Financial Update For Dec. 17, 2009

• TSX +96.02

• DOW -10.88

• Dollar +.08c to 94.30cUS

• Oil +$0.25 to $72.91US per barrel.

• Gold +$4.40 to $1,140.60USD per ounce

The bond yield was up 0.03% to 2.60%, dropping the Spread to 1.39%.

Be ‘vigilant,' Carney warns on debt

‘When risks are still manageable is precisely the best time to act,' Bank of Canada Governor urges borrowers and lenders

Jeremy Torobin

Ottawa — Globe and Mail Update Published on Wednesday, Dec. 16, 2009 12:58PM EST Last updated on Wednesday, Dec. 16, 2009 5:24PM EST

Bank of Canada Governor Mark Carney again warned Canadians Wednesday not to borrow more than they will be able to handle when ultra-low interest rates start to rise, urging households and lenders to act responsibly while debt risks are “still manageable.”

“When risks are still manageable is precisely the best time to act,” Mr. Carney said in the text of a speech he was delivering to a business audience in Toronto. “We must be vigilant, and all parties must fulfill their responsibilities.”

While saying lenders should “actively monitor risk” and not take “false comfort” from mortgage insurance and the past health of household credit, Mr. Carney implored Canadians to “ensure that in the future, when the recovery takes hold and extraordinary measures are unwound, they can still service their debts.”

Mr. Carney's remarks expand on the central bank's semi-annual review of the financial system last week, in which he said household debt is now the biggest risk to the country's financial system, even if it's still “relatively low” and unlikely to reach levels that could cripple banks' balance sheets.

That review used a “stress test” to show rising interest rates between mid-2010 and mid-2012 would saddle a growing number of Canadians with debt loads big enough to leave them “financially vulnerable.” At the same time, Mr. Carney said in his remarks that although the Canadian economic outlook has improved, tepid demand in the U.S. for Canadian exports will make the economic recovery not only “more protracted” than usual, but also more dependent on spending at home.

And as the Canadian economy – which resumed growth in the third quarter on the strength of domestic spending – picks up steam, Mr. Carney warned that Canadians may save too little and borrow too much.

Nonetheless, he hinted that he would not seek to rush a return to higher borrowing costs to rein in spending and that monetary tightening won't come until inflation is closer to the bank's 2 per cent target.

“Whatever happens, the bank's monetary policy reaction to consumer behaviour will always be driven by its implications – taken in conjunction with all other relevant factors – for inflation over the medium-term horizon,” he said.

The central bank has made a conditional commitment to keep interest rates on hold until at least the middle of next year.

With the Bank of Canada's benchmark policy rate at a record low 0.25 per cent since April, cheap mortgage rates, and fiscal incentives such as allowing first-time home buyers to use more of their registered retirement savings as a down payment, have fuelled buying in the housing market and elsewhere in the economy.

In the speech, Mr. Carney pointed to the U.S. subprime mortgage collapse and the subsequent meltdown of that country's financial system to remind Canadians that growing debt burdens, even if confined to a small slice of the population, can cause problems for the whole economy.

“A shock to economic conditions could be transmitted to the broader financial system through deterioration in the credit quality of loans to households,” Mr. Carney said. “In such an event, increased loan-loss provisions and reduced quality of the remaining loans could lead to tighter credit conditions more broadly.” He also repeated much of the data from his report last Thursday, including the fact that personal bankruptcies in Canada rose this year to the highest level since 1991. In his remarks, he also noted that even as real consumer credit, including home equity lines of credit, declined during the recessions of the early 1980s and 1990s, it's up 7 per cent in the past year.

In his report last week, Mr. Carney said household debt remains “a key vulnerability over time,” and in the stress test model the central bank assumed that the ratio of debt to income would rise from 1.42, or 1.42 per cent, in the second quarter of this year, to 1.60, or 1.60 per cent, by mid-2012.

To illustrate the point that Canadians' debt could become a bigger risk once policy makers lift the main interest rate, the bank showed the proportion of households with debt-service ratios higher than 40 per cent of income would rise to 8.5 per cent by the second quarter of 2012, assuming the central bank's rate is 3.2 per cent. That share would climb to 9.6 per cent assuming the central bank's rate is 4.5 per cent. The proportion of households with more than 40 per cent debt-service costs was 6.1 per cent over the past decade and peaked at 7.4 per cent in 2000.

The central bank's report said Canadian banks currently have more than enough capital on hand to absorb potential losses, suggesting that even the worst-case scenario in the stress test would fall short of risking a collapse of the financial system.

Addressing the personal savings rate, Mr. Carney said a savings rate at current levels, or slightly lower, is what the central bank is projecting as part of a consumer-led recovery.

When asked about the potential for a bubble in the housing market he reiterated that the central bank's core focus remains fixed on inflation. “Monetary policy in Canada doesn't target specific assets or asset prices,” he said. “It will be set to achieve the 2 per cent [inflation] target.”