Mackenzie Gray
Producer, CTV National News
Updated June 9, 2022
With interest rates set to keep rising, the Bank of Canada is sounding the alarm on the risk record high house prices and an increasing number of households with high mortgage debt could have on the Canadian economy.
“In Canada, elevated levels of household debt and high house prices remain two key interconnected vulnerabilities,” the bank said in its annual Financial System Review.
Despite house prices increasing 53% nationally between April 2020 and April 2022, the bank is concerned that recent homebuyers lack the equity in their home to withstand a “significant price correction” and would “face more financial strain when they renew their mortgages at higher rates.”
The bank says many of the recent homebuyers “financially stretched” themselves to purchase a property at record prices due to a “fear of missing out” on the continued increase of house prices across the Canadian housing market.
Investors accounted for 22% of property purchases with mortgages in the fourth quarter of 2021, up from 19% in 2019, according to the bank.
Those investors are taking out existing equity in other properties they own to make new purchases, which the bank says “highlights the feedback loop between rapid gains in the house prices and the strong demand for housing that investors generate.”
House prices remain at all-time highs across Canada but the bank warns that it’s too soon to tell if the recent decrease in resale activity and prices are “temporary or is the start of a deeper, lasting decline.”
If investor demand dries up for Canadian housing, the bank warns that would “amplify the downward pressure on prices” and could “lead to an abrupt price correction in the future.”
Typical mortgage payment could be 30% higher in 5 years, Bank of Canada warns
Bank says those who took out a home loan in 2020 or 2021
should brace for higher rates at renewal
High house prices and debt loads associated with them are a major vulnerability to Canada's economy, the Bank of Canada said Thursday, warning buyers who bought during the pandemic that the impact of even slightly higher mortgage rates could be dramatic.
In its Financial System Review, the central bank said that while the country's financial system is strong and weathered the pandemic well, the economy remains vulnerable because of elevated debt levels tied to the country's increasingly expensive housing market.
"Even as the average household is in better financial shape, more Canadians have stretched to buy a house during the pandemic," Bank of Canada Governor Tiff Macklem said Thursday. "And these households are more exposed to higher interest rates and the potential for housing prices to decline."
The bank said that assessing risks related to high household debt levels has become more complex, but overall "the vulnerability has increased."
Roughly two thirds of Canadians are home owners, and about half of them own their homes outright while the remaining have some sort of mortgage debt attached to it.
Raising lending rates slowed housing market
Home prices increased by about 50 per cent, on average, during the pandemic, as low rates allowed buyers to qualify for larger loans while still keeping the ongoing payments relatively affordable.
After slashing its benchmark interest rate at the outset of the pandemic, in March of 2022 the bank began to raise its benchmark lending rate from 0.25 per cent at the start of the year to 1.5 per cent today, and the impact on the housing market has been almost immediate, with sales volumes slowing, along with average selling prices.
"Given the unsustainable strength of housing activity, moderation in housing would be healthy," Macklem said. "But high household debt and elevated house prices are vulnerabilities."
As part of its analysis of how resilient the financial system is in the face of various shocks, the bank examined what the impact of higher rates and lower selling prices might look like.
As part of that, the bank crunched the numbers on what might happen to the mortgages of recent home owners when their loans come up for renewal in five years.
The bank makes the assumption that in 2025 and 2026, variable rate loans will cost 4.4 per cent in five years, while fixed rate loans will be slightly higher at 4.5 per cent. Both scenarios are roughly two percentage points higher than what's available on the market today.
Mortgage costs could go up 30%
Under that scenario, the 1.4 million Canadians who got a mortgage in 2020 or 2021 would see their median monthly cost go up by $420, or 30 per cent upon renewal.
The impact on fixed-rate borrowers would be slightly less, as they'd see their payments go from $1,260 on average to $1,560 a month for an increase of 24 per cent.
But variable rate borrowers are even more vulnerable, under the bank's thought exercise, as their typical monthly payments go from $1.650 a month right now to $2,370 when they renew. That's an increase of 44 per cent.
"If those in highly indebted households lose their jobs, they would likely need to reduce their spending sharply to continue servicing their mortgage," Macklem said.
"This is not what we expect to happen … But it is a vulnerability to watch closely and manage carefully," Macklem said.
Stephanie Hughes - NATIONAL POST
The Bank of Canada warned that threats to the financial system have grown more complicated in recent months as the country grapples with tightening monetary policy, rampant global inflation and geopolitical tensions. However, the biggest vulnerability remains higher household indebtedness, the central bank highlighted in its latest Financial System Review .
A person walks past the Bank of Canada building in Ottawa.
Policymakers said they are facing a “delicate balancing act,” as surging inflation will force them to raise interest rates over the months ahead, even though Russia’s invasion of Ukraine has rocked global stability and the pandemic continues to hinder economic growth.
“Failure to balance these competing objectives could lead to a further global repricing of risk and a sharp tightening of global financial conditions, potentially triggering risks associated with high leverage,” the report said.
