This paper assesses the impact of high household debt on economic volatility in Canada. The debt per se may not necessarily be a risk for economic activity; it can amplify other shocks as well. A few studies have emphasized the link between the growth of household debt before 2007 and the severity of the Great Recession. Economies with debt tend to experience more severe housing busts and recessions. If household debt ratios are not stabilized, the vulnerability of the Canadian economy is likely to be high.

Abstract

This paper assesses the impact of high household debt on economic volatility in Canada. The debt per se may not necessarily be a risk for economic activity; it can amplify other shocks as well. A few studies have emphasized the link between the growth of household debt before 2007 and the severity of the Great Recession. Economies with debt tend to experience more severe housing busts and recessions. If household debt ratios are not stabilized, the vulnerability of the Canadian economy is likely to be high.

III. Recent Experience with Macro-Prudential Tools in Canada: Effectiveness and Options Moving Forward1

A. Introduction

1. Canada’s household debt as a share of disposable income has surged over the last decade. Since 2000, household debt has increased by about 60 percentage points, reaching a record high 163 percent of disposable income in mid-2012 a relatively high figure compared to other economies. To a large extent, this increase reflects robust growth in mortgages and home equity credit lines (HELOCs). Mortgage credit expanded on average by 8¾ percent yearly since 2000, outpacing the growth rate of disposable income (4½ percent) and supporting a significant increase in home-ownership rates. Consumer credit expanded at a similarly fast pace (mainly due to HELOCs), but slowed significantly after 2010. Mortgages and consumer loans secured by real estate (mostly HELOCs) are estimated to account for 80 percent of household debt and represent the single largest exposure for Canadian banks (about 35 percent of their assets).

2. Falling interest rates, surging house prices, and financial innovations were key factors behind the credit surge. Average 5-year mortgage rates fell from 8¼ percent in 2000 to 4¼ percent at present. With house prices almost doubling over the last ten years real estate assets now accounts for 40 percent of overall household assets, up from about 30 percent in 2000. Still, household leverage (debt over assets) has increased to a record high 20 percent, up by 5 percentage points from 2000, and is relatively high compared to other economies.2 Financial innovations also played a role in the expansion of housing credit, including with respect to government-backed insured mortgages.3

3. The Canadian authorities have taken several macro-prudential measures since 2008 to support the long-term stability of the housing and mortgage markets and prevent excessive household leverage. While the financial sector is partially protected by government-backed mortgage insurance, a sudden sharp fall in housing prices could cause financial distress among households and have a material impact on the economy (Selected Issues, Chapter I). The authorities tried to cool the housing market and contain household leverage through a series of macro-prudential measures that unwound many of the measures taken in the early 2000s to support the mortgage market. Since 2008, there have been four rounds of tightening regulations on government-backed insured mortgage loans. Moreover, these measures were accompanied by a strengthening of lending mortgage underwriting standards and enhancement to the oversight of CMHC (the major provider of mortgage insurance).

4. This paper assesses the effectiveness of these measures and looks at possible lessons from the international experience on macro-prudential policy. We assess whether the macro-prudential measures adopted in Canada since 2008 have been effective, by trying to isolate their impact from that of other variables that have a bearing on the housing market and mortgage credit. While household debt to income ratio continued to increase in 2012, house prices and mortgage credit growth have moderated at a national level since 2011, partly in response to the tighter conditions set by the Canadian authorities. Household leverage would be even higher if the authorities did not take action. International experience on macro-prudential measures confirms that they may be effective in curbing credit and house price growth, especially if taken in the context of higher interest rates. A lesson from this evidence is that reducing caps on the maximum loan to value (LTV) ratios may be one of the most effective instruments to reduce household leverage.

B. The Effectiveness of Recent Macro-Prudential Measures in Canada

Overview of the measures and its objectives

5. Mortgage lending conditions relating to the provision of government-backed mortgage insurance were relaxed in the mid-2000s. Financial innovation, on the part of mortgage insurers and lenders, ensured easy access to mortgage market and helped boost the housing sector. Measures included (Table 1): (i) broadening the eligible sources of funds for the minimum down payment; (ii) increasing the maximum LTV ratio that triggers mandatory insurance to 80 percent, and the maximum LTV ratio for any new government-backed insured loans to 100 percent; (iii) increasing the maximum amortization period from 25 to 40 years; and (iv) providing insurance on interest-only mortgages and on mortgages to self-employed. Together with sharply lower interest rates, these measures made mortgages more affordable, supporting the boom in mortgage credit and increasing home-ownership rates. In turn, higher house prices were one of the factors that led to a sharp expansion of home equity credit lines.

