Posted on June 22, 2012

Even Modest Growth at Risk

The Bank of Canada is likely to keep interest rates low for the rest of this year and central banks in Europe and Asia are poised to ease as well. The People’s Bank of China cut rates for the first time since 2008. Clearly, the European debt crisis is taking its toll as the situation drags on with no clear end in sight. Indeed, increasingly, markets are expecting a Greek exit from the Eurozone and, even then, other weak-country finances remain in jeopardy. Emerging market economies have softened as well, taking down commodity prices in their wake.

This has weakened the Canadian dollar, tempered activity in Western Canada and raised the spectre of lower-than-expected tax revenues in the western provinces and Newfoundland. U.S. unemployment is only inching downward, a negative fundamental for Mr. Obama, as voters are showing incumbent governments the exit sign in multiple elections over the past year. The Fed is doing what it can to boost interest-sensitive spending, but it is hard to imagine that at today’s record-low bond yields, further downward pressure on long-term interest rates is going to do the trick.

What’s more, the year-end fiscal cliff, along with the tightening regulatory environment, is causing a great deal of uncertainty. In consequence, businesses are more reluctant to hire and U.S. banks are more reluctant to lend. Households have tightened their belts as well. In a surprise move, the Canadian Government took action once again to tighten mortgage conditions—the fourth such move since 2008. The latest action reduces the maximum amortization on CMHC-insured loans from 30 years to 25 years. Minimum downpayments remain 5%, but the maximum refinancing (via a mortgage or home equity line of credit or HELOC, or a combination of the two) has been lowered from an 85% to 80% loan-to-value ratio. In addition, the Government has limited the gross debt service (GDS) ratio to 39% and the total debt service (TDS) ratio to 44%. The GDS ratio is the share of a borrower’s gross household income that is needed to pay for home-related expenses, such as mortgage payments, property taxes and heating expenses.

The TDS ratio is the share of income going to all such home-related expenses plus all other debt-servicing obligations. In addition, borrowers purchasing homes at or above $1,000,000 in price will no longer be eligible for a CMHC-insured loan, which means they must have a downpayment of at least 20% to qualify for an uninsured mortgage. In a separate move, the Office of the Superintendent of Financial Institutions (OSFI), the regulator of Canadian financial institutions, reduced the maximum amount of non-amortizing HELOCs (a hugely popular borrowing vehicle for homeowners) to 65% of a home’s value from 80% previously.

The combined mortgage and HELOC cannot exceed the new 80% refinancing limit, with the added proviso that the HELOC portion alone cannot exceed 65% of the home value. A homebuyer can still procure an insured mortgage for up to 95% of the home’s value, but would not be able to take out a HELOC until the mortgage was reduced to below 80% of the home’s value. For example, if the mortgage was reduced to 70% of the home’s value, the owner could take out a 10% HELOC. If the mortgage was reduced further to 15% of the home’s value, the HELOC could increase to up to the 65% limit. There’s no doubt that some households will be constrained from borrowing by these new rules, though the impact should not be large. A recent survey by the Canadian Association of Accredited Mortgage Professionals found that, of households with both mortgages and HELOCs, average loan-to-value was just under 60%. We believe these actions are prudent and responsible. The new measures will support the long-term stability of the Canadian housing market,” said Frank Techar, head of personal and commercial banking at BMO. “Minister Flaherty has tapped the brakes at precisely the right time and his actions should help ensure Canada’s housing market experiences a soft landing.” Governor Mark Carney and Finance Minister Jim Flaherty have long been concerned about the record level of household debt relative to income in Canada. While the growth in household debt has slowed to 4% this year, compared to 6% earlier in the cycle, the slowdown in economic activity raises the prospects of job losses and increases the potential for mortgage delinquencies. These Government actions are intended to slow the housing market, particularly the condo markets in Toronto and Vancouver.

The Bottom Line: It is not surprising, with this global financial and economic backdrop, that stocks have sold off and commodity prices continue to fall. Long-term U.S. and Canadian bond yields are dropping like a rock from already record-low levels. While the Government efforts to prevent a Toronto and Vancouver housing bubble and to reduce household debt accumulation are commendable, the global slowdown and substantial political and financial risks might jeopardize even a modest 2% growth trajectory.