Is debt too high? Debt, pensions, and houses

Debt to income levels are high by historical standards in Canada and the US. Here's a recent report (pdf) from TD Economics showing household debt/income ratios at around 150% in both countries. But is that "too high"? And is that evidence that some people, like the Flopsy Bunnies, are very improvident?

I'm going to play with a very simple model, and do some back of the envelope calculations, to try to work out what the average debt to income level would be even if everybody were perfectly provident.

In my toy model, total debt/GDP ratios are driven by lifecycle savings. It is providence that causes high total debt/GDP ratios. Provident people save and lend for their retirement, which creates debt. But the most interesting (to me) result is that forced saving in pension plans has a very large effect on personal debt/income ratios. The greater is forced saving, the smaller is voluntary saving, and the more slowly people pay down their mortgages. It is easy to explain high personal debt/income ratios in this way. You can easily get personal debt/income ratios around 100% just from this cause alone.

Here's the model:

Forget about kids. We don't count kids. Everybody is born at age 20, works for 40 years earning $150 per year, then retires for 20 years, then dies aged 80. So average adult earnings are $100 per year over the 60 year adult lifespan. Nothing ever changes in this economy. Every cohort is exactly the same size, and there is zero growth in income. Every individual is perfectly provident, and saves $50 per year while working, and so is able to consume a constant $100 per year both while working and in retirement. With zero time preference, and zero growth in income or population, the rate of interest is also zero.

Each person's stock of savings starts at zero, grows at $50 per year to a maximum of $2,000 at age 60, then declines at $100 per year until they die with zero. That means the average stock of savings is $1,000 per person. That is 10 times average income per person.

Suppose that all those savings are lent to firms, which therefore own all the real assets in this economy. And suppose the savings are lent in the form of debt, rather than equity. That means the total debt/GDP ratio in this economy would be 1,000%. Is that "too high"? That's what providence requires.

Now suppose that firms' CFO's insist they stick to a standard 60/40 debt/equity ratio. So the average stock of personal savings, $1,000 per person, is held as $600 in corporate debat and $400 in shares. That still gives us a total debt/GDP ratio of 600%. Is that "too high"?

So far, all debt is corporate debt. There is no personal debt. Let's change the model to bring in personal debt.

Suppose it takes 2 years' labour to build a house, so houses cost $300, and the average house price to income ratio is 3. A lot of different things could happen, now we have introduced houses into the model.

At one extreme, we could assume that firms own all the houses, and everybody rents. That has no effect of debt/GDP levels, and there's still no personal debt.

Or we could assume that everybody buys a house at age 26, with no mortgage, and sells it again at age 77, to finance their last 3 years of retirement. So people live in their own house for 51 years and rent for the remaining 9 years of their lives. So individuals own a fraction 51/60 of the housing stock, and firms own the remaining 9/60. That reduces total assets held by firms by (51/60)x$300 = $255. If firms use only debt-finance, and issue no shares, the debt/GDP ratio falls from 1,000% to 745%. If firms use 60/40 debt/equity financing, the debt/GDP ratio falls from 600% to 447%. Personal debt remains at zero.

Now let's bring in mortgages. Suppose nobody rents. They buy a house at age 20, with a 100% mortgage, then get a reverse mortgage sometime during retirement, and die with a 100% mortgage.

If people pay down the mortgage first, rather than saving by lending to firms, the average mortgage debt is very small, even though I have assumed zero-down mortgages initially. The initial mortgage is paid off with 6 years' savings, and the final reverse mortgage is run down over 3 years. So people only have a mortgage for 9 of their 60 years, and the average mortgage is $150 for those 9 years, so the averge level of personal debt is only (9/60)x$150 = $22.50, or 22.5% of income. If we assume people first rent and save for a downpayment, the average personal debt/income ratio would be even lower than 22.5%. What could explain the much higher levels of personal debt we see?

Let's bring in compulsory pensions. Suppose the government is afraid that some people might be improvident and won't save enough for their retirement, and so forces them to save. (OK, it's not in the model, but give me a break, because I want to keep the arithmetic simple, even at the expense of a minor inconsistency).

The interaction of compulsory pensions and mortgages will have a very big impact on personal debt levels.

Take an extreme case. Suppose the government makes it compulsory to save the full $50 per year in a company pension plan (which is that same amount a provident person would save voluntarily anyhow). And suppose people insist on living in their own homes, rather than renting, and finance the purchase of their home with a 100% mortgage, which is never paid down at all until the house is sold at death. Personal debt is now $300 per person, or 300% of income.

Let's relax the assumption about compulsory pension plans. Suppose the law requires only $40 per year be saved in the company pension plan, so there is $10 per year extra voluntary saving to pay down the mortgage. It now takes 30 years to pay off the $300 mortgage. So for 10 years, between ages 50 and 60, each person is debt-free. At age 60 they retire and get a reverse-mortgage and withdraw $15 per year for 20 years to supplement their pension. So a fraction (50/60) of the population holds a mortgage, with an average value of $150, meaning personal debt is (50/60)x$150 = $125 per person, or 125% of income.

Let's drop the assumption of 100% mortgage-financing. If a house purchase requires a 33.3% downpayment, of $100, people will rent for 10 years, while saving up the downpayment. And for the last ($100/$15) = 6.66 years of their lives they will rent again, because they will no longer have enough equity in their homes to support a larger reverse mortgage. So a fraction (16.66/60) of the population will rent, and the remainder will own a house, and a fraction (10/60) will own a house with no mortgage. So a fraction ((60-16.66-10)/60) will have a mortgage, with an average value of $100. So the average personal debt will be ((60-16.66-10)/60)x$100 = $55.56, or 55.56% of income.