Table 1.

Mortgage Insurance Products Until 2008

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Sources: CMHC, Genworth.

6. As house prices and mortgage credit surged, the focus changed towards ensuring a more sustainable expansion of the housing market and containing households growing imbalances. Since 2008, the federal government has undertaken four rounds of measures to tighten mortgage insurance, going beyond a reversal of the loosening in the mid-2000s (Table 2). Key measures included: reducing the maximum amortization periods to 25 years; imposing a 5 percent minimum down payment; introducing a maximum total debt service ratio of 44 percent; tightening LTV ratios on refinancing loans and on loans to purchase properties not occupied by the owner; and withdrawing government insurance backing on lines of credit secured by homes, including non-amortizing HELOCs.

Table 2.

Tightening Mortgage Insurance Regulations Since 2008

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Sources: CMHC, Genworth.

7. The latest round of measures (July 2012) was also accompanied by new prudential rules (that became effective only in late 2012) and efforts to strengthen the oversight of the mortgage insurance industry (Table 3).

Table 3.

Microprudential Measures in Canada

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Sources: Department of Finance Canada, OSFI.
  • Building on the FSB Principles for Sound Residential Mortgage Underwriting Practices and OSFI’s review of mortgage lending practices in Canada, OSFI issued a Guideline for Residential Mortgage Underwriting Practices and Procedures in June 2012. The OSFI Guideline applies to all federally-regulated financial institutions engaged in residential mortgage underwriting and or the acquisition of residential mortgage loan assets in Canada. The Guideline outlines requirements under the following five principles: comprehensive board-approved residential mortgage underwriting policy (for example, self-employed stated income mortgages, without some verification of income, and cash-back down payments were disallowed); due diligence to record and assess borrower’s identity, background, and willingness to service debts; adequate assessment of borrower’s capacity to service debt obligations (reduce the maximum LTV ratio on HELOCs); sound collateral management and appraisal processes; and effective credit and counterparty risk management that supports mortgage underwriting and asset management, including mortgage insurance; and4

  • Additional measures were introduced to strengthen the oversight of the mortgage insurance industry. The Protection of Residential Mortgage or Hypothecary Insurance Act (PRMHIA) was enacted, which formalizes the rules for government-backed mortgage insurance and other existing arrangements with private mortgage insurers. The authorities also introduced legislation to enhance the governance and oversight framework for CMHC, by mandating OSFI to examine CMHC’s insurance and securitization businesses.5 In addition, new legislation was announced that provides a robust framework for the issuance of covered bonds (e.g., high standards on disclosure) while at the same time prohibiting the use of government-backed insured mortgages as covered bond collateral. The later measure will likely make covered bonds a relatively more expensive source of funding for home loans.

How effective were the macro-prudential measures?

8. Prima facie evidence provides mixed results on the effectiveness of the measures adopted in 2008, 2010, and 2011 (Figure 1). Mortgage credit growth and house price growth fell considerably following the 2008 measures, but this largely reflects the impact of the international crisis as the housing market rebounded strongly a few months later, in line with Canada’s fast recovery from the recession. House prices and mortgage credit growth decelerated following the policy changes adopted in 2010, but again most of the decrease was short lived. The 2011 measures seem to have contributed to the slowdown in house prices and residential investment. Nevertheless, household credit continued to grow at a stronger pace than household disposable income. The authorities implemented a new tightening round in July 2012, with the latest data suggesting mortgage credit is slowing and house prices continue to moderate.

Figure 1.
Figure 1.

Impact of First Three Rounds of Tightening of Macro-Prudential Measures

Citation: IMF Staff Country Reports 2013, 041; 10.5089/9781475587050.002.A003

Sources: Haver Analytics, Canadian Mortgage and Housing Corporation, and Statistics Canada.

