Big banks or small lenders? A look at which stocks may benefit from Canada's new mortgage rules

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Big Canadian bank stocks are cruising at record highs while smaller mortgage lenders are struggling, suggesting that investors have already decided how new rules on residential mortgage underwriting practices will affect key players in the Canadian housing market.

But are investors reacting too soon, given the unknowns?

To be sure, the changes coming are substantial. Last week, the Office of the Superintendent of Financial Institutions (OSFI) released its final stress-test rules, tweaking proposed guidelines that had been released in July.

These rules are designed to strengthen Canada's lending standards at a time when levels of consumer indebtedness are sky-high and interest rates are rising.

Under the new rules, homeowners with down payments of more than 20 per cent will have to qualify for mortgages at higher rates. This new lending standard officially takes effect in January, although observers believe lenders will adopt it immediately.

The stock market has already reacted. The big banks, which underwrite about 80 per cent of Canadian mortgages, have continued a rally that began early last month. On Tuesday, the S&P/TSX commercial banks index touched a fresh record high, stretching year-to-date gains to nearly 9 per cent.

This rally is being driven in part by the strong Canadian economy, rising interest rates and higher oil prices. But the new mortgage rules certainly haven't hurt: Bank stocks have risen more than 1.5 per cent over the past week, or about three times the pace of the Canadian benchmark index.

Smaller mortgage lenders are struggling though. Home Capital Group Inc. has fallen about 7 per cent over the past month. That's knocked some value from Warren Buffett's 20-per-cent stake in the company – but don't worry, Mr. Buffett is still up about 40 per cent on his original investment. Although Equitable Group Inc.'s share price has been rising, it is still more than 20 per cent off its highs in February.

These moves come as investors try to get a handle on potential winners and losers – and these aren't obvious bets.

One idea is that the big banks are essentially immune to tighter lending requirements because they are well diversified and should benefit if the housing market raises fewer concerns among investors.

What's more, the new underwriting rules may provide an incentive for homeowners to stick with their current lender – probably a bank – rather than shop around when their mortgages come up for renewal, since the new rules don't apply to renewals.

A third benefit: According to RBC Dominion Securities, recent disclosure from the banks shows that OSFI's original guidelines would have left about 90 per cent of the banks' mortgage originations unaffected. So no big deal.

On the other hand, analysts expect that smaller lenders that offer non-prime loans will be hit harder because more stringent stress testing could bounce some prospective home buyers out of the housing market or into the arms of credit unions and private lenders.

But this downside risk was factored in by analysts when OSFI released its original guidelines in July. Marc Charbin, an analyst at Laurentian Bank Securities, noted that smaller lenders should see a 10-per-cent decline in originations.

Since this decline is likely already reflected in share prices, though, it's not clear that stocks such as Home Capital and Equitable Group should be shunned by investors now. And they may benefit as home owners who would have qualified for a mortgage from a big bank now have to look elsewhere.

But there are more complications that make categorizing winners and losers even more difficult.

One is what these rule changes will do to the housing market. If the changes stabilize a market that had been looking unsustainable, that's good. But if they weaken the market more than regulators had anticipated, then all lenders could suffer from substantially lower originations. Right now, this is an open question.

Another complication is that more rule changes are probably coming. Apart from OSFI, the Bank of Canada and various governments have also imposed changes to cool the housing market, and observers expect they're not done fiddling.

Jaeme Gloyn, an analyst at National Bank of Canada, noted that regulators could introduce measures capping loan-to-income ratios and longer amortization periods, and local governments could raise taxes on property transactions.

"The point here is that multiple levels of governments and agencies have several policy/regulatory tools still hanging on their belts, which reaffirms our view that the regulatory backdrop remains unfavourable," Mr. Gloyn said in a recent note.

Investors who wade into this sector today should be prepared for continuing uncertainty.