Canada's largest lenders – how vulnerable are they to price shocks?

Moody's says residential mortgages are "becoming riskier" for Canada's top lenders

Canada's largest lenders – how vulnerable are they to price shocks?

Prominent Canadian banks’ residential mortgage portfolios are becoming increasingly vulnerable to losses in a stress scenario, although strong earnings and loss provisions are likely to help them absorb potential future market shock.

That’s the view of credit rating agency Moody’s, whose recent report on the subject highlights rising house prices in Ontario and British Columbia and a reduced rate of insured mortgages as factors behind that growing vulnerability.

In Moody’s Investors Service’s 2021 stress test, the company said that action taken by the federal government to reduce its exposure to residential mortgage lending in recent years had shifted default risk to lenders, with the past five years seeing a 20% decline (from 46% to 26%) in the proportion of government-backed insured mortgages.

The agency’s vice president – senior analyst Jason Mercer (pictured top) said that high credit quality was partly a result of government stimulus to households, with mortgage losses likely to rise as that support is phased out. Still, he also highlighted that the top lenders seem reasonably well positioned to deal with future instability.

Read next: BMO's Porter: Housing market still a cause for concern

That’s because of strong capital levels at the major banks, with the agency saying that while it expected some turbulence in credit quality, Canada’s largest mortgage lenders would likely be able to avoid significant losses due to existing capital and credit strength.

“There are such high capital levels to absorb unexpected losses right now, much more than previous stress tests that we’ve done,” Mercer told Canadian Mortgage Professional. “We’ve done two prior tests, and the capital levels are several hundred basis points higher than they were in the last couple of tests. That’s a good thing – it’s an additional absorber of shock.”

A housing crash?

Despite the growing vulnerability of the country’s top lenders to losses, then, there appears little prospect that it could trigger a housing crash, with Mercer describing that risk as “actually quite low.”

Stimulus payments from the federal government being gradually reduced and the likelihood of interest rate rises next year are positive developments for the market’s stability in the long run, he said.

“[With] government stimulus being tapered off over time, we’re not anticipating major spikes in defaults because presumably those that need support are getting it and those that don’t… are employed and able to make the payment.

Read more: How likely is a Canada housing crash?

“We do expect interest rates to go up, so the refinancing risk that many of these borrowers have – the risk that interest rates are going to be higher when they go to renew – there’ll be a long runway for that to happen, because roughly only about one in five mortgages renews every year.”

Those factors, coupled with pent-up demand in the housing and mortgage markets as a result of immigration, are likely to counter the inevitable risk of some foreclosures and defaults. “I don’t think we’re going to see a price crash at the moment,” Mercer said. “There are just too many strong fundamentals on the supply side right now.”

Markets picking up speed

The blistering pace of housing markets in Toronto and Vancouver has grabbed the headlines since the beginning of the pandemic, with record activity in those cities seeing home prices shoot through the roof over the past 18 months.

Still, Mercer said that the Quebec market was also worth watching, with activity there having picked up substantially in recent months in a trend that he said would be a significant one for lenders in that province.

While the average exposure of Canada’s largest mortgage lenders to the Ontario and British Columbia markets stands at 65% this year – up from 59% five years ago – two of the country’s big players, Desjardins Group and National Bank of Canada, had been largely exempt from those risks because of their concentration in Quebec.

However, with house prices on the rise in Montreal and Quebec City, Moody’s report said that that had “negative implications” for those two companies. Quebec makes up 96% of Desjardins’ mortgage exposures, with that figure standing at 54% for National Bank.

“[Those price rises are] different to what we’ve seen in the past – normally it’s [the likes of] Toronto and Vancouver that have been pumping up the market,” he said. “That’s something we’re keeping our eye on because the Quebec-based institutions that we rate are fairly sensitive to that.”