Some of the above results are obvious.

If you allow 100% mortgages, you will get a bigger perrsonal debt/income ratio than if you don't. If firms use 100% debt finance you will get a bigger total debt ratio than if they don't.

But some results are not so obvious.

Even if there is no financial intermediation, so households lend directly to firms. And even if firms use 60/40 debt/equity financing, the savings preferences of fully provident households would imply a total debt/GDP ratio of 600%.

And the non-obvious result that interests me most is how sensitive the results are to compulsory savings. Small increases in the amount that people are required to save in pension plans will cause large increases in average levels of personal debt/income ratios. In this simple model, it is not improvidence that causes high levels of debt. (In fact, improvidence by itself never causes debt; it is only improvident borrowers plus provident lenders that can create debt, because it takes two to tango -- a borrower and a lender.) Compulsory saving in pension plans reduces voluntary saving outside pension plans, precisely because people are provident in this model. So compulsory saving means people pay down their mortgages more slowly; both because they have less income left to pay down their mortgages, and because they have less need to save by paying down their mortgages.

It's a simple model. If you have a calculator, you can play with the assumptions yourself, and get a wide variety of estimates for debt/income ratios. And you can easily get higher personal debt/income ratios. Suppose house prices are 4 times annual income, rather than the 3 times income I have assumed here. Or add in student debt. Or add in investment in other consumer durables, like cars and furniture. Even if people are saving all they need to maintain the same level of consumption after they retire, any direct investment by the young will be debt-financed. All their savings are tied up in their pension plans.

Of course, none of this says that some people aren't very improvident. And none of this says that there aren't more improvident people than there were in the past. But "high" and rising personal debt levels might also be caused by forced savings, and the use of RSPs and TFSAs. You save in the company pension plan, your CPP, your RSP, and your TSFA, instead of by paying down your mortgage. We can't tell just by looking at average debt/income ratios. You need to break down the aggregate figures, and look carefully at the micro data, and at assets as well as liabilities. And to its credit, TD Economics tried to do just that.

(Hoping I didn't screw up the arithmetic somewhere. Just in case you have never heard it before...There are three types of economist: those who can count; and those who can't.)

 

Comments

[Bill Woolsey]

Great post.

How can we combat the argument--people are "overleveraged" and until they pay down their debts, the economy will only grow slowly and unemployment will remain high?

[Nick Rowe]

Thanks Bill. I think the first thing we have to explain is that "spending more" does not mean the same as "going deeper into debt". It is perfectly possible to have an increase in spending and a reduction in debt (not to mention an even bigger reduction in debt/income ratios, as income increases). Creditors spend more, and debtors hold their spending constant. So total debt falls, while total spending and income rises. Sometimes, even people who advocate more spending don't seem to recognise that it doesn't necessarily mean more debt.

But, that point aside, I don't have any good ideas.

[David Pearson]

Nick,

"But "high" and rising personal debt levels might also be caused by forced savings, and the use of RSPs and TFSAs."

Some quick, albeit incomplete, tests of the hypothesis:

-Assuming similar access to credit, countries with the highest rate of compulsory savings (Germany?) would also have the highest household debt to gdp levels. Within a region that has similar compulsory savings rates (Europe?), household leverage would also be similar.

-Household debt to gdp would be stable some years or decades following the introduction of a compulsory savings scheme, as households have had time to adjust debt levels to the new level of forced savings.

-Within a country, the leverage of different populations would depend mostly on their participation in a compulsory savings scheme. In other words, public sector employees, as a group, would be found to have far higher leverage than similarly-compensated non-union employees of small firms.

[Nick Rowe]

David: Good thoughts.

Germany: I didn't know they had the highest level of compulsory saving. They also have very low home ownership rates, I think. They all rent. I had always put that down to very high transactions costs in buying and selling a house. But maybe it's the high level of compulsory saving means they don't save enough for the downpayment.

Hmmm. I wonder, if I tweaked my little model, could I get an inverted-U shaped relation between compulsory savings and personal debt? With no compulsory saving, everybody pays off their mortgage very quickly, so debt is low. At very high levels of compulsory saving, nobody manages to save enough for the downpayment, so rents instead, and debt is low?

Of course, the Germans are all old too, and old people don't have much debt. They lend abroad. My model is of a closed economy, and has no demographic shifts.

On lags: suppose you introduce a new savings vehicle, like RSPs or TSFAs, that compete with paying down the mortgage. It might take a very long time to reach the new steady state. You might have to wait up to 60 years, before the people who were 20 just before the new vehicle was introduced finally die off.

RSP's came in, what, 35 years ago? TSFAs about 3 years ago? CPP is a bit older, I think. What I don't know is what has happened to work pension plans. Has their coverage increased or decreased over the last several decades? And have they required an increasing or decreasing proportion of annual earnings?

"Within a country, the leverage of different populations would depend mostly on their participation in a compulsory savings scheme."

Aha! That looks to be a good way to test this hypothesis. There might be confounding factors (the extra security of public sector jobs might mean they can borrow more), but they look less problematic than other ways.

