Higher mortgage rates are weighing on the Canadian housing market and raising questions about the big banks’ exposure to potential credit losses. But an analysis from CIBC World Markets concludes that the impact on bank profits should be relatively light.
“Even if we assume conditions worse than anything experienced in Canada to date, we don’t expect the earnings-per-share impact to be all that significant,” Paul Holden, a CIBC analyst, said in a note.
Though bank stocks have rebounded this week, they are down nearly 19 per cent, on average, since early February.
The downturn has occurred as central banks in Canada, the United States, Britain, the euro zone and elsewhere have raised their key interest rates in response to surging inflation.
The dramatic shift in monetary policy has raised mortgage rates to multiyear highs and triggered concerns about the ability of households to meet their debt obligations.
That’s partly because consumer debt remains exceptionally high. According to Statistics Canada, Canadian households owed an average of $1.82 for every dollar in disposable income in the second quarter, which is near a record.
The other threat comes from house prices, which many observers expect will decline further. Royal Bank of Canada RY-T now estimates that home prices will decline by 12 per cent, on average, by early 2023. Capital Economics sees prices falling an even steeper 20 per cent.
Add a looming recession into the mix and there is little wonder that bank profits look vulnerable. However, Mr. Holden expects that the damage from the housing market will be contained.
He modelled three economic scenarios, ranging from a mild recession to a general recession to a severe downturn that stretches the historical limits. He also looked at past housing market downturns to see how credit losses responded.
He found that mortgages have not been a source of alarming credit losses for the banks, even during tough times. The average residential mortgage loss between 1990 and 2021 was just 0.03 per cent of overall lending, rising to highs of 0.06 per cent in the early 1990s and 0.09 per cent in 2020, when the pandemic hit.
As a share of total credit losses set aside by banks, residential mortgages have typically accounted for just 2 per cent, in dollar terms, rising to a peak of 10 per cent in 2020. Other consumer loans, including auto loans and credit cards, account for far more of the overall losses.
Mortgage insurance plays a significant role in limiting losses for the banks, Mr. Holden said.
So do elevated home prices, which can provide a cushion. Even in the current environment, mortgages underwritten before 2021 can be sitting on a lot-embedded equity value. Home prices would have to tumble more than 50 per cent to put older mortgages at risk, the analyst said.
Today’s rising variable mortgage rates are a threat. But a solution includes shifting homeowners to fixed rate mortgages. And, so far, variable-rate borrowers have been able to handle the higher payments, given that the number of past-due mortgage payments has been holding relatively steady.
“We view the impact of higher rates on variable mortgages as a manageable risk,” Mr. Holden said.
Even if credit losses on residential mortgages surged to 0.19 per cent of overall loans – recall that the ratio reached a high of 0.09 per cent in 2020 – bank profits, in terms of average earnings per share, would be just 4.5 per cent lower than projected 2023 earnings, Mr. Holden estimated.
Bank stocks could remain volatile, of course, if stock markets take another turn for the worse and the economic backdrop deteriorates. But as a source of deep concern to investors nervous about bank profits, the Canadian housing market may be overrated.