9. But a proper assessment of the effectiveness of these measures requires controlling for the context in which they were taken. Other factors may have been at play at the same time, diluting the effects of the measures on the housing market and household leverage. Moreover, while the measures may not have led to an observable significant slowdown in house prices and credit, they may have been successful in preventing an even stronger increase. In order to control for other factors and have a better assessment of the effectiveness of the macro prudential measures, we estimate the equation:

Yt = α + βXt + γDit + εt

where Yt is mortgage credit or house price growth; Xt is a matrix of control variables (both current and lagged); and Dit is a dummy variable equal to 1 in the months following the implementation of a set of measure i where i represents a specific set of measures (2008, 2010, 2011 and 2012) and zero otherwise (in the mortgage equation). To isolate the effects of individual rounds of measures, each dummy variable takes a value of 1 until the end of the sample. In other words, the effect of subsequent measures is estimated taking into account the existence of previous measures.6 The mortgage credit equation includes the unemployment rate and hourly wage growth, 5-year mortgage interest rate, and house prices.7 In the house price equation we include the number of completed houses, mortgage credit growth, GDP growth, and sales of existing houses.8 We assess the impact of the first three rounds of measures using the entire sample, but also test the impact over 1, 3, 6, and 9 months after they were introduced, and for the whole period between rounds.9 In some specifications, the dummy variable is replaced with changes in a specific instrument (e.g., maximum LTV ratio). We also assess the impact of the fourth round of measures, although with a still very limited sample.

10. The results suggest that the measures introduced helped limit the increase in household leverage.

  • The first round of measures does not appear to have had an impact on mortgage credit growth. The estimated coefficients for the 2008 measures are not statistically significant across the different specifications, and have the wrong sign in almost all specifications (Table 4). While credit growth did decelerate significantly in the 12 months following the measures this reflects the increase in unemployment and fall of household income in that period. The lack of effects could be partly related to the limited scope of the measures, as the maximum amortization period was still high and the effective LTV ratio still at 100 percent.10 This was also a time when the authorities took measures to promote economic activity and make liquidity available to the financial system, including through the purchase of pools of insured mortgages.

  • The evidence, on the other hand, suggests the last three rounds of measures dampened credit growth and household debt. They had a statistically significant impact on mortgage credit growth, ranging from 1 (the 2010 measures) to about 2 percentage points (the 2012 measures) on average during the period when they were in force (Table 4, panel 1). All measures had an immediate impact on mortgage credit growth (Table 4, panel 2), but while the effect of the 2010 measures tapered off after 3 months, the impact of the 2011 and 2012 measures got stronger with time. The effectiveness of the 2010 measures reflected the focus on the LTV ratio on refinance loans, one of the main drivers of household debt;11 the significant increase of the down payment on properties not occupied by owners; and the more stringent eligibility criteria introduced.12 The measures taken in 2011 and 2012 have been more effective, as they came on top of the former tightening rounds.13 Both rounds tightened further the LTV ratio on refinance loans and brought the maximum amortization period closer to the average, which likely prevented more borrowers from taking new loans (or reduced the size of the loans).14 The new LTV ratio on refinance loans (down to 80 percent) could also be quite effective, as more than half of the new insured refinance loans in recent periods had a LTV ratio higher than 85 percent. Moreover, the new mortgage underwriting standards proposed by OSFI could curb mortgage credit further as they will reduce the effective LTV from 100 to 95 percent.15

  • The results for individual measures suggest that tightening LTVs for new mortgages and for refinancing loans had the largest impact. The estimates indicate that a 1 pp reduction of the maximum LTV for new mortgages and for refinancing loans tends to reduce y/y credit growth by 0.4 percentage points (Table 6). Reducing the amortization period appears to have a more modest impact, but the effect seems to depend on the level of interest rates. In particular, with a mortgage rate of 4½ percent, reducing the amortization period by 5 years dampens credit growth by 0.45 pp. But with mortgage rates at around 8 percent (as in the early 2000s) the impact would be close to 0.8 pp.16

  • While the household debt to income ratio continued to increase in 2012, it would have likely been even higher if the authorities did not take action. We run a simple counterfactual exercise, and calculate the fitted regression values of mortgage growth rates both with the measures and without them. Assuming all else stays the same, without the measures the average monthly growth (y/y) of mortgage credit would have been 1 pp higher than actually observed since April 2010, while house price growth would have been on average higher by 1.2 pp (Table 5). The household debt-to-income ratio would have been closer to 170 percent as of Q3:2012, instead of the actual 165 percent.

