Low rates, high risk: Behind debt's record climb

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This is part of a Globe series that explores our growing dependence on credit – from the average household to massive institutions – and the looming risks for a nation addicted to cheap money. Join the conversation on Twitter with the hashtag #DebtBinge

Bank of Canada Governor David Dodge was getting nervous.

The year was 2006 and the mortgage market was heating up. Canada Mortgage and Housing Corp. appeared to be adding fuel to the fire by agreeing to back risky interest-only mortgages – mortgages with 35-year amortizations and home equity lines of credit.

In a letter to Karen Kinsley, then president of the Crown mortgage-insurance agency, Mr. Dodge called the moves "very unhelpful."

"We were increasingly relying on household borrowing for both purchases of housing and other consumption, as opposed to household income growth," recalled Mr. Dodge, who left the bank in 2008. "We were very worried that by loosening up the rules about mortgage insurance we were putting additional pressure on Canadians to borrow for housing, and that was leading to house price inflation and increased indebtedness.

"We argued that the right thing to do at that point in time was to be tightening conditions, rather than loosening."

Nearly a decade and a lot of debt later, Mr. Dodge's fears have come home to roost. Years of easy borrowing conditions have helped push household debt burdens to unprecedented heights.

As of the end of March, Canadian households' combined debts totalled more than $1.8-trillion – equivalent to more than $50,000 for every man, woman and child in the country. The total is more than five times the amount in 1990, and is up more than 50 per cent since the end of 2007. The ratio of household credit-market debt to disposable income – the most common benchmark for consumers' capacity for shouldering their debts – stands at a record-high 163.3 per cent, nearly double the rate of 1990 and up nearly 20 percentage points from the 2008 onset of the financial crisis. And we've reached these heights at a time when Canada's economy is wobbling, its housing market is significantly overvalued and the Bank of Canada has cut already-low interest rates even further. Since the central bank's January rate cut, the pace of mortgage debt has re-accelerated to its fastest growth in more than two years.

Mr. Dodge's recollections are a reminder that our national household-debt dilemma didn't happen overnight; its foundations began years ago, even before the global financial crisis and Great Recession created the conditions that have brought the issue to a head. A combination of relaxed public policy, cheap borrowing costs, an explosion of new credit offerings and an extended boom in real estate prices put Canadians on a slippery slope to record debts. Government agencies, banks, businesses and consumers themselves have all played a role in creating Canada's biggest economic dilemma – abetted by a technological revolution that has made accumulating debt easier, faster and more deceptively painless than ever before.

For years, a string of policy makers in Ottawa – from the scolding of overstretched consumers by former Bank of Canada governor Mark Carney, to the finger-wagging at mortgage-rate-cutting banks by the late finance minister Jim Flaherty, to the low-level fretting by current Bank of Canada boss Stephen Poloz – have been warning that the debt predicament poses a potential risk both to Canadian households and to the stability of the country's economy and financial system.

Yet their policies have sent consumers a different message. The central bank has kept interest rates persistently low – aided by the federal government's zeal to eliminate its budget deficit, which has starved the economy of government contributions to economic growth and thus strengthened the case for low rates to stimulate the economy. The low-rate environment continues to act as a flashing green light for consumers to borrow.

"We have the wrong mix of policies," Mr. Dodge said. "We have very distorted financial markets at the moment, and one of the consequences of these very low interest rates is that there has been additional incentive for households to take on debt. Why not take on debt when you can borrow mortgage money for 3 per cent?

"You can't go and criticize households for doing what is sensible, given the incentives they face."

A history of borrowing

The early groundwork for the unprecedented build-up of consumer debt was laid more than two decades ago, when the Canadian government and the Bank of Canada committed to inflation targeting, the key to breaking the back of the dual threat of bloated inflation and high interest rates. The enduring benefit was an extended era of low, stable inflation that continues to today, bringing with it low borrowing costs. The new low-rate environment helped unleash a wave of pent-up consumer demand in the 1990s after years of prohibitive rates, recession and tepid recovery, and ushered in an unprecedented stretch of economic expansion through the 2000s, not just in Canada but throughout much of the Western world that had pursued similar policies to contain inflation. But the downside, to which the world was rudely awakened in 2008, was a teetering tower of excessive debt and risky lending that eventually toppled on a global level, sending the world's financial system into major crisis and triggering the worst economic downturn since the Great Depression. In the height of that crisis, the actions taken by policy makers, not just in Canada but throughout advanced economies, almost certainly rescued the world from a second Great Depression – but they also poured gasoline on Canada's household debt fire.