(Behind this post is the image of my maternal grandparents. Their saving plan was direct investment in housing, which they lived in themselves and also rented out -- rather than lending. And seriously-binding rent controls stole my grandmother's pension from her.)

[adjacent / q]

this is absolutely great. i have been asking the same question to people: how can we fund retirement if everyone in the world needs $1 million to retire, so people need an average of $500K in assets say, now multiply this by 6 billion folks, and you get something like 3,000 trillion dollars. that's about 10X the total current value of all assets in the world.

[Nick Rowe]

adjacent/q: Thanks! And yours is a good question to ask. I would quibble with your numbers though. Some of those 6 billion are kids, so haven't started saving yet. And a lot of them are poor, so won't need anything near $1m to maintain their current consumption levels when they retire.

Try it with Canadian or US numbers. Does the total stock of all capital assets (including land and houses etc) add up to enough to equal (say) half the amount needed to provide a retirement annuity sufficient to maintain consumption through retirement? If it's insufficient, what would have to adjust to make them equal? Asset prices, presumably.

[Determinant]

Nick:

RRSP's were introduced in 1957. They were seriously reformed in 1988 when the RRSP/Pension system was integrated.

Your concept of "pensions" in this post, and other posts I have read contains a serious flaw. You assume "pension" = defined benefit pension. Those are rare in the private sector today. INCO just shut theirs down, a factory in my town closed theirs down, I've worked for large employers who didn't have them. Even the Royal Bank stopped their DB Pension plan and converted to DC.

Money-Purchase Pension Plans or Defined Contribution Pension Plans are different beasts indeed. First of all they are voluntary. You don't have to contribute at all. They only "mandatory" thing about them is that the employer will chip in a percentage if your contributions meet the minimum threshold.

They only thing that really separates them from RRSP's is that DC Pensions must conform to provincial pension legislation which usually means compulsory annuitization into a life annuity by age 80.

DC Pension Plans are also like RRSP's in offering a selection of investment choices to the contributor instead of the complete "hands off" approach of DB Pensions.

DB Pension statistics in this country are skewed because they are almost universal in the federal, municipal and provincial governments. Outside the government sector, the compulsory factor of pensions really falls away.

In short, I really think your idea of "compulsory" savings needs work.

[Nick Rowe]

Determinant: you sure about that? I've got a defined contribution plan at Carleton, and it's compulsory (once you turn 30). (Well, actually it's a hybrid plan, with a defined benefit minimum, but I don't think that affects the point.) Aside from the differences in risk of the two sorts of plans (stock and bond market risk vs company risk, if a defined benefit plan is not fully funded), they are both compulsory savings vehicles.

[RSJ]

It might be helpful to decompose "improvidence" into 2 factors. The first is the risk exposure and the second is whether those debts are priced appropriately to give realistic returns, even if there is no volatility.

For the first, you want to measure leverage, or Assets/Equity. It's a question of whether there is enough of an equity buffer to absorb the fluctuations in asset values.

In your example for firms, it's a bit tricky. These are apparently non-profits. Their stock liabilities pay zero dividends and have zero earnings. The bond liabilities pay zero interest and are not discounted. In this case the bond liabilities are exactly the same as the stock liabilities -- they are both pet rocks. The only reasonable way to value the assets would be at purchase price, which would be the liabilities of the firm, so the firm would have a leverage of 1, because equity = debt in this case. It's subjective in a zero rate model.

But for households, it's easier. If A is assets and D is debt outstanding, then leverage is A/(A-D) = 1 + D/(A-D). For the denominator, it makes no difference to pay down D and leave A fixed, or to increase A and leave D fixed. The denominator does not change, but the numerator does.

Without house borrowing, leverage is also 1. With borrowing, if households pay down D entirely as soon as possible, then the average leverage over the life of the household will be about 1.15 -- still small. If forced savings plans prevent them from paying down the house until it is sold in the year of death, then average leverage will be about 1.6 -- higher, but still nothing extreme.

Your other examples would fall between these two.

But for sustainability you want to look at Assets/Income, and specifically Firm Assets/Capital Income and Household Assets/Household Income.

Here you need to include equity as well as debt. That should be the effective rate of interest. If that rate is zero, then everything is sustainable. But for a non-zero rate, which will be the case, if there are too many Assets, then either capital income or household income must rise (causing the residual income to fall), or some of those assets will not perform. Alternately the rate of interest must fall in order to match the larger pool of assets.

And regards to leverage, you can say that either spending must increase (causing incomes to increase), or assets must be decreased, or the rate of interest must fall. To decrease spending in the hope of retiring assets wont work, since A is a stock that will decline only gradually but income is a flow that will fall immediately forcing the existing pool of assets into default. You want to decrease the assets by a balance sheet operation, such as debt cancellation or re-financing, rather than by adjusting a flow, particularly a flow that is in the denominator.

[Determinant]

No, Nick, anything "hybrid" with any sort of DB minimum is treated as a DB plan in both law and financial planning. Revenue Canada sees it as a DB plan too. Check what sort of Pension Adjustment you get.

The reason they require your participation at 30 is to make the DB portion work financially and actuarially. Otherwise it wouldn't.

If they stripped off the DB minimum and went pure DC, you'd have what I had at a former employer. That was purely voluntary, but you didn't get the employer contribution if you didn't participate. It was organized under the Pension Benefits Act and everything. We had a selection of five mutual funds to choose from provided by a large life insurance company.

DC and DB pensions are very different beasts in implementation.