Table 4.

Effects of Macroprudential Measures on Mortgage Credit

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*,**,*** indicate respectively statistical significance at the 10, 5, and 1 percent level. Standard deviations in italic.

The estimation period is 1998:8–2012:11, using montly, seasonally adjusted data. Newey-West consistent variance estimator is used to calculate coefficients’ standard deviation.

Regressions I to IV estimate macroprudential measures effects after 1, 3, 6 and 9 months respectively after their implementation. Regression V estimates effects of each macroprudential measure between rounds of measures.

Table 5.

Effects of Macroprudential Measures on House Prices

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*,**,*** indicate respectively statistical significance at the 10, 5, and 1 percent level. Standard deviations in italic.

OLS estimation, period of 1998:8–2012:8. Monthly, seasonally adjusted data are used.

Newey-West consistent variance estimator is used to calculate coefficients’ standard deviation.

The dependent variable is the y-o-y change in house price index (source: CREA).

Table 6.

Effects of Specific Macroprudential Measures on Mortgage Growth—OLS Estimation (1998–12)

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*,**,*** indicate respectively statistical significance at the 10, 5, and 1 percent level.

The estimation period is 1998:8–2012:11, using montly seasonally adjusted data. Newey-West consistent variance estimator is used to calculate coefficients’ standard deviation. Standard deviations in italic.

All regressions include control variables as in Table 4 but are not shown here.

Policy options based on international experience

11. Countries have used a variety of policy tools to deal with house price and mortgage credit booms. Studies on effectiveness of macroprudential measures show that a number of tools can reduce credit growth pro-cyclicality (Lim et al., 2011) and reduce the risk of a bust (Dell’Ariccia et al., 2012, CGFS, 2012). There is also some evidence that suggest that LTV caps can be an effective tool in dealing with credit and real estate booms.17

12. In this section we look at international experience with a few major macro-prudential measures. We focus on four measures: limits to loan to value ratios; caps to debt to income ratios; greater risk weights for banks’ credit assets; and higher provisioning requirements for banks. To estimate the quantitative impact of these measures on total credit growth and house price growth we use panel data regressions across a sample of 25 countries which have introduced such measures over the 2000–2011 period.18 A first set of regressions uses a “step function variable” for each macro-prudential instrument, that is, a variable that increases by one every time the instrument is tightened and stays there until the instrument is changed. A second set of regressions uses the actual LTV limits instead of the step function. We control for the business cycle and the cost of borrowing by including GDP growth and long-term lending rate as independent variables.

13. The results suggest that LTV ratios, debt-to-income (DTI) ratios and risk weights can be effective in containing credit and house prices growth.

  • Tightening LTV ratios, DTI ratios, and risk weights lead to a reduction in credit growth. During the period when these instruments are tightened, the quarterly credit growth rate is lower by about ½–¾ pps (on average during the period when they are tightened). By contrast, tighter provisioning requirements do not seem to have a significant impact on credit growth (Table 7, columns 1–4).

  • LTV ratios and risk weights appear to have a significant effect on house price growth (Table 8). The significant impact from changes in risk weights is probably due to their direct impact on banks’ balance sheet.

  • Tightening LTV ratios on new mortgages tends to have an impact on credit growth similar to the one we estimated in Canada. A 10 pps reduction in LTV ratios would result in lower (total) credit by 1.3 percent (y/y) (Table 9). This is a similar to the impact we found for Canada (Table 6), where a reduction of 10 pps in first buyer LTV ratios would result in a fall of 4 percent in mortgage credit (y/y) on average during the period when it is applied (mortgage credit accounts for about 40 percent of total credit to private sector in Canada).

Table 7.

Effects of Macroprudential Measures on Credit; Panel GMM Estimation (2000–11)

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*,**,*** indicate respectively statistical significance at the 10, 5, and 1 percent level. Standard deviations in italic.

