A significant number of Canadians are at risk of defaulting on mortgages and other loans if the global financial crisis deteriorates and triggers a deeper recession, 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.
"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. That would mean tens of thousands of households could face crushing debt as Canadians lose jobs and family incomes drop to the point where they can't pay their bills.
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 cash injections, asset swaps and credit guarantees to backstop financial institutions to pump addditional billions of dollars of credit into the economy.
But the Canadian 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."
That's the kind of negative feedback that felled the American economy, noted Douglas Porter, deputy chief economist with BMO Capital Markets, the brokerage arm of Bank of Montreal, adding it is no longer far-fetched to think it could happen here.
"Given the fact we're looking at the recession in the teeth, some of the worst-case scenarios have to be studied a little more closely," he said.
"It looks like we're going to get as close to the bank's worst-case scenario than anyone would have imagined possible as recently as three months ago."
After resisting the call for months, the Bank of Canada declared the economy in recession Wednesday when it slashed its trendsetting interest rate to the lowest level in 50 years at 1.5 per cent.
Most economists are forecasting growth at or below zero for 2009 with job losses of more than 100,000 and an unemployment rate above seven per cent.
For much of the last year, experts said the Canadian economy would perform better than the recession-ravaged U.S., where the housing, financial and manuufacturing sectors have been battered and the services sector is now feeling the effects.
But now, the slump in the auto, manufacturing and forestry industries in Ontario and Quebec has spread to the resources-based West as oil projects get shelved because of low crude prices and mines close because of slumping prices for nickel, copper, zinc and other primary metals.
Pressure is mounting on the federal government to shock the economy into recovery with a big stiumulus spending plan in its Jan. 27 budget. Late Thursday, Bank of Montreal's Porter urged Ottawa to spend as much as $16 billion next year to arrest the economy's slide into recession.
Porter said such a package should include spending on roads and bridges as well as a one-time bonus for seniors on public pensions, temporary cuts to payroll taxes and the GST, and spending vouchers that would give Canadians government cheques on the condition they spend rather than save.
As well, Porter says Ottawa should consider a one-time financial transfer to the provinces, which could put the money more directly to use.
Given the rising uncertainty, the Bank of Canada officials outlined five potential risks for the world and Canada, including a deeper and more prolonged recession as banks compelled to restore cash reserves tighten the screws on credit conditions even further.
For Canadians, the repercussions will be profound - higher joblessness, 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 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.
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. 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.
According to the latest figures compiled by the Canadian Bankers Association, the percentage of mortgages that have gone unpaid for at least three months as of September was 0.29 per cent, or 11,362 of about 3.9 million mortgages in the country. Arrears in the U.S. are 6.5 times higher.
"Canadian trends are stable. American trends are worsening," according to the bankers' group.
In its report, the Bank of Canada says consumer debt woes will also cut deeply into bank profitability. In their recent financial reports, the six biggest Canadian banks reported a 38 per cent drop in profits for the just completed 2008 fiscal year to about $12 billion.
Much as has happened in the U.S., the central bank officials say the contagion could spread through the banking system and further restrict the availability of credit.
The Bank of Canada 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. Banks are also insulated for defaults through government guaranteed mortgage insurance.
As well, although debt is high, low interest rates means that at present most households are able to comfortably manage their financial obligations.
Merrill Lynch economists David Wolf and Carolyn Kwan warned back in September that Canada was experiencing a similar housing meltdown as occurred in the U.S.
But Derek Holt of Scotia Capital agreed with the Bank of Canada that the situation here is not as dire.
"If we start off by looking at the household balance sheet it's 20 cents in debt for dollar of assets in Canada versus 26 cents in the United States. So we have 30 per cent less debt per each dollar," he explained.
Adam Affleck
Charlottetown Remax
What should be done
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