There is nothing in law, finance or actuarial science that requires at DC plan to be compulsory. It is a tax-deferment vehicle with special laws attached so that you can't spend the money on anything but your retirement. Compulsory annuitization at 80 is the other key difference, though consumers and financial advisors HATE annuitization of personal accounts, including DC pensions. They're fine with DB plans though.

Yes, I'm very sure about the fact that RRSP's were introduced in 1957. It is given in several financial planning books I have and appears on the Wiki page for RRSP's.

[Frances Woolley]

Nick, I was going to write and say 'you're wrong about Germany' and then I found out you were right:
http://www.informaworld.com/smpp/content~content=a911060688~db=all~order=page

[David Pearson]

Determinant is right in the case of the U.S.. Defined benefit plans have been shrinking since the early 80's when the 401k concept was launched. 401k's are typically voluntary.

Unlike a Defined Benefit plan, a Defined Contribution plan depends heavily on high, real after-tax returns from investments to provide complete coverage of retirement needs. The low savings rate and high household leverage in the U.S. from 2000-2008 had more to do, I think, with confidence in those future real 401k returns during bubble years (as well as in future housing capital gains). One can think of U.S. households, in aggregate, as investors using margin-- borrowing on their homes to earn future cap gains.

I look at the leverage issue as a problem of post-bubble lower future expected returns. When margined investments fall in value, you get a margin call -- households are receiving that "call" now in the form of debt repayment. Creditors, in turn, can support more current consumption, but their propensity to consume is obviously much lower. What can the Fed do about this? Restore bubble-era real return expectations (good luck!); or reduce the value of the margin debt (through inflation/negative real rates).

[Determinant]

Nick, I took a look at the Carleton pension. In short, it is a DB Pension with a DC component to let people make additional contributions. The key is to look at the DB formula by itself.

The Carleton Minimum Monthly Benefit is:

Monthly Benefit = 2%*(Years of Service)*(average of top 5 earnings years)

Note: The 1.29% up to CPP Yearly Maximum Pensionable Earnings means that your pension contributions and payouts are integrated with the CPP contributions and payouts. This is standard in Canada for DB Pensions.

Compare this to the Government of Canada's Public Service Pension Plan

Monthly Benefit = 2%*(Years of Service)*(average of top 6 earnings years)

The PSPP recently moved to a 6 year average from a 5 year average.

The PSPP also does not allow Additional Voluntary Contributions.

Furthermore, your AVC or DC contributions are annuitized at 65 and paid out with the rest of your pension by Carleton. A true DC Pension pays out into a life annuity of your choice at retirement, from a life insurer of your selection, or into a Locked-In Retirement Fund or Life Income Fund, the two forms of locked-in personal vehicles for handling pension funds in Ontario.

In short Nick, you and Frances DO NOT have a DC pension. You have a Defined Benefit Pension with a generous provisions for additional personal personal contributions. It's really nice and I like it, but it's not a Defined-Contribution Pension Plan as such.

In short Nick, you have a classic

[David Pearson]

BTW, I realize "households" includes both borrowers and creditors; only in different groups, and given the level of income inequality, with much different propensities to consume. Above, I what I refer to as "margined investors" are middle class households, whereas net "margin" providers are the wealthy. In effect, the bubble era was a time when middle class households tried to access the income supplement from capital gains that historically are the province of wealthy households. The only way they could do so while increasing current consumption was through the use of leverage.

[Gregory Sokoloff]

"And to its credit, TD Economics tried to do just that.

Nick, do you have a link for that? Thanks.

Krugman has a blog post chiding Canada's rising debt to income ratio. If I understand you, his analysis would benefit from subtracting all pension savings, including CPP and Social Security, from debt to get a normalized ratio for comparing the US and Canada.

Another question: how does homeowner equity enter this picture? E.g. person X has a mortgage that is twice her income, but only 20% of the value of the house. Is she improvident? And by the way, this can easily happen in a place like Germany where the key to home ownership is inheritance! Is the debt to income ratio important in and of itself?

[Determinant]

David:

Canada has followed the US's lead in the reduction of private-sector DB Pension coverage. As always there is no exact equivalent of a 401(k) here, but the concept is covered through the use of true Defined Contribution Pension Plans (regulated under provincial Pension Benefits Acts and as DC Plans by the Canada Revenue Agency) or Group RRSP's.

For an employee, DC plans feature forfeiture of employer contributions before the vesting period is over and lock-in after vesting, which means if the employee leaves the pension funds must be discharged into a lock-in retirement investment fund regulated under the provincial Pension Benefits Act.

Group RRSP's feature voluntary participation, employer contributions (in excess of straight pay) and compulsory use of group-selected investment vehicles. However they are not regulated under provincial Pension Benefits Acts and are not subject to lock-in provisions. They also have no forfeiture provisions, or stated another way immediate vesting of contributions.

One of the weird advantages of DC plans is that their forfeiture provisions let employers reduce their own costs if they have relatively short-term employees while still offering a "pension plan".

The RRSP up here fills the role both of a 401(k) at small companies and a traditional IRA in the States. The RRSP is similar in structure to a Traditional IRA but the contribution limit is 18% of income up to $21,000, rather than 100% of income up to $5,000 for an IRA.

[Gregory Sokoloff]

Nick, sorry for the question--I see the link now at the top.

[Nick Rowe]

RSJ: I would split improvidence into two factors, but different from your two: making provision for a rainy day you know is coming; and making provision for a rainy day that might come. In my simple model, with no risk, "improvidence" simply means not saving enough for the future. So it can't handle the risk associated with leverage, for example.

