moderating house prices and mortgage debt, without its intervention over the past 10 years Canada would be in an even more precarious situation. It is hoped that the latest change enacted in January combined with rising interest rates will bring about a “soft landing.”
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