Housing crash in Canada could cost mortgage lenders almost $12 billion, Moody’s warns
Story by: Barbara Shecter
If Canada were to experience a U.S.-style housing crisis, with house prices falling by up to 35 per cent, mortgage lenders including the country’s big six banks could lose nearly $12 billion, according to a new report from Moody’s Investors Service.
Mortgage insurers including CMHC would rack up further losses of as much as $6 billion, according to the ratings agency, which crunched the numbers to test how Canada’s housing market would respond to stresses such as a sharp increase in interest rates or an employment shock where people lost their jobs and were unable to make mortgage payments.
“The latter is more likely to occur, but probably only if there’s a global slowdown as well, as Canada’s economy is so highly tied to global trade,” said Jason Mercer, an assistant vice-president at Moody’s and lead analyst on the report.
The ratings agency says rising household debt relative to income in Canada, along with rapidly increasing house prices, has created similar conditions to those in the United States prior to the financial crisis of 2008. However, the report released Monday concludes that Canada seven largest mortgage lenders would be able to absorb such a downturn “without catastrophic losses.”
“We believe that while a U.S.-severity mortgage event would lead to substantial losses, it would not threaten rated bank solvency,” the report said.
The banks would generate sufficient internal capital to cover the stress losses within a few quarters, the report says, noting that Canadian Imperial Bank of Commerce would be the only “negative outlier” in the group, given that bank’s larger proportion of domestic mortgage operations relative to peers.
“While RBC (Royal Bank of Canada) would suffer the largest absolute loss, CIBC’s capital is most at risk owing to its operational focus on Canadian retail lending,” said the report, which based its stress scenarios on historic mortgage delinquencies in Canada in the 1990s and the U.S. experience in 2008.
Moody’s suggests Canada-wide house price declines would be on the order of 25 per cent, while the red-hot markets in British Columbia and Ontario would experience steeper declines of 35 per cent.
The authors point out that banks and mortgage insurers don’t just have to deal with declines in house values when calculating losses from foreclosures. Additional costs include legal fees, back taxes, real state fees, and outlays for necessary repairs.
Mercer, the lead author, says the Moody’s analysis suggests a bank would realize only $550,000 on a $1 million home in British Columbia, after taking into consideration a 35 per cent decline in the price, and additional foreclosure costs of around $100,000.
The ratings agency says the probability of a large, wide-reaching housing and banking downturn in Canada is reduced by a number of important structural differences with U.S. mortgage markets, including explicitly government-guaranteed mortgage insurance, lower rates of subprime lending and lower prevalence of “originate-to-distribute” securitization practices.
“Further, Canadian policy-makers have adjusted macro-prudential policies in light of risks revealed by the U.S. experience, which were unforeseen and exacerbated the crisis,” the report says.
Still, the authors say modelling a U.S.-style crisis for Canadian banks provides insights into “systemic vulnerabilities,” such as the potential for exacerbated house price declines due to the expected experience of a sub-group of lightly regulated mortgage lenders.
Moody’s calculates that “riskier underwriting practices” could affect about six per cent of the overall mortgage market because some lenders are not subject to enhanced mortgage underwriting guidance issued by regulators of deposit-taking banks and credit unions.
“In the event of a housing downturn, these riskier loans could exacerbate price declines,” the report says.
“The riskier loans, in theory, would default first,” explains Mercer. “And when those houses are sold in foreclosure, prices of nearby properties fall.”
The Moody’s analysis also highlights the potential for government guarantees to be challenged in times of crisis, as occurred during the U.S. housing meltdown when mortgage paperwork was frequently challenged and rejected.
Mercer says the losses calculated in Moody’s stress analysis would be more evenly split between banks and mortgage insurers including CMHC and two private insurers if the insurers did not challenge and reject claims.
“The banks would lose about $8 billion [and] the insurers would lose about $9 billion,” Mercer said, noting that the Canadian experience would likely be less dramatic than in the U.S. because the Canadian government explicitly backs CMHC and the two private insurers.
However, he added that there has been a trend toward less taxpayer support in the banking system.
“This could include mortgage insurers,” Mercer said.
While mortgages tend to be high quality in Canada compared to U.S. home loans at the time of the crisis, the Moody’s report also notes that higher debt levels make Canadian consumers vulnerable to an employment or interest rate shock that would exacerbate their debt-servicing burden. There was almost $1.6 trillion in mortgage debt outstanding at the end of March, including home equity lines of credit, more than double the amount outstanding 10 years ago.
“Highly indebted consumers are more sensitive to employment or interest rate shocks, either of which could increase mortgage delinquency rates,” the report says. “At the same time, overvaluation concerns raise uncertainty around collateral values, and litigation and/or a government risk-transfer reversal could lead to further unexpected loss at Canadian banks.”
The report also notes a “five-year balloon loan feature” of Canadian mortgages, which Moody’s says exposes borrowers to refinancing risk since debt repayments would increase when interest rates rise.
“Any resulting spike in defaults could exacerbate price corrections from foreclosure sales,” the report warns.
