Hilliard’s Weekend Notebook


Thoughts, views and opinions as current events unfold: With topics taken from current market events and my latest book — When the Bubble Bursts: Surviving the Canadian Real Estate Crash (Dundurn: March 2015)  and my first book Investment Traps and How to Avoid Them (1999) — this short piece will give you unique and valuable insights filtered by my thirty-six years’ experience as an investment professional.


 

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Where is the deleveraging that was supposed to happen after the 2008 crisis?

Where is the deleveraging that was supposed to happen after the 2008 crisis?

In February 2015, just after the publication of “When the Bubble Bursts,” McKinsey and Company - a large management consulting firm - published a massive tome on the state of debts on the Planet Earth. This report, titled “Debt and (not much) deleveraging,” points out that major economies, including Canada, have made no progress on reducing debts or lowering the leverage ratio. Instead, total debts of all economies increased by US$57 trillion, or about 17 percentage points.

Canada went along with the trend and managed to borrow more than most others, placing second only to Greece in expanding its ratio of debt to income.

In fact, among all economies Canada’s main economic participants including households, non-financial corporations and governments increased the ratio of the amount owing to income by 22 percentage points, well above the 17 average. On page 39 exhibit 13 the McKinsey report shows several countries that increased that ratio and Canada stands out as second only to Greece (added 30 points) in adding 22 percentage points to the ratio of debt-to-income in the period 2007-14. A few countries like Ireland, Spain and the United States lowered their ratios of debt-to-income after the global financial crisis but not Canada. In fact, Canadians carried on as if the crisis never happened.

The report is available here.

In Canada as in all other advanced economies the instrument of choice has been the residential housing mortgage. Canadian banks add a wrinkle by promoting the Home Equity Line of Credit, or HELOC, as it’s known in the banking trade. The advantage of the HELOC for the bank is that there is no amortization so the size of the loan doesn’t shrink with every payment like a mortgage. The HELOC is still backed by the collateral of the house, if the borrower fails to pay. This increases the profits for the bank and keeps the consumer more indebted. Because of these advantages, banks promoted the HELOC so aggressively to Canadians the total soared to more than $266 billion, from under $50 billion a decade ago. HELOCs now make up about 40 percent of consumer credit (not including mortgages) now. Both mortgage loan and HELOC debts have expanded exponentially in the last ten years, briefly pausing to pay tribute to the worst financial crisis since the 1930s.

As McKinsey states: “Seven countries have household debt that may be unsustainable: The Netherlands, South Korea, Canada, Sweden, Australia, Malaysia and Thailand.”

In the House of Debt by Mian and Sufi the authors explain who gets hurt when debt reaches a level that can’t be sustained, as happened in the US.

“The combination of high leverage, high exposure to housing, and little financial wealth would prove disastrous for households that were the weakest.” The authors studied the US crisis but they could be talking about what will happen in any of the seven countries singled out by McKinsey.

Many Canadians believe, with encouragement from leaders in politics and banking, that mortgage debt is “good debt”. While that might be true for modest levels of debt at the individual household level for young couples with good incomes, it is demonstrably false for the collective welfare of a country that allows its workforce to become overly indebted with an illiquid asset, a house, as the collateral for the loans.

As the McKinsey report states, “Unsustainable household debt in some of the world’s largest economies, notably in the US, was at the core of the 2008 financial crisis.”

The US, having already endured a major crisis and started down the road of deleveraging, will be in good shape for the next crisis, whether it be global or at the individual country level. Canada, not so much.