News of increased financial strain in Spain today has caused the Bank of Canada to brace for a ripple effect on the other side of the ocean. Any spillover from the increasingly vulnerable European market is expected to carry over to North American, rocking the fragile U.S. banking sector before it lands on the doorstep of Canadian homeowners.
Households with high debt will be the first to feel the impact. Already debt-burdened households could begin defaulting on their mortgages as historically low rates begin to rise and banks begin to tighten their lending restrictions in response to growing uncertainty. From there, it’s a domino effect of job loss, a housing freeze and decreased market action.
According to The Bank of Canada’s bi-annual Financial System Review, Canadian households need to brace for aftershocks as the situation continues to intensify overseas. And that’s not the worst of it. Given all of the uncertainty that engulfs the European market, things could become even worse. “Conditions in the international financial system are fragile,” was the Bank’s ominous message on Thursday.
The Global Effect
If the sovereign debt crisis continues to intensify in Europe, the impact will cause global markets to weaken. As banks around the globe attempt to curb risk, it will be the average mortgage seeker and homeowner who is forced to pick up the slack. A weaker global outlook will fuel sovereign fiscal strains and further impair the credit quality of bank-loan portfolios everywhere.
While this is by no means new information, the tone in which it was portrayed last week seemed far more urgent that in previous addresses. The central bank stated that growing concerns over the euro crisis continues to “reflect widespread doubts about the capacity and resole of policy makers to address unsustainable fiscal situations, the capital adequacy of some euro-area banks and the underlying balance-of-payments problems within the euro area.” If these issue are not dealt with quickly and efficiently, the “contagion effects on global financial conditions could be significant.”
How We’ll Feel it in Canada
While the exposure will be limited, the Canadian banking system, especially the mortgage market, will not be immune. A tightening of lending conditions will cause Canadian financial institutions to incur losses as high-debt households are unable to handle increased interest rates. The Bank of Canada is increasingly worried about the 150.6 percent debt-to-income ratio that has remained unchanged in Canada since the last quarter of 2011. This household debt level is now higher than that of the U.K. and the U.S.
Thursday’s release provided a detailed analysis of what could be two inter-related shocks – a big drop in housing prices and a “sharp deterioration in labour market conditions.” Lower confidence and lower household net worth, combined with the initial decrease in housing prices, will likely lead to lower household spending and employment, creating the perfect storm of economic strain. It’s expected that, under this shock scenario, Canada’s jobless rate will rise by three percentage points, causing the average period of unemployment to increase by six weeks.
Until the European Stability Mechanism comes into play in July, it’s difficult to foreseen global financial conditions. What’s more, the regulation hasn’t been fully ratified by many eurozone member states’ of parliament, including Germany’s Bundestag.
Mortgage Talk will continue to follow this story. For now, Canadian home hunters can take advantage of low mortgage rates by speaking with an experienced mortgage broker.
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