Debt Crunch

debt-crunch-1

The alarm bells are ringing again. Today Fitch ratings agency issued a report stating that Canada’s housing marking is overvalued and subject to a potential significant correction. I think this is pretty obvious as housing prices have increased by 16% and 25% in Toronto and Vancouver since 2014, respectively. It is not like housing prices started increasing from a point of undervaluation in 2014. They were probably overvalued in 2014. So we went from a point of overvaluation to even more overvaluation today. At the same time, income growth among individuals has been nominal. The result is that housing prices in Toronto and Vancouver have become significantly detached from fundamentals. So what filled the gap if housing prices are increasing but income growth is non-existent? Debt.

Housing price increases are not all that bad alone. However, when a substantial increase in housing prices is coupled with a substantial increase in debt, it can be dangerous. As Atif Mian and Amir Sufi outlined in their book, House of Debt, excessive leverage coupled with high house prices generally results in a severe recession. The higher the debt burden, the more severe the recession. Highly leveraged households feel the brunt of the housing correction the worst.

Fitch is also clearly concerned with Canadian household debt levels, “Household debt reached a new high of almost 168 per cent of disposable income in (the second quarter of 2016) and breached 100 per cent of GDP. This is the first time that household debt has exceeded the size of the Canadian economy and is higher than the U.K. and U.S. household debt burden. Mortgage debt is the number one contributor to household debt in Canada.”

So what has caused this debt binge in Canada? Rock bottom interest rates.

You can look to the Bank of Canada (the “BOC”) and the US Federal Reserve (the “Fed”). They set monetary policy in Canada and the US, respectively. Both the BOC and the Fed have held interest rates in the 0%-1% range since 2009. What has this done? In Canada, people have become addicted to debt. Cheap debt has made buying houses easier because mortgage payments are lower based on current interest rates. There is no incentive to save because savings accounts, GICs, and bonds pay little interest.

Interest rates have been kept at historic lows to spur the economy by pumping money into it. This is supposed to drive up inflation but this has not worked in Canada and the US after 8 years of near zero interest rates. Rather, asset bubbles have now formed or are forming in the housing, bond, and stock markets.

People use cheap debt to buy houses. They fight over a limited number of houses. This in turn drives up housing prices and the next set of buyers has to take on even more debt. A vicious cycle upward.

The policies at the BOC and the Fed have encouraged taking on debt and discouraged saving. This punishes retirees who rely on fixed income as a source of retirement income.

I also believe that the low-interest rate policies of the BOC and the Fed add to income and wealth inequality. For example, you have individuals in Canada who have been in the housing market for years with large amounts of built up equity because of the rapid increase in housing prices. You have large investors who have achieved the same. This has happened all the while the middle class has been saddled with historic debt in order to enter the housing market recently. The number of households taking on large mortgages (450% debt to income ratio) has increased substantially in Vancouver, Calgary, and Toronto.

I think a correction in Canadian housing prices may cause not only economic issues, but also social and political issues as well. There may be an angry middle class wondering how it got saddled with so much debt while some people made out like bandits. We already saw this in the US during the housing crash in 2008-2009. The wounds of the middle class in the US still have not healed. I think this led to the election of Donald Trump as many of the people in middle America felt that they had been left behind.

The Fed has stated that they may raise rates three times this year. The BOC has stated that they may even cut rates this year. I think what is needed to subside the debt binge, particularly in Canada, is increases in rates by the BOC and the Fed to normal levels. Debt is a fundamental risk to the Canadian economy and lowering the debt burden would reduce the potential for an economic shock. This will also reward savers and retirees again. This may hurt over-leveraged individuals but that is the nature of a capitalist economy.

As an individual, you can only watch and see what the BOC and Fed do. I think the key is to stay out of debt or pay it off while you can, and accumulate assets that pay you (cash, real estate, stocks, etc…). This is another case of not following the herd. I do not want to take on excessive debt to buy a house, boat, car, or whatever else. I think it is good to be a contrarian at times like this. As Warren Buffett says, “Only when the tide goes out do you discover who’s been swimming naked.” We might find that out in Canada soon.

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