Home prices and household debt are shooting up in Canada and the effects indicate a housing crisis in the near term. While similar conditions faced by the U.S. led to the 2008 financial crisis, the situation seems to be a bit better for the major Canadian banks, according to a report by Moody's Investors Service, the rating services arm of Moody's Corporation MCO .
Moody's Stress Testing
Moody's conducted a stress test to determine the impact of a severe housing downturn on major Canadian banks. The assumptions made by the rating agency as part of the test included an event of an overall home price slump of 25%.
Also, the analysis comprised an additional 10% house price decline in Ontario and British Columbia, the regions which have experienced significant price appreciation over the past several years.
In such a scenario, total direct losses to the Canadian banking system would reach almost C$18 billion. However, Moody's said that the banks would be able to generate internal capital to cover losses within a few quarters.
"The majority of banks would be able to absorb losses within one quarter of earnings or, assuming the current average dividend payout ratio of 45 per cent, two quarters of retained earnings," the Moody's report stated. "Therefore we believe that while a U.S.-severity mortgage event would lead to substantial losses, it would not threaten rated bank solvency."
According to the Moody's severe stress scenario results, Royal Bank of Canada RY would suffer the biggest loss, while Canadian Imperial Bank of Commerce's CM capital level will be hurt the most due to its operational focus on Canadian retail lending.
Why Canadian Banks Are Relatively Safe
Though the major Canadian banks will be affected like their U.S. counterparts from the looming housing crisis, considerable structural differences between the Canadian and US mortgage markets denote that the impact will be less severe. The leading Canadian banks are expected to withstand the direct effects of a severe housing downturn without incurring any disastrous losses.
Moreover, the Canadian government guarantees majority of mortgage insurance through the Canada Mortgage and Housing Corporation, which was lacking in the U.S. at that time. Further, lower rates of risky subprime lending along with stronger lending practices mean that Canadian mortgages are of much higher quality than the U.S. ones.
Also, banks do comparatively less securitization of mortgages in Canada. Further, legally mandated minimum down payments reduce the risk of collateral value declines in Canada.
"We believe several structural characteristics of the Canadian mortgage market, as well as macroprudential adjustments made by Canadian regulators following the U.S. sub-prime crisis, would help Canadian banks to weather the effects of a major housing shock," Moody's said.
The Bank of Canada recently warned that markets in Vancouver and Toronto are "unlikely to be sustained," while The Bank of Nova Scotia's BNS chief executive officer described house prices in both markets as "frothy." Moreover, the Organization for Economic Co-operation and Development raised similar concerns about both market areas.
Also, Moody's warned about other risks still threatening the Canadian banks. These risks include doubled mortgage debt raising concerns of overvaluation and over-extended borrowers.
"In the aftermath of the U.S. mortgage crisis, many banks were forced to repurchase mortgages sold to the Federal Home Loan Mortgage Corp. (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae) owing to inadequate origination documentation," Moody's said.
"We do not believe Canada is immune to such risk: in a stressed mortgage environment, mortgage insurers may increase claims rejection for purposes to preserve capital, and the political environment could prompt a shift of the risk-sharing burden to the banks and away from taxpayers," Moody's further stated.
Though Canada is exposed to certain risks, Moody's believes that Canadian lenders are better positioned to weather the imminent housing crisis given key differences with their U.S. peers.
While the Canadian economy is still grappling with volatility in the energy sector, the strength in exports and consumer spending should continue to lend support. Additionally, the fiscal stimulus measures unveiled earlier this year by Canada's new Liberal government should aid growth prospects of the nation.
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