Do Canadian households carry too much debt?
By Peter Diekmeyer • Bankrate.com

In a bid to allay fears the country's residential real estate market may be heading for bubble territory, Finance Minister Jim Flaherty recently announced new steps to tighten up mortgage credit. "Canada's housing market is healthy, stable and supported by our country's solid economic fundamentals," said Flaherty. "However, a key lesson of the global financial crisis is that early policy action can prevent negative trends from developing."

As a result of the new rules, all new borrowers must now meet the higher standards needed to qualify for five-year mortgages, even if they choose those that offer shorter terms at lower interest rates.

In addition, the minimum down payment that buyers who do not plan to live in the properties they purchase (mostly investors and speculators) need to come up with was raised to 20 per cent. And lastly, the maximum loan amount that Canadians who refinance their homes can withdraw was been lowered to 90 per cent.

On the surface, Flaherty's moves, though modest, make sense. Canada's banking industry, which has been widely acclaimed as one of the world's soundest, escaped much of the agony that befell its US counterpart during the financial crisis. As a result, history has shown that erring on the side of caution may not be such a bad thing. That said, the moves do raise questions as to how serious Canadian household indebtedness is.

The Canadian housing market
While Canadian families now carry more debt than ever before, to evaluate how serious current levels are, one needs to compare them to the value of the assets they own. According to the Canadian Real Estate Association, or CREA, residential properties, which constitute most families' main asset, have been doing quite well.

The average price of homes sold via CREA's Multiple Listing Service, or MLS, during January rose an impressive 19.6 per cent, compared to one year ago, to $328,537. That said, according to Pascal Gauthier, an economist with TD Bank Financial Group, price gains will likely taper off during coming months. "We expect growth to cool gradually heading into 2010," wrote Gauthier in a recent note to bank clients. "Sales momentum has eased from the summer of 2009. A substantial increase in new listings and an easing in sales have softened the market balance significantly, which in turn has led to slower month-over-month price growth."

If Gauthier is right that price gains will weaken (as opposed to going into outright decline), that would be good news, particularly in light of the fact that current levels are extremely attractive from a historical perspective.

In fact, residential real estate is doing far better in Canada than it is in the U.S., where prices have fallen in the double digits in almost all major markets. According to Benjamin Tal, an economist at CIBC World Markets, residential real estate resale values there could fall by an additional five per cent to 10 per cent once tax support from the U.S. government's stimulation initiatives for the sector start to level off.

Household indebtedness in Canada
Canadian stocks, too, have done well. While they are nowhere near their historic highs, the S&P/TSX composite index is up by more than 40 per cent from last year's lows.

According to Marc Pinsonneault, an economist with National Bank Financial, the problem is that while assets of Canadian households have bounced back from their financial crisis lows, they haven't come back enough to keep up with their current rate of borrowing.

"Canadian debt levels have progressed normally (during the past 18 months) at a pace akin to that of previous years," says Pinsonneault. "However, the deterioration in financial assets following the collapse of the stock market during that time caused household debt to rise by four percentage points to 24.7 per cent of net wealth."

On the positive side, Pinsonneault says current low interest rates make it far easier for Canadian households to handle their debts. During the third quarter of 2009, the effective interest rate on Canadian household debt was just 5.39 per cent compared to 12 per cent during the early 1990s.

"No matter how you look at it, Canadian households are in a decent financial position," says Pinsonneault. "The real test will be what happens when interest rates start to rise, which they are expected to starting at about mid-year."

Peter Diekmeyer is a writer living in Montreal.