Merrill Lynch Canada Inc. is warning that the market is being too complacent about the resilience of the housing market, and by extension, the financial sector and the economy in Canada.

Banks lending too much money to homebuyers is the underlying source of the financial crisis now gripping the U.S., Merrill points out in a report published on Wednesday. In retrospect, it’s obvious how excessive the lending in the U.S. was, Merrill says, but at the time it wasn’t clear, “because the banks kept doing it and the market kept accommodating it.”

However, it notes that there were obvious danger signs in the aggregate data, most importantly, the growing household financial deficit. A similar story underpins the British financial crisis too. “What worries us is that Canadian households have been running a larger financial deficit than households in either the U.S. or Britain,” Merrill warns. It reports that after 40 years of net savings, Canadian households moved into sustained deficit in 2002.

It also notes that in 2007, household net borrowing amounted to 6.3% of disposable income, which represents a wider deficit than in Britain and not far off the peak U.S. shortfall seen in 2005. “These data imply that the Canadian household sector is now overextending itself as much as the U.S. or Britain ever did, challenging the consensus view that Canadian lenders and borrowers have been far more conservative through the cycle,” it says.

“So, why haven’t we seen housing and credit markets in Canada crack?” Merrill wonders. “The market view is that it’s not going to, that the household overextension evident in the aggregate data is somehow more sustainable in Canada, to judge from the massive outperformance of Canadian bank shares through the global crisis.

“We fear, however, that it may simply be a matter of time,” it warns. “The clear ‘tipping point’ in the U.S. was the emergence of falling house prices in the summer of 2006, kicking off the vicious circles that have brought the financial system and the wider economy to the brink. We’re just now starting to see house prices fall in Canada, and sharp rises in unsold home inventories increasingly imply that this will not be a transitory phenomenon.

“From this perspective, the absence of a Canadian credit crunch to date may be cause for concern, not comfort,” it says. “How can it be good that mortgage debt is growing at a double-digit pace against an asset class now seeing deflation? We believe that markets remain overly sanguine with respect to the prospects for the Canadian housing market, the financial sector and the overall economy.”