Posted by: Daryl & Wendy Ashby | March 25, 2011

Benjamin Tal Has the Last Word

With interest rates expected to stay on hold until about the middle of the year, Finance Minister Jim Flaherty may be forced to act after the holidays to rein in overstretched borrowers.

Most observers believe any such move will be modest, however. With the recovery still somewhat fragile, the last thing the economy needs is a sharp pullback in the housing-related investment and consumer spending that powered the rebound this year.

At the same time, economists and finance experts are divided about the magnitude of the problem. Some question whether Canadian indebtedness – despite rising to unprecedented levels in the third quarter – could trigger a wave of defaults, given that the most at-risk mortgages in the country are insured by the government.

“I don’t think it’s a foregone conclusion that they do anything,” said Doug Porter, deputy chief economist at BMO Nesbitt Burns Inc. in Toronto.

“For basically the last year people have been encouraged left, right and centre to lock in for longer, and the new mortgage insurance rules are basically aimed at making sure people could handle a five-year rate,” Mr. Porter said, referring to Mr. Flaherty’s last move to curb borrowing, which included boosting the qualifying rate for floating-rate mortgages earlier this year.

“In most cases a lot of first-time buyers probably did move into the five-year rate,” Mr. Porter said. “So, I’m really not convinced there’s a lot of people who would be vulnerable to a moderate backup in [interest] rates at this stage.’’

Still, even those who question the true severity of the debt problem say Bank of Canada Governor Mark Carney is right to highlight, as he did again in recent weeks, the perils of failing to prepare for higher interest rates, which will almost certainly rise above the central bank’s current benchmark rate of 1 per cent. And most agree that, in general, making it tougher for the most at-risk borrowers to get loans is prudent, even if the problem isn’t yet a crisis.

Although Mr. Carney reiterated that the central bank is studying how it might play a greater role in safeguarding the financial system from simmering threats like household debt, he clearly is looking to Mr. Flaherty to heed his warnings. Mr. Carney told BNN, “These are not decisions for me to take.” But the Bank of Canada’s most recent analysis of the financial system, released in mid-December, said household debt is the main domestic risk to the economy.

Toronto-Dominion Bank chief executive officer Ed Clark, one of Bay Street’s longest-serving senior bankers, told The Globe and Mail earlier this month that if policy makers want Canadians to stop borrowing too much, it’s up to Ottawa, not financial institutions, to change their behaviour by tightening government rules on residential mortgages.

Mr. Clark has advocated shortening the maximum allowable mortgage term from the current 35 years – already a step down from the 40-year limit introduced by the Harper government four years ago – to 30 years.

Mr. Flaherty, meanwhile, has been non-committal, vowing to tighten the rules again if necessary, but emphasizing that borrowers must use “common sense.” He has also touted a soon-to-be-released government report on Canadians’ financial literacy and how it could be improved.

Aside from shortening the maximum amortization, other options include higher minimum down payments, or another increase in the qualifying rate – the equivalent fixed-rate payment someone who elects a floating-rate mortgage must be able to afford – to a six- or seven-year rate from the current five.

But as Mr. Clark has said, the course Mr. Flaherty opts to take depends on how large a threat the government believes consumer debt to be. Privately, top government officials say the problem is nowhere near a crisis, while acknowledging it makes sense to watch it.

Should the government decide to act, the most constructive move may be to limit home-equity withdrawals, perhaps by tightening the qualifications for such loans.

The share of equity in Canadian homes is at its lowest level in almost 10 years, and Bank of Canada figures show that banks held $218.9-billion in personal lines of credit – many of which are secured against homes – in October 2010, compared to $199.7-billion a year earlier.

Mr. Carney has said such loans make sense for most borrowers, who use them to renovate their homes or pay for their children’s post-secondary education, but that others need to be careful.

“It is always of interest when a financial product grows at double-digit rates for a very long time,” Mr. Carney told reporters this month after a speech to the Economic Club in Toronto. “We are levering more and more against the housing sector in Canada. At a minimum for us at the bank, we have to think what the implications of this are for how the economy performs if there is an adjustment to housing prices; because then, the wealth is less.”

Some economists, including Benjamin Tal of CIBC World Markets, argue those concerns suggest Mr. Carney may be urging Mr. Flaherty to focus on more than mortgages.

“The next wave, whatever and whenever that will be, will be not just mortgages,” Mr. Tal said. “In fact, I will not be surprised if they leave mortgages alone and deal with other loans. It’s not just a mortgage story, it’s an overall story. A lot of the debt that you see in non-mortgage loans are basically real-estate-type loans as well, so they’ll attack the whole space if they do anything.”

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