Housing market downturn poses challenges for Canadian banks

Rising rates, stricter mortgage requirements, and higher mortgage carrying costs could weigh on lending business, report says

Housing market downturn poses challenges for Canadian banks

With Canada’s scorching-hot housing markets getting summarily cooled by the central bank’s efforts to dampen inflation, the Big Six banks will face a crucial test to their resilience, according to a new report from DBRS Morningstar.

Drawing on data from Statistics Canada and the Canadian Real Estate Association, the report noted that national home prices have dropped for three straight months, with June representing the steepest monthly drop since 2005.

“Although the magnitude of the impact of monetary policy tightening on the housing market is still unclear, rising rates will continue to erode housing affordability at current price levels, further depressing demand and putting downward pressure on housing prices,” the report said.

While DBRS Morningstar expects a structural supply-demand imbalance to create a floor for Canadian housing prices over the long term, the country’s housing market is entering a rough patch. The 1.9% monthly decline in national home prices in June contributed to a 3.3% cumulative decrease in prices since March.

Aside from interest rates, borrowers have been challenged by an increase in the minimum qualifying rate (MQR) for mortgages introduced under Guideline B-20 by the Office of the Superintendent of Financial Institutions (OSFI).

Higher interest rates and the tighter underwriting standards in the prime mortgage market, dominated by traditional lenders including the Big Six banks, could drive more borrowers to the alternative mortgage lending market. Affordability could become a challenge in the alternative lending segment, the report said.

Asset quality metrics in Canadian banks’ residential mortgage portfolios are strong, as credit quality improved during the pandemic to historically low levels. A downward trend in mortgage delinquencies could be attributed to high savings rates, a tight labour market, and the buoyancy in the housing market over the past two years.

But the report “expects deterioration from these unsustainably low levels that could be magnified if borrowers struggle with higher mortgage carrying costs.”

The Big Six banks’ uninsured real estate secured lending portfolios could provide them with a considerable cushion against the negative impacts of a housing market downturn. However, the steep rise in housing prices during the pandemic also pushed a higher proportion of borrowers to reach further financially to buy a home, taking on larger mortgages and longer amortizations.

Variable-rate mortgages, which are more exposed to interest-rate risk during a rising-rate environment, were tagged as particularly vulnerable.

“[T]hese borrowers purchased homes at record low interest rates at the peak of the market and have less home equity to borrow against in situations of financial distress,” the report noted. “Additionally, once highly leveraged investors must renew/refinance at higher rates, they may start to experience negative cash flow on their investment properties and decide to sell.”

To brace for economic uncertainty and rapid interest rate hikes, DBRS Morningstar anticipates banks will start building up provisions for credit losses reserves on performing loans in the coming quarters, though unemployment shocks triggered by an economic slowdown could create risks as they lead to a steeper drop in housing prices.