It is when the tide recedes that we see those bathing naked.
This comical quote from the famous American investor Warren Buffett makes sense in light of the collapse of Silicon Valley Bank in the United States and Credit Suisse in Europe in recent days.
This is a first warning of the brutal effect that a sudden rise in interest rates, such as the one that burst the tech bubble in 2000 and triggered the credit crisis in 2008, can have.
Now we have to pull out the lifelines again to rescue the banks that took too many risks during the pandemic, when borrowing cost nothing and everyone was swimming in money.
But we are not at the end of our troubles, because we are “celebrating” the first anniversary of the start of the tightening of interest rates, which generally takes 12 to 18 months to take effect.
So who will be the next to drink the cup?
Rest assured, Canadian banks have solid foundations. We can tip our hats to our regulators, in particular the Office of the Superintendent of Financial Institutions, which has always kept their reins tight. This is what allowed Canada to get through the 2008 crisis with fewer scratches than other countries.
But that doesn’t mean we’re safe. Canada has its vulnerabilities. Just take a look at mortgages.
Go for it ! This was the watchword of the Governor of the Bank of Canada, at the start of the pandemic, who sent an unequivocal signal by asserting that interest rates would remain low for a very long time. Error !
Canadians listened to him. How to blame them?
They bought homes, many opting for variable rate mortgages. They didn’t see the danger, especially since three-quarters of these mortgages have fixed payments. This ensures that the monthly payment does not move when the rates go up. There is simply a larger portion of the refund that is used to pay the interest, rather than to repay the principal.
But when interest rates rise too high, there comes a point where the monthly payment is no longer enough to cover the interest. Today, 73% of those mortgages have reached breaking point, according to a Bank of Canada assessment.
Result ?
Some lenders force their customers to increase their payment, which they did not expect. Other banks allow “negative amortization” which increases the balance from month to month and stretches the period needed to repay the loan.
In other words, we shovel forward. But watch out for the next renewal! It should come as no surprise to see monthly payments jump from $1,500 to $2,500.
That won’t be easy to swallow for households watching payments soar, as home values have fallen by a historic 11% in Canada since peaking in May 2022, according to the Teranet-National Bank Index.
For now, households are holding out. They continue to spend thanks to the savings cushion accumulated during the pandemic. By the end of 2022, Canadians still had $350 billion more in savings than before COVID-19, according to the BDC.
But above all, households are holding on because they have a job. The unemployment rate is very close to a historic low, due to the labor shortage which will be very difficult to reverse given the demographics.
In this context, central banks will find it difficult to break the inflationary spiral that has gripped wages and is keeping inflation high, at 5.9%.
To bring inflation back to the 2% target, central banks may have to keep interest rates high longer than expected, which is no better.
In short, we are stuck between two fires: inflation and interest rates.
Will all this inevitably end in a recession? Soft or deep? Economists insist on this. But meanwhile, inequalities are growing.
Rising interest rates are particularly hurting young people, while real estate has never been so inaccessible for a generation. And the rise in the cost of living is hitting the less fortunate the hardest, who cannot cut the fat.
These widening gaps can lead us to a more deleterious social climate, if we are not careful.
More than ever, the watchword must be: caution. For the governments that will be tabling their budgets over the next two weeks, in Quebec City and Ottawa. But also for companies and households.
Now is not the time to take risks.
Already, insolvency cases jumped 33% among consumers and 55% among businesses in January in Canada. Over the next few months, we will discover those who swim naked.