David, Gregory, Determinant: I made too sharp a distinction between "compulsory" and "voluntary" saving. Anything that makes it advantageous to save in some way other than paying down your mortgage would have the same consequences in my model as a compulsory saving plan. RSP contributions are voluntary, for example, but if you will be in a lower marginal tax rate bracket when you retire it may (but won't necessarily) be more advantageous to save in an RSP rather than pay down your mortgage. And if you lose your employer's contribution by not joining a defined contribution plan, it's effectively compulsory, because you wouldn't want to pay down your mortgage as a savings vehicle. Though paying down your mortgage will always dominate a TSFA, I think, given the spread between borrowing and lending rates.

It has to be different in the US, where you can deduct some mortgage interest against income tax. I think that would make any tax-free savings vehicle more advantageous than paying down a mortgage, unless the borrowing-lending spread is very large.

Gregory: "Krugman has a blog post chiding Canada's rising debt to income ratio. If I understand you, his analysis would benefit from subtracting all pension savings, including CPP and Social Security, from debt to get a normalized ratio for comparing the US and Canada."

Basically yes. What matters is a person's total net wealth: total assets minus total liabilities. Except, when there's risk, leverage matters too. The TD charts show debt rising along with assets. The problem is not that Canadians aren't saving (though you can't distinguish there between savings in the National income Accounting sense from savings inclusive of capital gains). But there may (or may not) be a problem of leverage.

[The Money Demand Blog (123)]

Nick, Bill, I will accuse you of anti-long term interest rate bias, of anti-private sector interest rate bias, and other relatied biases here:
"How can we combat the argument--people are "overleveraged" and until they pay down their debts, the economy will only grow slowly and unemployment will remain high?"

Let's start with a little bit of Wicksellian magic here. The cost of bank capital is an interest rate. In fact, it is one of the most important interest rates out there. There is a cost of bank capital that is compatible with the monetary equilibrium, and then there is the actual cost of bank capital. Usually these two are equal, and the economy is in the monetary equilibrium.

But sometimes a new shock arrives that causes these two interest rates to diverge. After Bernanke's monetary shock market cost of bank capital is much higher than previously, and the cost of bank capital that is compatible with the monetary equilibrium is much lower than previously, and the optimal level of private sector debt is much lower than previously - i.e. private sector is overleveraged.

What if the gap between these two interest rates is so huge that any politically plausible monetary or fiscal interventions can do very little to close the gap? What if the gap between these two interest rates is so huge that our only hope is massive helicopter drops that allow the private sector to pay down their debts?

Until people pay down their down their debts and economy returns to the normal leverage, economy will remain in the monetary disequilibrium and the economy will only grow slowly. Or alternatively, we could use technological improvements such as new version of iPad (as suggested by Tyler Cowen), or price level targeting (as suggested by Dave Altig) that increase the optimal level of leverage, and the economy will grow a bit faster.

[The Money Demand Blog (123)]

And my above argument explains why Greenspan was a much better chief of the Fed than Bernanke. Greenspan has always monitored the developments in the cost of bank capital, and he always made sure that the market cost of bank capital is equal to the rate that is more or less consistent with the monetary equilibrium, look at his actions during the 1987 crash.

[Nick Rowe]

TMDB: I plead guilty! Lovely comment. If I were running your blog I would link to it!

But I was with you right up to this point: "...and the optimal level of private sector debt is much lower than previously - i.e. private sector is overleveraged.", where you lost me. What caused the optimal level of private leverage to fall? And how is that related to the interest rate on bank capital?

[Ian Lee]

Nick,

Your analysis of this very important issue was excellent.

Last spring, I testified before the House of Commons Finance Standing Committee, arguing that we do not have a pension crisis in Canada because:

1. per OECD 2009 Pensions at a Glance 280 page report (http://www.oecd-ilibrary.org/docserver/download/fulltext/8109081e.pdf?expires=1287928646&id=0000&accname=guest&checksum=4A2E266091A1C8B2D2520253A5785547), Canada's elders are the 4th wealthiest in the world in terms of income

2. approximately 67% of Canadians own their homes and Canadians understand deeply - while pension advocates do not - that the home is the largest single source of savings for retirement (explaining why Canadians "under save" for pensions (we are told repeatedly by pension advocates) and "overinvest" in housing) - as many Canadians downsize upon retirement by selling the larger home to move to a smaller condo in the same city OR sell in a higher cost city e.g. Ottawa to move to and buy in a lower cost city e.g. Kingston.

In other words, I was arguing there is a very strong relationship between home ownership, debt and pensions. Thus, those scholars and e.g. CLC arguing for a Big P CPP, that would replace all existing private and public pensions - costing approximately 15% per month payroll deductions according to Jack Mintz at U Calgary - are unaware of the devastating unintended consequences and the havoc this would place on home ownership and household indebtedness.

In other words, driving up payroll deductions from roughly 5% to 15% (and for those 8 million without a pension mostly in SMEs in the private sector, the increase would be a pure 15%) would have an enormous negative impact on the ability to service mortgage debt.

Your analysis demonstrates this rigorously while my arguments were based on logic and observation without data (from my time as a bank lender of mortgage funding).

I will pass your name on to the Chair of the House Finance Standing Committee - James Rajotte (Calgary) - as your analysis is most useful, timely and empirically illuminating.