To keep the suddenly credit-squeezed global financial system from freezing up, central banks around the world aggressively slashed interest rates. In Canada, where the banking system was remarkably healthy but the economy was slipping into the global quicksand, the Bank of Canada's rate cuts were designed to fuel household consumption, carry the country's economy and avert a potentially long, painful recession at a time when export markets had flamed out and manufacturing output was slumping badly.

"We knew back in 2008 that stimulative monetary policies would encourage people to borrow more to buy more homes and cars. That is why we do it – to buffer the downturn in the economy," said Mr. Poloz in a speech last fall. "This happens in every business cycle, not just this one."

But the difference in this recovery, Mr. Poloz acknowledged, is how extraordinarily long it has taken – five years and counting. The continuing need to prop up the teetering economy with stimulative monetary policy has meant consumers have been exposed to rock-bottom borrowing rates for an unusually long time, keeping the door wide open for cheap borrowing that has helped stretch household debts to new extremes.

"There are trade-offs, lots of them," he said in a late-2013 speech. "Today, the most obvious is that prolonged low interest rates can result in the development of imbalances in the household sector."

Real estate: an asset or liability?

The biggest element, by far, in Canada's ballooning household debt numbers has been residential real estate. The country's mortgage debt has more than doubled in the past decade, to nearly $1.3-trillion.

The new era of cheap interest rates dramatically lowered mortgage costs, fuelling a corresponding surge in home prices. The Canadian government responded to the housing boom by softening mortgage regulations to make it easier for Canadians to buy homes – even Canadians who couldn't afford to under traditional mortgage structures.

Despite Mr. Dodge's 2006 misgivings, by the end of that year CMHC had followed the lead of private insurers, such as Genworth MI Canada Inc., and bumped up mortgage amortizations to 40 years. The move added more fuel to an already hot housing market, and made home-buyers out of a new class of higher-risk borrowers and speculative investors. In doing so, Canada was following the lead of the United States, where high-risk mortgage products had become all the rage in the financial industry – and would provide the toxic fuel for that country's mortgage meltdown.

Canada's high-risk mortgage party didn't last long. Starting in 2008, the federal government did an about-face, taking a series of measures to try to cool the housing market and discourage excessive borrowing. It cut amortization periods to 35 years, then 30 years and finally 25 years in 2012, while progressively ratcheting up minimum down payments to 20 per cent from zero on government-insured mortgages, and capping the volume of CMHC mortgage insurance and stopping the practice of backing second-home mortgages.

What spared Canada the mortgage meltdowns experienced in the United States and elsewhere in the financial crisis was that the government opened the spigot relatively late in the game, Mr. Dodge said, curbing the use of riskier mortgage products. Still, critics aren't convinced that Ottawa ever quite managed to put the genie back in the bottle. With persistently low borrowing costs still fuelling an uncomfortably hot housing market, many observers, including the International Monetary Fund, argue that Canada needs tighter mortgage regulations – its "macroprudential" measures – to apply some brakes on the housing boom and slow the growth in mortgage debt.

Quenching Canadians' debt thirst

While cheap interest rates led Canadians to the credit trough, they don't entirely explain why consumers have been so eager to drink. Current consumers' taste for debt has increased from previous generations.

"A 30-year-old today has a higher propensity to borrow, and a lower propensity to save, than a 30-year-old person 10, 15, 30 years ago," said Benjamin Tal, deputy chief economist at CIBC World Markets. "There's a change in behaviour."

The extended period of low interest rates has, indeed, gotten consumers comfortable with cheap borrowing. But Mr. Tal said another key factor has been the slow pace of income growth over the past decade.

"We are a generation that was unable to duplicate the income growth of our parents," he said. "The income is insufficient to finance what you need and what you want." As a result, "We use credit to supplement our income," he argued.

Queen's University business professor Nicole Robitaille, who specializes in consumer behaviour, isn't convinced the modern consumer is any more debt-happy than his or her parents or grandparents. But this generation has much more, and faster, access to the temptations than any generation before it.

"Credit is just so accessible to us now. It's very, very easy for us to get lines of credit, to get mortgages, to get credit cards," she said. "I don't think it used to be as prevalent, how much people could take on. I think if our parents' generation would have had the same access, they probably would have made the same mistakes."

