Taming the household-debt dragon

Flaherty’s threats against banks are empty.

Finance minister Jim Flaherty (Photo: Sean Kilpatrick/CP)

Finance minister Jim Flaherty (Photo: Sean Kilpatrick/CP)

Jim Flaherty seemingly cannot keep Canada’s banks in line. In early March, the Bank of Montreal advertised an interest rate of 2.99% on five-year fixed mortgages, crossing a psychological threshold and prompting the latest hand-wringing about Canada’s household-debt burden. The federal finance minister publicly warned them to avoid imitating aggressive practices that led to the U.S. mortgage crisis, and thanked BMO’s competitors for not lowering their own rates in response. He made similar noises in January 2012 when BMO first lowered posted rates below 3%—and the bank did subsequently withdraw slightly. But Flaherty’s remonstrations are not sufficient to deter banks from competing for market share.

Ottawa has more to lose than the banks if all goes to pot. Under federal rules, any mortgage for which the downpayment is less than 20% of the purchase price must be insured against default. This allows banks to lend at negligible risk to themselves. The same cannot be said for Ottawa, which provides federal backing for the dominant insurers. In effect, Ottawa has bailed out Canada’s banks in advance of any future housing catastrophe.

The caveat is that borrowers must meet Ottawa’s minimum qualifying standards. Flaherty can therefore influence banks’ behaviour through tweaking those standards. He’s done it four times since 2009, most notably by gradually lowering the maximum insurable amortization period to the current 25 years from 40. He lowered the loan-to-value ratios that govern what Canadians can borrow by refinancing their homes, and he raised the minimum downpayment. All this had the intended effect of slowing mortgage growth. But if Flaherty really wants higher mortgage rates, the obvious solution would be for the Bank of Canada to raise its overnight rate. Last fall Craig Alexander, TD’s chief economist, said that’s ultimately what must happen. “As long as interest rates remain at their current low levels, households still have a strong incentive to borrow,” he wrote.

Yet this option is now less palatable than ever. Sluggish growth has overtaken household leverage as the chief concern among federal policy-makers. Previously, the Bank of Canada hinted it might raise rates to curb the borrowing binge, but in March it abruptly changed tack by affirming the household debt-to-income ratio is “stabilizing near current levels.” Since Flaherty and Carney have sung in practised unison since the financial crisis, this likely reflects a broader shift. Expectations are rising that Canada has entered a prolonged economic stagnation, an outcome policy-makers seek to avoid at all costs. Robust consumer spending will be necessary just to tread water, and the Bank of Canada hopes consumers will spend slightly more this year.

Flaherty’s warnings to the banks were inert—and this was almost certainly intentional. BMO’s move is only the latest in what has been a secular decline in mortgage rates, which by itself does not appreciably worsen matters. Very few Canadians are behind on their mortgage payments, and the World Economic Forum has rated Canada’s banks the world’s soundest for five years running. But the household-debt dragon is merely tamed temporarily, not slain. Ottawa turns its back at considerable peril.