Ian

[The Money Demand Blog (123)]

Nick, thanks.
Try again.
When the required return on bank capital is high, financial intermediation services are expensive, final lenders and borrowers desire to have lower leverage.
When the required return on bank captial is low, financial intermediation services are cheap, final lenders and borrowers desire to have high leverage.

Before September 2008, we had Great Moderation, with low required return on bank capital and high equilibrium level of leverage.
Now that we all know that the greatest scholar of Great Depression could not prevent another one, and our collective tastes have changed - the required return on bank capital is higher, and we all desire deleveraging.
On the other hand, the cost of bank capital that is compatible with the monetary equilibrium is lower than before, and the level of leverage that is compatible with the monetary equilibrium is higher than before. If we could collectively increase our leverage, we could return to the monetary equilibrium, but we can't.

[Ian Lee]

Nick,

From above:

"And to its credit, TD Economics tried to do just that. Nick, do you have a link for that? Thanks.

Krugman has a blog post chiding Canada's rising debt to income ratio. If I understand you, his analysis would benefit from subtracting all pension savings, including CPP and Social Security, from debt to get a normalized ratio for comparing the US and Canada.

Another question: how does homeowner equity enter this picture? E.g. person X has a mortgage that is twice her income, but only 20% of the value of the house. Is she improvident? And by the way, this can easily happen in a place like Germany where the key to home ownership is inheritance! Is the debt to income ratio important in and of itself?
*******************************************

I would like to inject some useful information to this very important debate dealing with ``improvident`` or ``imprudent`` choices concerning household indebtedness and savings or alleged lack thereof.

In approving mortgage applicants, each Canadian bank uses two very important credit metrics: the Total Debt Service Ratio (TDSR) and the Gross Debt Service Ratio (GDSR) for conventional and high ratio mortgages (i.e. CMHC accepts and requires the application of these two metrics for all high ratio or insured mortgages).

To be approved for a mortgage, the monthly mortgage (PIT) payment can NOT exceed the maximum (32%) GDSR of gross monthly salary.

TDSR is the GDSR PLUS all other debt payments e.g. credit cards, lease payments, alimony, child support, as a percentage of gross monthly - and it may NOT exceed 40% of gross monthly income.

Banks (and CMHC) require written confirmation of income from the employer.

Why these metrics? Every bank records defined critical variables of each loan that is charged off to bad debt e.g. gender, age, years of employment, income, credit rating etc. etc. – to develop a statistical bad profile (which BTW is a young male under 25 with less than 2 years on the job). Over time, these metrics were shown empirically to be the cutting points between significantly increased risk of delinquency.

EVERY Canadian bank follows these standards. Every Canadian bank branch is audited at least once every 24 months by the Bank Internal Audit team (who are ruthless and widely concerned to be robotic aliens devoid of any emotion). And, I understand that OSFI randomly audits these internal bank audits.

In addition to the income metrics standards, there is a down payment requirement (embedded in the Bank Act!) of a minimum of 20% (was 25% until mid 90s) - unless insured by CMHC or private mortgage insurance firm and then only 5% down payment is required.

The 40% TDSR and 32% GDSR requirements have been supported and followed consistently since at least the early 1970s until the present - without variation - as has the down payment requirement (unlike US banks).

Thus, absent loss of employment or some similar calamity, no mortgage borrower is over leveraged - by definition in Canada. This is confirmed empirically by the annual mortgage delinquency ratio in Canada - which must be reported annually to BoC and OSFI - and is always and forever below 1% (I believe it is now below .5% after a protracted recession - compare this to the US where 1 in 4 mortgages are delinquent).

Now, let us turn to the ``grave concern`` expressed over Canadian household indebtedness. What analysts ignore is that household indebtedness is offset by household assets – currently just over $6 Trillion – including real estate values – which is 4 TIMES as much as current household debt of $1.5 Trillion. In other words, Canadians are “covered” i.e. coverage ratio of 4:1. If any homeowner gets into a debt jam due to e.g. loss of job, the ultimate exit strategy or `takeout strategy` is to sell the home and liquidate indebtedness (as some Canadians in fact do).

Please see BMO Douglas Porter’s very nice analysis at: http://www.bmonesbittburns.com/economics/focus/20101008/feature.pdf

Finally, it should be noted that the allegedly inadequate national savings rate in Canada excludes unrealized capital gains – including real estate – which was my point in the post above re pensions. (and to those critics who respond with “what about the 33% of Canadians that do not own a home and likely have no pension”, the answer is OAS and GIS – that will not be clawed back due to low income and thus they are looked after – which is why our elders are the 4th wealthiest in the world).

Canadians are NOT over leveraged or profligate concerning indebtedness and we do not “under save” – when unrealized capital gains are taken into account. Indeed, Canadians have the highest percentage of home ownership in the world – which provides eventual additional savings to supplement our formal pension plans.

Moreover, we have very rigorous credit underwriting standards w.r.t income metrics and equity metrics - that are ruthlessly enforced by the banks with OSFI, BoC and Finance `looking over their shoulders`.

Ian

[Jim Rootham]

Does this model survive fractional reserve banking? Is not debt the sum of direct debt, people buying bonds, which you do model and indirect debt, people depositing money in banks which lend a multiple of that money, which you do not model?

[Nick Rowe]

Ian: thanks! Remember though, I made up all my numbers, and it's just a back of the envelope calculation to try to get a handle on some of the conceptual issues, and to get an estimate in the general ballpark for what debt/income ratios should be. You've got real numbers.