Statistics show, too, that as the world of consumer commerce becomes increasingly cashless, customers are more likely to whip out their credit cards than ever before. A recent study by the Bank of Canada shows Canadians used credit cards for 31 per cent of all store transactions in 2013, up from just 19 per cent in 2009. Meanwhile, the use of cash has fallen to 44 per cent of all transactions from 54 per cent.

(Canadians are also willing to pull out the credit card for increasingly small purchases; the average price per credit-card transaction fell by 15 per cent from 2009 to 2013, to $34.)

Experts in consumer psychology say the use of credit cards and, increasingly, other forms of online and electronic payments has weakened the negative emotional response that people get from spending money, since they no longer see their pile of cash shrink as they acquire goods. That has made overspending more painless.

"It's an emotional experience, when you're paying with cash. That provides some checks and balances," said financial psychologist Brad Klontz, a professor at Kansas State University. "We're not even using money any more, we're swiping cards – it becomes unconscious.

"The more distant you can be from what you're doing, the less likely you are to think of the consequences."

Still, Canadians are not the credit-happy spendthrifts we are often made out to be. Bank of Canada data show that the pace of growth of "consumer credit" – credit cards, lines of credit and non-mortgage loans – has generally been in decline for most of the past decade, and is hovering near two-decade lows. Total national credit-card debts grew by just 20 per cent in the seven years from 2005 to 2012, according to Statistics Canada – an average of less than 3 per cent a year. And since 2012, total credit-card debt among Canadians has been essentially flat. But the big boom in consumer debt has been the banks' great consumer lending leap of our generation: Consumer lines of credit. In 1999, they accounted for less than 6 per cent of all household debts. By 2012, real credit-line debts had more than quadrupled in value, and made up 11 per cent of household debts. The median outstanding line-of-credit balance is nearly triple what it was in 1999.

"I don't think we're dumber, I don't think we have less self-control. But I think we have more ways to make bad decisions now," Prof. Robitaille said. "I don't think we're sophisticated enough to take on all of what is available to us."

The Big Six aren't too worried

Lenders have played a large role in Canada's household debt expansion – making consumers a much bigger focus of their lending strategies.

Twenty years ago, Canadian banks' outstanding loans to households (both consumer and mortgage lending) were roughly double the size of their business loan portfolios. Today, those household loans are three and a half times the size of the banks' business loans. Household loans have increased nearly sixfold in value, to more than $1.4-trillion.

In 1970, household credit accounted for just one-third of all lending in Canada, according to Statistics Canada data. By the 1980s, it had crept over 40 per cent. Today, household credit makes up more than half of all lending in this country.

Canadian banks have been happy to cater to consumers' insatiable appetite for debt. The reason is simple: Consumer loans are highly profitable and default rates are minuscule.

In 2014, the big six Canadian banks made a collective $33-billion in net earnings from a variety of business lines that include wealth management, insurance and capital markets. Their personal and commercial banking lines, which include mortgages, credit-card debt and personal loans, drove about half of those earnings – underscoring the importance of consumer debt to the banks' bottom lines.

At Royal Bank of Canada, the portfolio in residential mortgages has grown to $194-billion, or about double the size since 2006, the year before the start of the financial crisis. Toronto-Dominion Bank's residential mortgages have grown to more than $175-billion, more than tripling since 2006. Over the same period, TD's credit-card loans have risen nearly sixfold.

But bank chief executives don't see any looming crisis in consumer debt – or, more to the point, their banks' financial exposure to it. CEOs have expressed little concern about the housing market in particular. Royal Bank of Canada's Dave McKay and Toronto-Dominion Bank's Bharat Masrani said this year that the housing market looks relatively healthy, with prices rising because of a shortage in single-family homes and a growing population.

"For TD, we are very happy with our mortgage business. With our underwriting standards and all the stuff we do, we are quite comfortable with how this impacts the bank," Mr. Masrani said after the bank's annual general meeting in March.

And why wouldn't bank chiefs feel comfortable? For all the worries about record-high consumer debt burdens, the number of Canadians falling behind on debt payments isn't raising any alarms.

The Canadian delinquency rate on Visa and MasterCard credit cards fell as low as 0.75 per cent last year, tied for the lowest rate for data going back to 2004.

Mortgage holders look even better. According to the Canadian Bankers Association, only 0.29 per cent of residential mortgages were in arrears at the start of 2015 – meaning that just one in every 345 mortgages are going unpaid for three months or more. The rate has fallen for six straight years, and is now close to the lowest rate seen in the past decade.

