Canada’s economy is shrinking, housing crisis and negative amortization add strain

Canada’s economy experienced an unexpected shinkage in the second quarter, with an annualized rate of -0.2%. According to Statistics Canada, the slowdown in the quarter can be attributed primarily to declines in housing investment, reduced inventory accumulation, and household spending.

Meanwhile, the second-quarter figure is significantly below the Bank of Canada’s (BoC) projection for a 1.5% annualized GDP growth and the 1.2% gain anticipated by analysts. 

Canada banks grapple with negative amortization

Approximately 20% of outstanding mortgages at major Canadian banks, including Bank of Montreal (BMO), Toronto-Dominion Bank (TD), and Canadian Imperial Bank of Commerce (CIBC), are experiencing negative amortization, amounting to around $130 billion. That means that the monthly payments made by homeowners are no longer sufficient to cover the interest expenses, resulting in an increasing debt amount over time.

This situation is typically observed with variable-rate mortgages that have fixed payments, especially in environments where interest rates are rapidly rising. In such cases, homeowners might face the risk of foreclosure in the coming months.

A substantial interest rate hike, such as the Bank of Canada’s increase from 0.25% to 5% in less than two years, can lead to fixed payments not covering any of the loan balance and, in some cases, not even the full monthly interest owed. The unpaid interest is then added to the principal, causing the loan size to grow to a certain limit.

When these borrowers renew their loans, they must follow their original amortization schedule unless they opt to refinance and secure a new mortgage. This becomes challenging during renewal for many borrowers as they are exposed to higher payments. Hence, some borrowers with negative amortization are taking proactive steps, such as increasing monthly payments or switching to a fixed-rate mortgage.

The banks have emphasized that they are actively working with borrowers approaching the point where larger monthly payments are required. This effort is reflected in the gradual decrease in the percentage of borrowers with amortizations exceeding 30 years, observed from the first quarter ending in January to the third quarter ending in July.

Is there a solution to the housing crisis? 

Canada is clearly grappling with a pressing affordable housing crisis. Finance Minister Chrystia Freeland recently stated that it will take years to address the issue even if construction reaches levels not seen in 80 years. Notably, housing is primarily the responsibility of provinces and major municipalities, with the federal government providing policy advice and financial incentives.

Freeland emphasized the need for a collaborative effort involving all stakeholders, including the federal government, provinces, cities, private sector, and non-profit organizations. She stressed that this endeavor would be a long-term commitment, requiring sustained effort over several years.

Meanwhile, the government has announced measures to stimulate the Canada housing supply, such as removing the federal 5% consumption tax on constructing new rental apartment buildings. Additionally, cities are urged to take more proactive steps to tackle the housing challenge.

The housing crisis is exacerbated by the emergence of negative amortization in variable-rate mortgages due to rapidly rising interest rates. That has led to ballooning debts and the potential for foreclosures as homeowners find themselves underwater. The housing market is also experiencing a correction, with the consequences of earlier reckless lending practices becoming apparent. This shift marks a significant departure from the central bank-driven boom, now giving way to a period of adjustment.