The estimation period is 2000:1–2011:4; quarterly, seasonally adjusted data. The sample is composed of 25 countries. The regression includes individual (country) effects. Time effects are not included because of high correlation with the macroprudential policy variable.

A step function variable is used for all MaPP instruments (takes +1 at the time the instrument is tightened).

Instrumental variables for the policy instrument (lags) and the (one-step) GMM Arellano-Bond estimator are used to address selection bias and endogeneity.

Table 8.

Effects of Macroprudential Measures on House Prices—Panel GMM Estimation (2000–11)

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*,**,*** indicate respectively statistical significance at the 10, 5, and 1 percent level. Standard

The estimation period is 2000:1–2011:4; quarterly, seasonally adjusted data. The sample is composed of 25 countries. The regression includes individual (country) effects. Time effects are not included because of high correlation with the macroprudential policy variable.

Instrumental variables for the policy instrument and the (one-step) GMM Arellano-Bond estimator are used to address selection bias and endogeneity.

Real house prices is defined as house price indices deflated by CPI (source: OECD, Global Property Guide, IMF dataset)

Table 9.

Effects of Macroprudential Measures on Credit Growth—Panel GMM Estimation (2000–11)

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*,**,*** indicate respectively statistical significance at the 10, 5, and 1 percent level. Standard deviations in italic.

The estimation period is 2000:1–2011:4; quarterly, seasonally adjusted data. The sample is composed of 25 countries.

The regression includes individual (country) effects. Time effects are not included because of high correlation with the macroprudential policy variable.

14. In light of this evidence, and given the relatively generous LTV ratios, further tightening LTV ratios could be an effective response in Canada if household leverage continues to rise. The average (maximum) LTV ratio on new mortgages in our sample of countries is around 80 percent, and only two countries have LTV ratios higher than Canada.19 Canada has DTI limits in line with other countries. In addition, while average risk weights on mortgage are relatively low, this mainly reflects the prevalence of government-backed mortgage insurance in Canada (which have a zero risk weight if a mortgage loan is insured by CMHC). To be effective, increasing risk weights would likely need to be accompanied by some scaling back of government-backed insurance. Alternative options could be increasing risk weights on consumer loans secured by real estate (mainly HELOCs), which would increase the cost of the loans, help reduce overall household credit growth, and at the same time strengthen the resilience of the banking system.20

uA03fig01

LTVs on First Home Loan

(Percent)

Citation: IMF Staff Country Reports 2013, 041; 10.5089/9781475587050.002.A003

Source: Country authority websites.

15. Finally, there is some evidence that the effectiveness of macro-prudential measures would be reinforced by a rise in interest rates. An interaction term between the instruments and the interest rates was introduced in the regressions to assess whether the effectiveness of the instruments depends on the levels of the interest rates. In particular, we would expect the measures to be less effective if interest rates are low, as more borrowers would be able to withstand the increase in borrowing costs. The results show that tightening LTV, DTIs, and risk weight will have a larger impact when interest rates are higher (Table 7, columns 5–8). This is consistent with the results on Canada’s measures (in particular, the reduction of the maximum amortization period), as discussed above. The implication is that macro prudential measures are likely to be less effective under the present environment of very low interest rates. At the same time, this also implies that monetary policy would have a stronger effect once macro prudential measures have been tightened.

uA03fig02

Average Risk Weights on Mortgages

Citation: IMF Staff Country Reports 2013, 041; 10.5089/9781475587050.002.A003

Source: Riksbank Financial Stability Report Q1 2012, and Annual Reports of Largest 6 Canadian Banks.

C. Conclusions

16. The macro-prudential measures taken so far by the authorities have been somewhat effective, but more may need to be done if households financial imbalances continue to rise and the house prices and real estate activity were to accelerate. These measures, especially the latest rounds, have curbed credit growth and moderated the spike in house price. But household debt continued to rise and house prices remain high (relative to rents and income) and overvalued according to staff estimates. In addition, although mortgage credit growth has slowed significantly relative to pre-crisis levels, it continues to exceed disposable income growth, despite record high household debt. While it might be too early to assess the full impact of the measures taken in 2012, international experiences on macro prudential measures provides some insights for Canada. In particular, higher down payment requirement (tighter LTV limits for first-buyers), lower caps on the debt-to-income ratio and tighter LTV ratios on refinancing could all be effective options worth exploring if needed. Finally, the evidence suggests that the effectiveness of macro-prudential measures increases with the level of interest rates. As Staff expects interest rates in Canada to increase in 2013, this result implies that new changes to mortgage insurance and lending requirements should occur at a gradual and measured pace.

