Chart of the Month – September 2019

How Vulnerable is Canada to a Catastrophic Mortgage Meltdown (Part 1 The Banking System)

There is no doubt in our mind that we are approaching a recession. This has many prognosticators very concerned that the Canadian banking system is enormously exposed to a crash in real estate prices given the huge gains made in the market in the past decade. As can be seen in the charts above a huge percentage of the Canadian consumer debt is made up of mortgage and home-equity loans (HELOCS).
Most of these prognostications follow the line that the real estate crash in the USA caused an economic crisis that adversely affected most of the world. These doomsayers look to the potential losses that the banks will take in the mortgage markets as defaults follow job losses and exacerbate the drop in real estate prices. To fully appreciate this argument, one needs to understand the systemic risk in Canada’s mortgage market. This system is vastly different to the USA where the mortgage holders often did not originate the mortgages they own and the originators often do not service the mortgages they originated, thus they have completely rid themselves of any losses should the mortgage they originated default.

Under the Canadian system most of the mortgages remain on the books of the entity that originated them and that service them. It is for this reason that the six major banks (plus The Caisses Depot) have such large positions. This gives many analysts concerns that they are overexposed to a potentially dangerous asset class.
Let us look at the actual risk inherent in Canadian mortgages. As a start any mortgage that has less than 20% in equity must be guaranteed. The guarantor in this case is either the Canada Mortgage and Housing Corporation or a registered mortgage insurance company. CMHC is guaranteed for 100% of its deficit up to $600 billion by the Canadian Government. The company has $15 billion in unencumbered capital, having paid the Canadian government a dividend of $10 billion as their actuaries deemed the company to be overcapitalized. The privately-owned mortgage insurers pay premiums to the Canadian government in exchange for a 90% guaranty of their deficits.

The banks have thus passed on their exposure to the highest risk mortgages to the Canadian government. We shall address the risk to the government later in the piece. The balance of the risk that the banks are taking in the mortgage market is shown graphically in the chart below which shows the distribution of unpaid mortgage versus the market value. Since the doomsayers are afraid of a 35% drop in the value of Canada’s housing stock as a worst-case scenario, we can ignore the 49% portion of the loan book that has a “loan to value” ratio of 65% or below as even with such a huge drop in value the property is still worth more that the mortgage.

This leaves us with 19% of the mortgages with loan to value ratios of 65%-75% (maximum of 10% exposed to 35% drop in prices) and 16% with a loan to value ratio of 75%-80% (maximum of 15% exposure to such a decline). In dollar terms this amounts to $267 billion and $225 billion of mortgages respectively. The total at risk is ~$60 billion. The combined capital in the banking system in Canada is in excess of $300 billion thus although it would be a severe hit the worst-case scenario would not bankrupt the Canadian banking system. This resiliency of the Canadian banking system was tested by the Bank of Canada in 2019 using the following stress test parameters:

Their results showed that under extremely severe economic circumstances that would produce the risk scenario above the Tier 1 capital of the banks in total would decline from its current 12% to just under 8% before recovering.