A Nation's Heavily Indebted Consumers Face a Painful Margin Call

(Bloomberg) — At the height of the Covid-19 pandemic, with his job as a delivery driver bringing plenty of overtime and the cost to borrow at record lows, James Kebe went on a spending spree. He leased a boat and an all-terrain vehicle, and when his bank offered him a bigger line of credit, he maxed it out.Then interest rates started rising at their fastest pace in generations. And because Kebe’s line of credit had a floating rate, his monthly payments soared, too. The cost of his debt has now outpaced his take-home pay by C$900 ($660) a month, leaving him with little choice but to enter a form of creditor protection that will see his toys repossessed and keep him on a tight budget for the foreseeable future. “I’ve always been able to squeak by until now,” he said by phone from his home in West Kelowna, in the Canadian province of British Columbia. Now when he’s at the store, Kebe says his new mantra is: “Do I need this? No I don’t.”The refrain is becoming more common across Canada as the hangover from the country’s pandemic-era borrowing binge starts to take hold. Canada’s steep rise in interest rates is akin to a national margin call, especially among homebuyers who took advantage of rock-bottom rates offered by adjustable mortgages.

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Canadian consumers suddenly must come up with more money for their abruptly higher monthly payments, either by tightening their belts or liquidating assets. How they fare could offer clues to whether the rapid-fire interest rate hikes by central banks globally have further to go, or if they’ve already gone too far.

Read more: The World’s Hottest Housing Markets Are Facing a Painful Reset

Last March, with inflation unexpectedly roaring to a four-decade high, the Bank of Canada became one of the first major central banks off the mark in a global campaign of interest rate hikes enacted at near unprecedented speed. It raised its benchmark rate from the pandemic low of 0.25% all the way to 4.5% in less than 11 months.

The Bank of Canada was also among the first to take a break from rate increases, signaling after January’s hike that a pause is warranted now that inflation seems to be easing. The US Federal Reserve and other central banks, meanwhile, say they’re still not done. “We should be a bellwether,” said Tony Stillo, a Toronto-based economist with Oxford Economics who forecasts consumer spending in Canada will drop 1.8% from its pandemic-era peak, tipping the economy into a recession that will be steeper than in other countries. “One of the reasons the Bank of Canada did pause before others is because those vulnerabilities are a little more acute.”

Canadians for decades have been among the developed world’s most indebted people, and the low interest rates the central bank deployed to help the economy through the pandemic drove their borrowing to new heights. The country’s debt-to-income ratio reached a record 185% by the end of 2021, the highest in the Group of Seven countries. By comparison, the ratio is 101% in the US and 148% in the UK .

Consumers are starting to show signs of stress. The latest insolvencies data shows a 33% jump in January filings from the year before. The share of indebted households behind on their interest payments also climbed to 2.07% in the quarter ending September 2022, the latest reading, from 1.86% in the 2021 quarter.

Though the increase in both these stats is from very low levels, and still leaves them well below historic norms, anecdotal evidence suggests the strain has increased since.

“What we’re seeing is consumers are stressed and insolvency rates are starting to climb up to pre-pandemic levels, which is alarming,” said Stacy Yanchuk Oleksy, the chief executive officer of Credit Counselling Canada, a national association and accrediting body for nonprofit credit counselors. “The folks that are struggling are going to cut back, and so I think consumer spending will slow down with them.”

That’s already starting to appear in sales of discretionary purchases like luxury cars and all-terrain vehicles. But a main source of stress, and of economic weakness, could turn out to be the housing market.

Similar to many other countries, the largest portion of Canadians’ pandemic debt binge went to finance home purchases, fueling a huge run-up in real estate values. But as prices climbed, a record number of people turned to the lower interest rates offered by variable-rate mortgages, with interest payments that track the Bank of Canada’s benchmark rate.

Adjustable mortgages now account for about 30% of all outstanding home loans, according to calculations from National Bank of Canada. That leaves Canadians more vulnerable than homeowners in the US, where only about 5% of mortgages have floating rates.

Though the majority of Canadians’ adjustable mortgages are fixed payment, meaning the increased interest is taken out of monthly principal repayments first, rates have risen so quickly that at least 73% of new borrowers in that category aren’t repaying any principal at all. That means they will have to increase their monthly payments or cut a check to their bank to get the balance down, according to National Bank.

There’s also a double-whammy effect: As rates increased, home prices have also declined, resulting in less equity for some homeowners, which makes it harder for them to sell or refinance, similar to what happened in the US in the run-up to the 2008 financial crisis.

“There is a risk that this might be the straw that breaks the camel’s back,” Stefane Marion, an economist with National Bank, said of the latest interest rate hike in January. “This increase will have some impact on the economy.”Already, there are early indications that some borrowers are in trouble.

In Toronto, Canada’s largest city, the number of homes whose owners had fallen behind on their mortgage payments, allowing them to be seized and sold by the lender, hit 35 in February. There were no such “power of sale” listings three years ago, according to data compiled by Daniel Foch, a Toronto-based real estate broker and researcher.

Foch said he’s handling some of these listings himself, and most seem to be cases where a variable-rate mortgage was used to finance an investment property whose interest payments are now greater than what can be charged in rent, forcing the borrower into default. In major Canadian markets like the provinces of Ontario and British Columbia, investors account for about a third of the housing stock, and they became more active in the market nationally through the pandemic buying frenzy.

“It’s just going to continue until rates start coming down,” Foch said of the distressed sales. “People have to pay their mortgages once a month, so every month that goes by that rates are high is more time under tension, and more people that can’t afford to debt service their investment properties or pay their mortgages on their primary residences.”

With benchmark home prices already down more than 15% nationwide, such distressed sales could continue to weigh on the market, though a recent bump up in prices in Toronto might suggest the worst of the price declines may be over.

But with the pandemic boom helping drive real estate and related activities to a record share of the total economy in that time — think construction and renovation as well as buying and selling — the industrywide pullback now playing out will likely have knock-on effects as everyone from contractors to developers see less work. A Bloomberg survey of economists suggests Canada may already be near a recession.

“We’re just being a lot more frugal and on top of our finances,” said Peter Esper, a mortgage broker in the Toronto area who was hit hard by interest-rate increases after relying on variable-rate mortgages to finance his own real estate investments. The payments on the home he shares with his wife and two kids went up by nearly C$3,000 a month, while the difference between mortgage costs and what he was charging in rent on the four condos he owned as investment properties ballooned to a collective C$4,000 a month in negative cash flow.

Now he’s sold two of those condos and plans to list the third, while also canceling his cable TV package and opting to brew coffee at home rather than buying it at Tim Hortons for the foreseeable future. “Everyone’s just cutting back, watching what they’re spending,” Esper said. “People aren’t going away as much, they’re not eating out as much. I think it’s been a big shock, considering how quickly it happened.”