Ottawa urged to take concrete steps to limit growing consumer debt

Ottawa is being urged to drop its warnings about consumer debt in favour of more concrete measures to stop more borrowers from getting in over their heads.

With the Bank of Canada expected to keep interest rates on hold for several more months and household debt already at record highs, leading economist Craig Alexander says policy makers need to act soon to lower the risk of economic damage.

The debt-to-income ratio actually fell in the fourth quarter, Statistics Canada said Thursday, to 151 per cent from 152 per cent. But that was due to a surge in income for farms and unincorporated businesses. Total debt was 6.1-per-cent higher than a year earlier – the slowest increase in a decade, but still an increase. And in an economy that has created few new jobs for six months, wage growth could be tepid for years to come.

Economists say Bank of Canada Governor Mark Carney, while increasingly concerned about the debt burdens families have accumulated, has little room to lift his 1-per-cent benchmark interest rate as long as the U.S. Federal Reserve keeps its rate on hold – which it's expected to do until late 2014. Moving too far from the Fed could send the loonie soaring, making life even harder for exporters.

Still, interest rates will eventually rise and housing prices – which almost all economists believe are overvalued – could start falling. Either way, policy makers fear many overstretched Canadians could hit the wall at the same time, causing a sharp decline in consumer spending and, in an extreme scenario, another recession.

For all of these reasons, Mr. Alexander, chief economist at Toronto-Dominion Bank, says the government, which has tightened mortgage rules three times since 2008, should step into the housing market again and gradually roll out a series of steps to ensure the risk doesn't get worse.

"We want to ensure that the imbalance we have doesn't get any bigger, so the economy over the medium term can weather the inevitable future adjustment in interest rates," Mr. Alexander said in an interview. "If we incrementally lean against credit growth while we have low rates, it will be a better outcome for the economy."

In a report he will release Friday, Mr. Alexander recommends four possible measures:

First, he says, the maximum amortization period for government-insured mortgages should be cut to 25 years (as it was before the Harper government increased it to 40 years in 2006) from the current 30, a move Ed Clark, TD's chief executive officer, has endorsed.

Second, anyone applying for a mortgage should be required to show they could still afford it if the rate rose to 5.5 per cent. (Currently, most banks assess whether a borrower applying for a mortgage shorter than five years, whether variable or fixed-rate, could afford a five-year fixed mortgage. But fierce competition has led to five-year fixed rates as low as 2.99 per cent.)

Third, he says, lenders should assess the ability of anyone applying for a home-equity line of credit to pay it off within 20 years. The Bank of Canada says such loans, known as HELOCs, made up almost 50 per cent of all consumer credit last year, compared with 11 per cent in 1995. The new standard would reduce the maximum size of HELOCs, which have exploded as home prices rose.

Finally, the minimum down payment for a government-insured mortgage should be raised to 7 per cent from the current 5 per cent, Mr. Alexander said.

However, he is careful to note that the government should not attempt to implement all of the changes at once, or even closely spaced, for fear of causing the very economic damage that policy makers are trying to prevent.

"We need to be careful that changes in regulation don't trigger the unwinding that we fear, so you need to be very gentle about it," he said. Mr. Carney also will need to move very slowly whenever he starts tightening again, said Mr. Alexander. With the current level of consumer debt, "any quarter-point increase in interest rates today will have a much bigger impact on the economy than it had in the past."