High household indebtedness from bigger mortgage volumes and soaring house prices are interwoven issues the central bank said are receiving extra attention, especially as rising interest rates put more strain on the carrying costs of all that debt. As households renew their mortgages , they could find themselves with less disposable income, and potentially tied to less valuable assets if housing markets correct.
© Mark Blinch/Reuters files
But Bank of Canada governor Tiff Macklem argued in a Thursday morning press conference that households were in strong enough shape to shoulder a more aggressive rate hike path.
“We think the economy can handle higher interest rates, we think the economy needs higher interest rates,” Macklem said. “The likelihood that we may need to go to the top of that two to three per cent neutral range, or possibly somewhat above it, to bring inflation back to target has increased.
“When we indicate that we’re prepared to move more forcefully if needed, what we’re indicating is we may need to take more … interest rate steps to get inflation back to target, or we may need to move more quickly. (We) may need to take a larger step.”
In April, Macklem suggested he had not ruled out an interest rate hike larger than the 50-basis point increases the bank has put in place during the past two rate announcements.
Housing has been a concern for years, but now financial markets are emerging as a significant threat to financial stability. The Bank of Canada said that while the Canadian financial system remained resilient throughout the pandemic, global inflationary pressures and the war in Ukraine brought higher volatility in commodity markets and significant market repricing as investors moved away from riskier assets.
The central bank added that tighter global financial conditions would put this resilience to the test, and would more clearly expose system vulnerabilities moving forward. As China pursues a COVID-zero strategy, new outbreaks of COVID-19 are another concern the central bank said it is watching.
Countries emerging from the pandemic have lifted restrictions, bringing robust demand for goods and services, straining supply chains. These factors working in tandem pulled inflation up to multi-decade highs. As the central bank tightens its policy to put a lid on inflation, corporate bond yields hit multi-year highs and borrowing costs for homeowners are soaring.
Policymakers said they are paying particular attention to the greater number of Canadian households carrying a much larger mortgage debt, noting that the number of new mortgages with a loan-to-value ratio of 75 per cent or more has risen 40 per cent in recent quarters. Canadians are taking on larger mortgages compared to their income, with the share of mortgage originations with a loan-to-income ratio above 450 per cent surpassing 25 per cent since the start of the pandemic.
“Higher interest rates at the time of mortgage renewal will significantly reduce the financial flexibility of some households, particularly the most indebted,” the report said, while adding that rising borrowing costs will erode homeowners’ purchasing power if wages cannot keep pace.
Assuming variable- and fixed-rate mortgages originating in 2020 and 2021 renew at 4.4 per cent and 4.5 per cent in 2025 and 2026, the central bank estimated that households that took out a mortgage during the pandemic could see a median 30-per-cent boost in monthly mortgage payments once they renew.
Despite household net worth increasing $230,000 on average, the report noted that indebted Canadians may not be able to tap into home equity if the housing market corrects and these wealth gains are wiped out. The lower purchasing power could present a drag on consumption in the economy at a time when the economy is getting back on its feet following the pandemic.
The central bank noted that high house prices and household debt could weigh on projected economic growth, and the probability of negative growth projected for the first quarter of 2024 is nearly two times greater than if these vulnerabilities were not there. An economic disruption lowering household income and spending would hit consumption and weaken housing market activity.
According to Bank of Canada data, home prices have risen over 50 per cent on average during the pandemic with investors disproportionately driving up home prices last year, bringing the risks of a housing correction up with it. Canadian markets are already seeing this moderation take hold as resale activity slowed in March and April. The report noted this could be an “echo effect” as demand was pulled forward, seeing homeowners lock in mortgages before rates rose — or could be “the beginning of the end of the pandemic upswing.”
Macklem said the housing market is still being supported by strong fundamentals, such as solid employment and wage growth, as well as rebounding immigration, though he said he would not be surprised to see markets moderate given the pandemic-fuelled run-up in home values.
Most major Canadian housing markets saw higher price exuberance in the first quarter, according to the central bank’s house price exuberance indicator. According to this metric, the Greater Vancouver Area, Hamilton, the Greater Toronto Area, Ottawa, and Montreal are among the most exuberant markets across the country.
Another potential risk the Bank of Canada flagged is a sudden spike in demand for liquidity from asset managers outpacing supply, which poses stronger risks of large price swings and even potential freezes in fixed-income markets. It was an issue the central bank flagged in last year’s report, though a tightening monetary environment this year has reduced liquidity even further.
In an increasingly digital world, the central bank has grown more wary of cyber threats, particularly as the ongoing Russian invasion into Ukraine gives rise to more state-sponsored cyber attacks, which could run the risk of targeting Canadian financial institutions, especially as they grow more sophisticated. The report added that a successful attack could have far-reaching impacts on the broader financial system since financial infrastructure is so inter-connected, causing households and firms to lose access to funds and the ability to move money electronically.
To combat these risks, financial institutions and authorities are investing in cybersecurity improvements to keep pace with sophisticated attacks.
• Email: shughes@postmedia.com | Twitter: StephHughes95
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