TMDB: "When the required return on bank capital is high, financial intermediation services are expensive, final lenders and borrowers desire to have lower leverage."

Got it! Much clearer now. I would call this a shift in the supply curve of financial intermediation, and hence a movement along the demand curve, rather than a change of tastes. But, quibbles aside, that makes an awful lot of sense. It explains a lot.

Ian: If people were improvident, compulsory pension plans make sense. If people are provident, compulsory pension plans may make leverage and hence risk worse. Since there are some of each, it's presumably a trade-off. But yes, it would be good if policymakers recognised this undesirable side-effect of compulsory pensions.

I worry a bit about older people having all their eggs in the housing basket though. It's not a problem for young people, since we are all born with a short position in housing (we need somewhere to live for the next 60 years, and want to hedge against future rents), so buying a house is a way to educe risk. But for older people, who plan to sell or downsize or reverse mortgage to spend their housing assets on other consumption goods, house price variance creates more of a risk.

Same with the capital gains on housing. If it's just inflation, or reflects increasing fundamental value due to rising building costs, increasing central land scarcity, or permanently lower real interest rates, no problem. But otherwise it could be a bit risky.

And, if all the boomers try to sell at the same time, that's a problem. But that's a problem for any asset in any pension plan, not just houses. The only safe investment is to stockpile all the things the boomers will need in retirement: food, drink, drugs, zimmer frames, whatever.

Jim: my model has no financial intermediaries. It's fairly easy to see what would happen, in broad outline, if you introduced them. Take my first simple example, where people own no assets directly, and lend all their savings directly to firms by buying corporate debt. Now assume all those savings get intermediated once. The total debt/GDP ratio would double from 1,000% to 2,000%, because for every $1 of corporate debt to banks, there will be $1 of bank debt to people.

[Gregory Sokoloff]

Ian, thanks for that very helpful comment. With such a high coverage ratio, can you imagine any plausible scenario in Canada where deleveraging would lead to the kind of systematic collapse we have seen in the US housing market?

[The Money Demand Blog (123)]

"I would call this a shift in the supply curve of financial intermediation, and hence a movement along the demand curve, rather than a change of tastes."
Yes, shift in the supply curve of financial intermediation is what I had in mind. Changed perceptions about Bernanke are very important in our role as bank shareholders, they have permanently shifted the supply curve (hence New Normal instead of Great Moderation), and price level targeting is an attepmt to shift it back. New versions of iPads shift the demand curve, but we need an iHouse if we want to solve our problem by moving the demand curve of financial intermediation.

[Gregory Sokoloff]

Ian: you say that "Indeed, Canadians have the highest percentage of home ownership in the world – which provides eventual additional savings to supplement our formal pension plans." What is your source for this statistic? Other sources I could find without a lot of work would seem to show a far different story. E.g. recent testimony before the U.S. congress places Canada at 14th. Of course, this quibble does not necessarily impair your overall argument.

[The Money Demand Blog (123)]

Nick, Robert Waldmann has got almost the same idea:
"I will have a Wicksellian type story such that no form of QE works. Consumers have decided that they have to deleverage. ... QE can't eliminate indebtedness. ... If consumers are just as worried about owing money to the Fed as to a private agent, then the Fed can only satiate their desire to deleverage by giving them money. ... The Fed can't do that without specific permission from congress -- money can be disbursed only as appropriated by Congress. The Fed can do pretty much whatever it wants with its balance sheet so long as it balances. ... Now QE2 what the hell, it's worth a try. Better to light one small candle than to curse against the filibuster."

http://delong.typepad.com/sdj/2010/10/why-quantitative-easing-needs-to-involve-securities-other-than-government-securities.html#comment-6a00e551f0800388340134886ae423970c

[Determinant]

With respect to debt and retirement savings, consider the classic formulation of the Canadian retirement system and mortgage payments.

The retirement system consists of three "pillars":

1) CPP, a compulsory income deduction through the tax system and a DB payout on retirement.

For American readers, low-income support for seniors is handled by Old-Age Security/Guaranteed Income Supplement in Canada which is paid out of current general government revenue, not a dedicated tax.

2) Work-based retirement plans, ranging from Defined-Benefit plans to DC plans to Group RRSP's.

Assume that all workers pay this while working.

3) Voluntary personal RRSP's.

DB Pensions usually aim to provide 2/3 replacement of pre-retirement income. The balance is left to RRSP's.

Since mortgages aren't tax-deductible, they represent a high and guaranteed return on assets relative to RRSP's. Under the "classic" formulation, CPP plus private traditional DB pension deductions are adequate retirement planning for most young and middle-aged workers. With these arrangements, it is entirely reasonable to save as much as you can for a mortgage and then pay it off as quickly as you can. Since RRSP room ks cumulative over a person's earning lifetime, once the mortgage is paid off the free funds can be diverted into an RRSP, bringing the "third leg" up to standard.

However most private employers don't offer DB plans. Many existing private DB plans are closed to new members. Many DC plans are far short of being adequate compared to DB plans. Therefore a young or middle-aged employee must choose between saving for retirement or paying down a mortgage. If you choose to pay down the mortgage, you take the risk that you are forfeiting investment time and returns and your income in middle age or late working years will be adequate to make up the difference. In this case it can be less risky overall to pay down a mortgage AND invest in an RRSP at the same time, if the employer leg of the triad is not adequate.

