Finance minister warned about indebted Canadians’ increasing vulnerability to higher rates before the pandemic


The memo obtained by the Financial Post outlines a risk that could re-emerge even stronger when borrowing costs rise again

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The federal government was warned before the coronavirus pandemic that indebted Canadians could be increasingly vulnerable to higher interest rates, a risk that has been watered down by COVID-19-related monetary easing, but that could re-emerge if borrowing costs rise above their currently rock-bottom levels.

The concerns were laid out in a memorandum addressed to then-finance minister Bill Morneau from his deputy in early 2020. The document, which was recently obtained by the Post via access-to-information request, explored the drivers of rising numbers of consumer insolvencies.

The memo noted that formal insolvency proceedings, which aim to restructure or eliminate debts, hit a decade-high 13,200 in October 2019, up 13.4 per cent from a year earlier.

What’s more, the increase in insolvencies was happening at a time when the job market was strong, with the unemployment rate trending below six per cent. Previous jumps in insolvencies had coincided with increased unemployment, the memo noted, “raising concerns that some households are struggling to cope with elevated debt loads.”

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With employment solid, the finance department fingered interest rates as the likely culprit. By the fall of 2019, the Bank of Canada’s key interest rate sat at 1.75 per cent, its highest level since the Great Recession.

“The rise in insolvencies appears to be fuelled by a lagged impact to interest rate increases over 2017-2018, which have put pressures on household budgets,” the memo, dated Feb. 6, 2020, said. “This is also supported by the debt service ratio (the share of household disposable income needed for debt payments), which has trended up over the last year to reach a record high of 15 per cent in the third quarter of 2019.”

It takes time before higher interest rates start increasing consumer debt costs and prompting insolvencies, the document said. Yet trends in major loan delinquencies showed “some financial stress building up,” as those missed payments were rising for non-mortgage, more interest rate-sensitive credit products such as credit cards and auto loans.

“The recent rise in insolvencies despite a solid labour market backdrop and a relatively low yield environment suggests that increasing indebtedness has made Canadian households more sensitive to higher interest rates,” the memo said. “While household debt growth in Canada has moderated since 2016 along with cooling in housing markets, debt levels remain elevated. Recent declines in borrowing costs should provide some relief in the near-term, leading to lower debt payments and a decline in insolvencies.”

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What the authors of that memo probably didn’t see coming was that borrowing costs were about to crater, as the Bank of Canada slashed its key interest rate in March 2020 to 0.25 per cent in response to the coronavirus pandemic.

Those rate cuts, along with loan-payment deferral programs offered by commercial banks and a barrage of support programs enacted by the federal government, have helped to keep consumers solvent over the past year, and even allowed some to amass a considerable amount of savings. A sudden rise in interest rates also seems unlikely given the Bank of Canada has signalled its policy rate will remain untouched until 2023, which could keep the pressure off borrowers.

But the Bank of Canada has warned in the past that the relatively large stock of household debt, which began to tick up again in the third quarter of 2020, could make borrowers more sensitive to interest-rate moves.

If you don’t get your financial house in order over the next three to five years … you’re going to be susceptible to the next thing, whatever that is

Credit Counselling Society CEO Scott Hannah

Housing markets have been heating up again recently as well, a trend that was cited in the memo as another possible reason for consumer insolvencies.

According to the document, the number of insolvencies filed by consumers with a mortgage had declined since 2012. However, it had “increased significantly” for people without a mortgage, with delinquency rates on non-mortgage debt rising in the quarters leading up to the memo.

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“A potential explanation for this phenomenon is that consumers with mortgages in areas with high house price growth have been shielded from insolvency over the past few years by the growing value of their home (e.g. the ability to extract home equity to consolidate their debts or sell their home to pay their debts),” it states. “Conversely, non-mortgage holders in hotter housing markets have missed out on the benefits of house price appreciation, while still bearing the costs associated with living in affordability-challenged areas (e.g. higher rents).”

In line with this possible explanation, the memo says, is that in British Columbia and Ontario, home to the pricey real estate markets of Vancouver and Toronto, the share of insolvencies filed by mortgage-bearing consumers had fallen sharply. Meanwhile, in the rest of Canada, those insolvencies had remained steady.

Recent public-opinion surveys have suggested that consumers have not forgotten about the risks posed by rising rates either.

A Royal Bank of Canada “Home Buying Sentiment Poll” found 45 per cent of those polled were concerned about interest rates in the coming year. And a recent poll conducted by the Credit Counselling Society, a non-profit that aims to help consumers manage their finances better, found that 31 per cent of Canadians it surveyed were having trouble paying down their debt, even with interest rates so low.

“If consumers don’t make a concerted effort to reduce their … non-mortgage debt over the next two to four years, and then rates start to go up — that could have a material impact on mortgage rates, which could have an impact on rental rates — then consumers will put themselves in difficulty,” said Scott Hannah, chief executive of the CCS, in an interview. “So that’s the challenge that we throw out there for consumers is, if you don’t get your financial house in order over the next three to five years, pay off your consumer debt, set aside three to six months’ worth of living expenses for emergencies, you’re going to be susceptible to the next thing, whatever that is.”

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For now, low interest rates and government support programs appear to have given indebted households a reprieve: Consumer insolvencies for the 12-month period ended Nov. 30 were down by 27 per cent year-over-year, according to the Office of the Superintendent of Bankruptcy Canada.

But as debt levels creep up again, it is not clear how long that will last.

Household credit market debt as a share of disposable income rose to 170.7 per cent in the third quarter, up from 162.8 per cent as of the second quarter, but still below the 176.6 per cent seen in Q3 of 2019, Statistics Canada’s most recent figures show.

Likewise, the debt service ratio ticked up to 13.22 per cent for the third quarter, an increase over 12.36 per cent in the second, yet well off the 15-per-cent level it hit by the end of 2019.

The potential for another surge will likely weigh on any decision to ultimately raise rates, much as CIBC economists Benjamin Tal and Avery Shenfeld noted in December 2019.

“If raising the overnight rate to only 1.75 per cent could set off a climb in insolvencies, before any major job losses have been seen, it’s clear that taking rates to anywhere near what was historically neutral, or even where some models might currently put neutral, could prove to be overkill,” Tal and Shenfeld wrote at the time. “Monetary policy will have to look a bit dovish to be only neutral for the economy as a result.”

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In-depth reporting on the innovation economy from The Logic, brought to you in partnership with the Financial Post.

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