In the United States, the rate of mortgages in arrears is nearly eight times higher than Canada's, at 2.3 per cent, according to the Mortgage Bankers Association, and that figure doesn't include foreclosures. In Britain, the value of mortgage payments in arrears for more than three months, while falling, is 1.33 per cent of total payments, according to the Council of Mortgage Lenders.

CIBC's Mr. Tal said Canada's big increases in mortgage debt don't look like a problem because the real estate assets backing those mortgages have soared, too. (Indeed, household debts as a percentage of total assets has declined since the financial crisis, although it is still modestly elevated compared with precrisis levels.) But the problem, he said, is what would happen if those property values – estimated by the Bank of Canada at as much as 30-per-cent overpriced – were to suffer a sizable fall to earth.

"Asset prices can go down," he said.

Canadian banks haven't forgotten that conditions can change, but they believe the potential downside, for them at least, is limited. In conference calls with analysts after their quarterly earnings in February and March, the banks said that they had conducted stress tests on their lending portfolios – in some cases looking at the impact of a 20-per-cent decline in home prices and a surge in the unemployment rate by five percentage points. Even these dire scenarios failed to tip them into a hypothetical crisis.

"All kinds of different things can happen in this world, but when we run our various stress tests, we fall within our risk appetite," said Laura Dottori-Attanasio, chief risk officer at Canadian Imperial Bank of Commerce, during a call with analysts.

Reducing sensitivity a necessity

As for consumers, it has long been assumed that the inevitable slow rise of interest rates, back to more historically normal levels, would put the desired chill on borrowing. But that long-awaited rate upturn remains elusive, now years after it had first been predicted, as a sluggish global economy still demands that central banks, including Canada's, keep the rate-stimulus tap wide open. The most recent Bank of Canada rate cut was just four months ago. The yield on five-year Canadian government bonds, despite recent modest gains, is barely above a historically puny 1 per cent. Mortgage rates are at historic lows.

The Bank of Canada won't find it easy to get interest rates back up to more normal levels because easy credit has shifted future consumption to the present, according to Mr. Dodge, the former governor of the central bank. Canadians are buying on credit today what they wouldn't normally have been able to afford if rates weren't so low.

"The problem is that the last movement in rates was down, rather than up, and we know that over time [the bank is] going to have to get those rates up," Mr. Dodge explained. "That's where the real risk comes. This adjustment period is going to be very tricky because we've brought forward a fair bit of consumption in time and there will be a gap as households adjust to higher rates, which are going to come eventually." That "gap" implies that a lengthy stall-out of consumer spending could be on the way when borrowing costs begin to climb. And given the sheer size of the consumer debt out there, rates wouldn't have to rise by much for the broader economy to feel a serious pinch.

"When it starts going up, even 50 basis points [i.e. one-half of a percentage point] would be huge," warned CIBC's Mr. Tal. "Never before have we been so sensitive to higher interest rates."

Shifting priorities

2006:

CMHC insures interest-only mortgages and mortgages with 30- and 35-year amortization, up from 25 years.

Later bumped up to 40-year amortizations, on 100-per-cent interest loans.

CMHC insures home equity lines of credit for first time.

2008:

Amortization period reduced to 35 from 40 years.

Minimum down payment of 5 per cent for new government-backed mortgages.

Limit for total debt service ratio at 45 per cent.

620 minimum credit score requirement.

New loan documentation standards.

2010:

Must meet standards for five-year fixed-rate mortgage.

Minimum down payment of 20 per cent.

Maximum refinancing limited to 90 per cent of home value from 95 per cent.

2011:

Amortization period reduced to 30 from 35 years.

Maximum amount Canadians can borrow in refinancing their mortgages lowered to 85 per cent of the value of their homes from 90 per cent.

CMHC stops insuring home equity lines of credit.

Financial institutions assume risk for defaults, and eligibility requirements tightened up.

CMHC stops insuring lines of credit secured by homes, including home-equity lines of credit.

2012:

Amortization period cut to 25 years from 30 years.

Maximum Canadians can borrow when refinancing their homes cut to 80 per cent from 85 per cent of home's value.

Government-backed insured mortgages no longer offered on homes worth more than $1-million.

2013:

Banks, credit unions and other mortgage lenders restricted to a maximum of $350-million of new guarantees.

2014:

CMHC discontinues mortgage products for second homes and the self-employed, without third-party income validation.