While increasing household debt and rapidly increasing home prices in Canada demonstrate conditions similar to the US leading up to the financial crisis, significant structural differences between the Canadian and US mortgage markets mean that the largest Canadian banks would be able to absorb the direct effects of a severe housing crisis without incurring catastrophic losses, said Moody's Investors Service.
Over the past decade, Canada's mortgage debt outstanding has more than doubled, with the index of house prices to disposable income increasing 25% in the same period; faster than comparable OECD countries. The country's household debt levels have tracked closely with this increase, raising concerns of overvaluation and over-extended borrowers.
In a new report, Moody's simulated a historic-level mortgage crisis for rated Canadian banks and mortgage creditor insurers, quantifying losses using historical experience in Canada as a base and the US mortgage crisis experience as a severe scenario. Based on the results of its stress testing, the ratings agency said the largest Canadian banks would be able to absorb a major shock in the housing market without incurring catastrophic losses. The rating agency's stress testing assumptions included an overall house price depreciation of 25% in each scenario to simulate collateral value drop, then an additional 10% house price decline in the provinces of Ontario and British Columbia -- two regions that have experienced significant price appreciation over the past several years. The testing did not include consideration of spillover effects of a house price correction.
While the total direct stress to the system could reach losses almost CAD18 billion, Moody's said the banks would be able to generate internal capital to cover losses within a few quarters. While Royal Bank of Canada (Aa3 negative) would suffer the largest absolute loss under Moody's severe stress scenario, Canadian Imperial Bank of Commerce's (Aa3 Negative) capital is most at risk owing to its operational focus on Canadian retail lending.
Moody's noted that the direct negative effects of such a large, wide-reaching housing downturn in Canada is reduced by a number of important structural differences with US mortgage markets, including explicitly government-guaranteed mortgage creditor and lender insurance, lower rates of subprime lending and lower prevalence of "originate-to-distribute" securitization practices.
"Canadian policymakers have made significant structural changes to the market -- some informed by the US example -- that would help contain the effects that a severe housing shock could have on the country's banks," said Moody's Assistant Vice President Jason Mercer.
Though the country's mortgage debt levels have risen significantly, half of the debt outstanding -- nearly CAD700 billion in residential mortgage loans -- are explicitly supported by the Canadian government. Moody's noted that these backstopped loans have historically been of high quality as stable employment and historically low interest rates have helped to stabilize servicing costs relative to disposable income. Further, legally mandated minimum down payments reduce the risk of collateral value declines.
Read the June 2016 issue of Business Review USA & Canada magazine