Personal debt not as bad as it looks

By MICHAEL BABAD
Globe and Mail Blog 14/12/2010

BMO study finds consumers getting into better shape

Monday was D-Day. Statistics Canada reported on it. Bay Street's economists pontificated on it. And Mark Carney, in his own way, declared war on it.

"D" stands for debt, and Canada yesterday reached a high-water mark: For the first time, household debt hit 148 per cent of disposable income and, for the first time since the late 1990s, topped the U.S. equivalent.
Mr. Carney, the Bank of Canada governor, warned of the rising debt burden among Canadian families, and the risks they face when interest rates rates inevitably rise.

"Experience suggests that prolonged periods of unusually low rates can cloud assessments of financial risks," he said in a speech in Toronto. "Low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce: The greater the complacency, the more brutal the reckoning."

Economists quickly noted the central bank's growing anxiety over the vulnerability of Canadians who may not be able to juggle their debt payments when that day of reckoning comes. "An erosion in home affordability is expected to slow the pace of mortgage debt accumulation over the next couple of years," said senior economist Pascal Gauthier of Toronto-Dominion Bank. "If it does not, an increasing and potentially worrisome proportion of Canadian households would become vulnerable to higher interest rates."
Not to play down those significant risks, BMO Nesbitt Burns questions whether the state of family finances are as bad as they would appear.

"While debt has risen to record heights, so too have financial assets, due to a rebound in equities and an underlying rise in savings," said deputy chief economist Douglas Porter. "Taking these factors into account, as well as the recovery in Canadian full-time employment, leads to the conclusion that household finances are not nearly as weakened as the dire headlines would suggest."

In his study, Mr. Porter noted that the savings rate in Canada has averaged 4 per cent in the last year, or about double the record low of 2005. And that, he said, does not paint the full picture of Canadian savings because it "narrowly" examines money saved from current income, while ignoring unrealized capital gains and returns from tax-sheltered vehicles.

A better measure, according to Mr. Porter, is the change in net financial assets as a share of disposible income, which has been extremely volatile. Smoothed over a five-year period, though, it has averaged about double the reported savings rate.

"In other words, take all cash, deposits, bonds, stocks, life insurance and pension assets and subtract household debt to derive net financial assets. These net assets have recovered from last year's lows to $2.7-trillion by the end of [the third quarter] ... For reference, that works out to $80,000 per Canadian, or 167 per cent of GDP."

Stock market gains since the depths of the meltdown have pumped up net worth, Mr. Porter said, as he cited the debt-to-asset ratio that Mr. Carney put at its highest in more than two decades. Much of the deterioration there, according to Mr. Porter, came as equities plunged and home prices dipped.

But on the flip side, the "absolute" level of net worth has been rising, stitting now at 6.1 times disposable income. His point is that though household debt has climbed faster than assets in percentage terms, some of that is accounted for in the "skewering" of assets late in 2008. In absolute terms, assets are now rising faster than debt again.

"Amid the cacophony of warnings, balance sheet repair is in fact quietly under way among Canadian households thanks to a slight rise in savings and firmer equity markets, while debt growth is poised to slow more meaningfully amid the clear cooling in the housing market," Mr. Porter added.

"... The singular focus on debt portrays an overly negative picture of Canadian household finances, which have proven incredibly resilient this cycle and likely still have enough cushion to provide a soft landing for spending in the year ahead."