Canadian Mortgages Are “Riskier” For Lenders, Probability of Correction Rising: Moody’s

Canadian real estate has a rock-solid reputation with consumers but institutions are warning each other to be careful. Global credit rating agency Moody’s shared their latest Canadian mortgage market assessment. After stress testing portfolios, the agency warns mortgages are “riskier” for lenders. Big lenders are now more concentrated in BC and Ontario, where home prices have seen rapid growth. The agency warns rapid growth means there’s a higher probability those markets are mispriced. As a result, when mortgage defaults normalize there is a greater potential for losses. 

Fast Rising Home Prices Increase The Odds of A Correction

Faster rising home prices mean a greater chance they’ll encounter a misprice in value. That said, few places in the world have seen home prices rise as fast as Canada. Over the past year, urban home prices have increased 17.3% as of September. The recent price boom has been exceptional in two provinces — BC and Ontario.

“A rapid rise in house prices increases the probability of a price correction and, therefore, a deterioration in lenders’ collateral values in the event of a default,” wrote Moody’s analysts.

Before you think Moody’s is claiming the sky is falling, you should realize the banks are saying this too. BMO’s chief risk officer warned elevated home equity may “exaggerate” home equity. They said that earlier this year when explaining they expanded manual verification. They want to make sure home equity won’t be needed in a correction. At least the bank’s protected, right? This is going to be a theme going forward.

Canadian Bank Exposure To Fast Rising Markets Soars

Rapid home price appreciation has also concentrated lender exposure in Canada. Banks are increasingly seeing their market concentrate in BC and Ontario. Big residential mortgage lenders have 65% of their portfolios concentrated in these provinces. This is up 6 points from 2016. Nearly two-thirds of lender exposure is in markets with the fastest-growing prices.

Some banks are more exposed to BC and Ontario residential real estate than others. CIBC leads with 77% of their portfolio in these two markets, up from 69% in 2016. Scotiabank and TD are both in second place with 73% of their portfolio, up from 65% and 67% respectively. If you thought two-thirds was bad, how do you feel about three-quarters of exposure to these risks?

During this period, their exposure to the uninsured mortgage market also rose sharply. Insured mortgages represented 47% of loans in 2016. These loans were virtually risk-free for the lender since insurers would take the hit. This fell to 26% this year as more multiple property owners flooded the market.

Canadian Mortgage Delinquencies Expected To Rise

Whatever. What does Moody’s know? Mortgage delinquencies are at a record low, so there are no problems — right? They attribute the lack of delinquencies to government support. Not just mortgage payment deferrals, which have mostly expired. Fiscal income supports, such as enhanced unemployment. 

The share of households receiving income support is still historically elevated. Government transfers represented 22% of income in Q2 2021, down from the peak of 29% last year. But it’s still 4 points higher than it was during Q4 2019, the last quarter before the pandemic. As this normalizes, so should credit delinquencies.

“The Canadian government has extended its expanded employment insurance benefits and eligibility in the past, but not to the degree of pandemic-related measures,” writes the credit rating agency. “It is therefore likely that consumers’ financial health and credit quality will deteriorate as these programs wind down.” 

Canadian Banks Will Be Fine If Defaults Rise

Don’t worry about the banks, they’ll be fine if prices drop 25% or less. The aggregate core capital, called Common Equity Tier 1 (CET1), would decline 76 bps. This is up from 61 bps in the 2018 stress test and 56 bps in 2016. A home price crash would destroy almost 50% more banking core capital than it would have in 2016. 

Losing 0.76 points of core capital is a lot, but banks have historically high capital levels. To put it bluntly, banks are better off if your home crashed today than pre-pandemic. So don’t worry about the money you borrowed, it’s still very profitable if you default. 

“…we expect some turbulence in credit quality as consumers adjust, we do not expect the eight large Canadian mortgage lenders to experience significant losses on their portfolios that would materially erode their capital and credit strength,” writes the analyst.

There you have it. Home prices have a high probability of correcting, delinquencies will normalize, and mortgage losses are likely. In any case, your bank will be fine — even better off than if there was no pandemic surge in prices. The average home buyer? That’s a bit more of an unknown at this point. 

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