[R-G] Bank of Canada warns of possible debt, mortgage defaults if conditions worsen

[Anthony Fenton]

Bank of Canada warns of possible debt, mortgage defaults if conditions  
worsen

December 11, 2008 - 13:53

Julian Beltrame, THE CANADIAN PRESS

http://www.macleans.ca/article.jsp?content=n121161A

OTTAWA - Mortgage and consumer debt defaults could rise  
"significantly" if the global financial crisis deteriorates and  
triggers a widespread and deeper recession that cuts household income  
and makes it harder to pay the bills, the Bank of Canada warns.

In a sobering assessment of the financial crisis, the central bank  
concludes that significant risks remain for both the global economy  
and Canada if credit conditions don't begin to improve.

Continued Below

"With household balance sheets under pressure from weak equity  
markets, softening house prices, slowing income growth, and record- 
high debt-to-income ratios, a severe economic downturn could result in  
a substantial increase in default rates on household debt," the bank  
writes in its December financial systems review released Thursday.

The Bank of Canada says the number of "vulnerable households" - the  
three per cent with a debt-to-income ratio above 40 per cent - could  
double by the end of next year under this pessimistic scenario.

The central bank notes that this would be a worst-case scenario. The  
"most likely outcome" is for global markets and credit conditions in  
Canada to gradually improve, it states.

This is partly because central banks and governments around the world  
have leaped into action with extraordinary measures such as liquidity  
injections, asset swaps, cash infusions and credit guarantees to  
backstop financial institutions.

But the central bank's top officials also warn that the crisis is far  
from over and that there is "a significant risk of mutually  
reinforcing weakness in the financial sector and in the real economy."

The Canadian economy is now in recession and is expected to shrink or  
grow only marginally in 2009, pushing the jobless rate to well above  
seven per cent, with little recovery until 2010.

Given the uncertainties, the bank officials outline five potential  
risks for the world and Canada that includes tighter lending  
conditions as banks are forced to restore their cash reserves, thereby  
creating a deeper and more prolonged recession.

For Canadians, the repercussions of a deepening recession will be  
profound, including more unemployment, lower income growth and more  
home defaults from crushing debt loads, the bank says in its worst- 
case assessment.

And while Canadians' access to credit has not tightened significantly  
during the financial crunch, this could change if the crisis persists,  
the bank says.

"The continued reluctance of lenders to enter the market, owing to  
uncertainty over their future funding needs and existing risk  
exposure, risks delaying the return of confidence and more normal  
financial conditions," the bank says.

"(This) could aggravate the adverse feedback loop between the  
financial system and the real economy."

The risk assessment is noteworthy for its predominantly gloomy outlook  
- although it remains a hypothetical one - and for the fact it was  
written by the bank's governing council headed by governor Mark  
Carney, rather than by lower-rank bank staff as is usually the case.

The global credit crunch has dried up lending to companies by banks  
and made it more difficult in many countries for ordinary borrowers to  
get money for lines of credit, consumer and car loans and mortgages.

In the United States, millions of Americans have lost their homes in  
the last two years with the collapse of the sub-prime, or high-risk  
mortgage market, which led to sharply higher interest rates for  
homeowners with poor credit and produced widespread foreclosures.

In Canada, however, the housing sector has been more stable, but the  
jump in home prices that led to soaring values in Vancouver, Calgary,  
Toronto and other cities has begun to reverse, with dropping values in  
previously hot markets.

Statistics Canada reported Thursday that new home sales fell for the  
first time in a decade in October, dropping 0.4 per cent from September.

Some economists warn that falling prices could lead to a housing slump  
and more defaults, although foreclosures are usually a last resort and  
banks try to cushion the blow by renegotiating easier repayment terms.

Canadian banks are among the best-capitalized in the world but would  
not emerge unscathed, the central bank's analysis concludes.

Much as has happened in the United States, the officials say household  
debt woes could be a channel of contagion spreading through the  
banking system and further restrict the availability of credit.

Banks are somewhat insulated by mortgage insurance, but the Bank of  
Canada says a severe economic downturn would nonetheless put pressure  
on their capital ratios.

The central bank does caution that the vulnerability of Canada's  
housing sector should not be overstated.

It notes that lending practices in Canada have been far more  
conservative than those in the U.S. and that subprime mortgages  
account for about five per cent of the market as opposed to 14 per  
cent in the U.S.

As well, although debt is high, low interest rates means that at  
present most households are able to comfortably manage their financial  
obligations.