Bearish Report for the Canadian Housing Market

Thanks to one of our preferred mortgage specialists - Al Nenshi from Quantis Mortgage Solutions - for sending along this article. We are certainly in the position to see some interesting changes in the market over the next few months and years - Dan

 

Brady Yauch, BNN.ca

Another day and another bearish report on the Canadian housing market – this time from analysts at Morningstar, the Chicago-based research group.

The analysts warn that if housing prices fall by just 10 percent, the country's largest banks and the government-backed Canada Mortgage and Housing Corporation (CMHC) face a "significant risk of losses or impairment to capital levels." The analysts add that the loan-to-value ratio of mortgages at Canadian banks is at the same level it was in the U.S. prior to that country's collapse in real estate values. Loan-to-value ratio is a measure of the amount of borrowed money used to purchase home.

"Canadian banks, as a group, state that the major difference between them and U.S. banks just before the housing bubble is the higher level of equity, on average, that most Canadian banks possess in their residential loan portfolios," Morningstar analyst Dan Werner says in a note to clients. But when comparing the data, he found that the average loan-to-value ratio for Canadian banks is about 45 to 60 percent, while that figure was 54 to 55 percent for U.S. banks prior to the financial crisis.

"More important, the distribution of Canadian mortgage loan/value ratios in 2013 and currently insured by the CMHC indicates a higher proportion of loans in the higher-loan/value categories compared with 2006 levels," he adds. "We think this demonstrates higher risk to the CMHC and banks' capital levels."

He warns that the proportion of mortgages with a loan-to-value ratio greater than 80 percent is higher for Canadian banks than it was in the U.S. prior to 2007. A higher figure for a loan-to-value ratio indicates that more money was borrowed to purchase a home.

Worse still, Werner adds that because a large percentage of the mortgages held by Canadian banks have loan-to-value ratios of 70 to 80 percent, it would take only a 10-percent decline to cause these mortgages to exceed the threshold allowed by the CMHC on new loans. The CMHC provides insurance on mortgages where the borrower has put down less than 20 percent of the value of a home.

"If housing values were to fall precipitously, many of those loans would fall into the higher-loan/value categories," he says.

The CMHC may not be able to handle a major pullback in housing prices, Werner says. With 28 percent of insured Canadian mortgages posting loan-to-value ratios greater that 80 percent, he says the CMHC's liabilities could exceed its equity should home prices across the country decline.

In a worst case scenario, if 100 percent of borrowers defaulted when the value of their mortgage exceeded their home, then a 10-percent decline in home prices "would more than exhaust CMHC's capital."

As for the banks, Werner says National Bank of Canada (NA-T 74.5 -0.21 -0.28%) and CIBC (CM-T 78.54 -0.78 -0.98%) will be hit hardest by a significant decline in prices, while Toronto Dominion (TD-T 82.64 -0.32 -0.39%) and the Bank of Montreal (BMO-T 61.62 -0.42 -0.68%) will be the least effected.

The recent catalyst for the more than decade-long run-up in home prices has been cheap funding, a result of the Bank of Canada maintaining low interest rates since the financial crisis. The Bank of Canada has held interest rates at one percent for more than two years, but has in the past year warned consumers that its next move will be to hike rates – a move that would make it more expensive to service debt.

 he debt-to-income level for Canadians is currently at a record 165 percent.

"We think sustained low interest rates will continue to feed cheap funding into the residential real estate sector and drive consumer debt," he says. "However, we continue to think that the growth of household debt to disposable income for Canadians is unsustainable in the long-term."