References

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1

Ivo Krznar and Paulo Medas.

2

It averages about 15 percent in a sample of OECD economies (including the United States, Australia, the United Kingdom, and Germany).

3

Mortgage insurance plays a big role in the Canadian mortgage market with around 60 percent of banks’ residential mortgage loans insured.

4

OSFI expects federally regulated financial institutions to comply fully with the guideline by the end of fiscal year 2012.

5

OSFI is required to undertake examinations or inquiries and report the results, including any recommendations, to the Corporation’s Board of Directors and Ministers of HRSDC and Finance. CMHC’s Corporate Plan must contain a proposal indicating how CMHC will respond to OSFI recommendations.

6

The cumulative effect of measures is just the sum of coefficients in vector γ.

7

This follows Crawford and Faruqui, (2012). The analysis is constrained by important data limitations. There is no publicly available disaggregated data on the different types of credit (especially those that were targeted by the measures). Therefore, the analysis focus on aggregated measures of mortgage credit.

8

This follows Peterson and Zheng (2011). Igan and Kang (2011) also use similar specifications for Korea.

9

To isolate the effect of the specific set of measures, we control for measures that were introduced before that specific set.

10

The amortization period limit was set at 35 years whereas the average amortization period for CMHC insured loan was 25 years. While the share of new mortgages with 40-years amortization fell sharply following the change in rules (from 32 percent to almost zero), Dunning (2009 and 2012) suggests that the vast majority of borrowers managed to substitute these with loans with 25–35 years. Even though the government set a minimum down payment of 5 percent for insured loans, “cash backs”, unsecured borrowing and gifts could have been considered part of the down payment. OSFI’s B-20 guideline from July 2012 stipulates that banks should make every effort to determine if down payment is sourced from the borrower’s own resources or savings.

11

Dunning (2011) shows that the share of new refinance mortgages with an LTV ratio of 90 percent or more fell from almost 50 percent to zero. However, many refinance mortgages with high LTV ratios were replaced by mortgages with LTV ratios between 85 and 90 percent.

12

All borrowers were required to meet the standards for a 5-year fixed-rate mortgage, even if they choose a variable rate, shorter term mortgage. Dunning (2011) shows that following this change there was a large rise in the qualifying interest rate used for variable rate mortgages (30 percent of total new mortgages), implying that more potential borrowers were not able to qualify for variable rate mortgages.

13

However, the evidence on the 2012 measures is only partial (based on the impact after only 3 months). The effects will be clearer once more data is available.

14

CMHC (2011) suggests that the volume of refinance loans dropped by 22 percent following the 2011 measures. Dunning (2012) estimates that the 2011 measures would push debt-service ratios above the maximum limit for about 6 percent of the high LTV mortgages taken out during 2010. He also suggests that about 11 percent of the borrowers in 2011 would have not been able to access credit following the latest reduction of the maximum amortization period.

15

OSFI’s B-20 guideline stipulated that banks should make reasonable efforts to determine if down payment is sourced from the borrower’s own resources or savings. CMHC (2012) claims that 35 percent of households who purchased a house in 2011 were first-time borrowers and about 15 percent of them borrowed at least part of the down payment.

16

Estimates of the isolated impact of changes in the amortization period were not statistically significant.

18

The data comes from Krznar and others (forthcoming) and the regressions from Arregui and others (forthcoming).

19

It is important to note that simply comparing LTVs can be misleading, as the appropriate or optimal level of mortgage LTV for each country will depend on a number of country-specific factors.

20

Secured personal lines of credit, which are mostly backed by houses (i.e., home-equity lines of credit), have risen sharply both in absolute terms and as a share of total consumer credit. In 1990, secured PLCs represented less than 10 percent of consumer credit; in 2011 their share had risen to about 50 percent (Crawford and Faruqui, 2012).

Canada: Selected Issues
Author: International Monetary Fund. Western Hemisphere Dept.