[Ian Lee]

Gregory,

I recall that I read this source in a paper published last year by the Hudson Institute concerning the subprime crisis.
On the assumption that residential real estate is capital intensive (hence much more skewed debt to equity ratios for real estate developers in each country that I examined), suggests that countries with the most "friendly" banking systems for consumer mortgage borrowing, will have the highest home ownership ratios, as home ownership implies a mortgage framework that faciltates borrowing.
Mass consumer credit was "invented" in the US in the Depression - not by banks - but by consumer loan companies i.e. Household Finance Corporation.
BTW, Canadian Banks were prohibited from making consumer loans or residential mortgages prior to the 1967 Bank Act revisions.
Thus, it seemed logical that Canada and the US would have the highest levels of home ownership - as mass consumer credit evolved earlier in these two countries than anywhere else.
However, I will investigate.

[Ian Lee]

Nick,

Re your concern for older people with all their eggs in one basket, I do not have empirical data. But I have loads of anecdotal data of older people - my parents and now my colleagues and friends living for years in one home.

Between the minimum down payment required under mortgage rules and sitting on the asset for 20 or 25 years, ensures very substantial equity when one finally cash out. So even if there is a downturn at the time that the 60 or 65 year old person cashes out, these people are sitting on $300 K or $400 K or $500 K of equity.

Concerning your query re deleveraging and systematic collapse in Canada,the mess in the US - I argue - was caused i.e. CAUSED, by the US Congress in watering down the credit unbderwriting standards for mortgages allowing zero down payment, 40 year am, no documentation mortgages - due to the American festish for home ownership by Dems and Republicans.

So long as Canada maintains its credit standards and hopefully reinstates a 10% down payment minimum for home purchase, we need only worry about a relatively dramatic increase in mortgage rates.

This can happen, In 1980, I wasa a 25 year Mortgage Manager at BMO Ottawa Main when a person called Paul Volker was appointed by Pres Carter to Gov of the Federal Reserve. In about 1 year, the prime rate went through the roof and the mortgage 5 year rate when from 10.5% to 18%.

Thousands of middle class Canadians whose mortgage came up for renewal, could not afford the enormous increase in mortgage payments - and elected to sell their house to avoid foreclosure. (and I decided to return to grad school because I decided I was not willing to continue to threaten hard working middle class Canadians with foreclosure).

The BoC announced recently it stress tested Canadian mortgages and if I recall, Carney said a 3% increase in mortgage interest rate increase, would place 10% of Canadian mortgages at "risk".

However, a meltdown is unlikely, as almost 500,000 immigrants intake annually ensures a steady increase in demand for Canadian housing stock.

If mortgage rates increase dramatically in a short period of time, we could see a rerun of 1980-81 where the number of homeowners decrease, as marginal borrowers cash out.

And while home values may become stagnant or sticky for several years or even regional declines in realty values, I think it is unlikely for the reasons above, that the meltdown of 25% to 40% declines in the US, will happen here.

Ian

[Determinant]

Ian:

Most mortgage lending before 1967 was done by Trust Companies (then a large and viable sector in its own right) and Life Insurance Companies. Both had been in the mortgage market since the advent of CMHC in 1945.

[Too Much Fed]

Doing in a hurry. Will probably need to edit.

"Forget about kids. We don't count kids. Everybody is born at age 20, works for 40 years earning $150 per year, then retires for 20 years, then dies aged 80. So average adult earnings are $100 per year over the 60 year adult lifespan. Nothing ever changes in this economy. Every cohort is exactly the same size, and there is zero growth in income. Every individual is perfectly provident, and saves $50 per year while working, and so is able to consume a constant $100 per year both while working and in retirement. With zero time preference, and zero growth in income or population, the rate of interest is also zero.

Each person's stock of savings starts at zero, grows at $50 per year to a maximum of $2,000 at age 60, then declines at $100 per year until they die with zero. That means the average stock of savings is $1,000 per person. That is 10 times average income per person.

Suppose that all those savings are lent to firms, which therefore own all the real assets in this economy. And suppose the savings are lent in the form of debt, rather than equity."

Make the firms all equity and no debt. Everyone owns the same amount. The firms all break even. No savings by the firms. "Stock price" value is zero.

It appears the model shows zero price inflation. I assume income means national income. The people can now all save in the medium of exchange. It can be all currency and no debt.

[Brian_Dell]

- James Rajotte represents an Edmonton riding, not Calgary
- the value of this analysis is limited because it doesn't distinguish domestic lending from foreign lending. As a planet, Earth cannot easily go bankrupt because all the debt is owed to other Earthlings. But that doesn't mean certain countries cannot have a debt problem. And in the case of North America, we have a far higher propensity to consume than, say, the Chinese. Not coincidentally, China is a net creditor, not a net debtor.
- From a scenario where the average household has net saving of $1000 and no household has any debt we get "the total debt/GDP ratio in this economy would be 1,000%." I'd like to see a little more explanation of this jump. Characterizing it as "debt" can be misleading unless "debt" is clearly explained. Because everyone's $1000 has been lent to firms, it has presumptively been used to purchase property, plant, and equipment. From an economy-wide perspective, it is an economy with a high propensity to invest. If the point is that a "debt ratio" is generally meaningless, fine, but it should be explained why, in my view, and the reason why is because it is just a rough proxy for the more important metric of marginal propensity to consume