D-SIBs Have Material Exposure To Domestic Residential Mortgages

Canadian D-SIBs hold material exposure to domestic residential mortgages, which represented a combined C$1.41 trillion (on balance sheet) or, on average, 37% of total loans as of first-quarter 2023. We consider their exposures to be a risk, given the sharp rise in interest rates causing strain on borrowers' capacity to service their mortgage debt with a background of already high and rising consumer indebtedness. However, in our view, D-SIBs are well placed, with strong balance sheets and capital levels to weather a downturn.

In Canada, the most popular mortgage products are fixed rate, variable rate with fixed payments, and variable rate with variable payments, which is less popular, given its unpredictable structure. Most mortgages in Canada renew every five years or less. Around 55%-75% of D-SIBs' mortgages are fixed rate. A variable-rate mortgage will fluctuate with a lender's prime rate, which is based directly on the Bank of Canada (BoC) rate, throughout the mortgage term. For a variable-rate mortgage with fixed payments, when interest rates rise, the amount of the mortgage payment does not change but the portion going to interest (rather than principal) increases. These borrowers may reach a point where their fixed payments cover only interest and not any principal. The interest rate at which this happens is known as "the trigger rate." If rates rise above the trigger rate, borrowers may then need to increase their mortgage payments to manage the additional amount of interest. On average, at first-quarter 2023 mortgages with terms of 30 plus years accounted for about 20% of D-SIBs' mortgage portfolios, a sharp increase from 1% one year ago. This percentage is higher today. The amortization period is increasing as the number of mortgage holders no longer able to cover a portion of principal on their monthly payments is rising (chart 1). The amortization period is also increasing because D-SIBs are working with borrowers to provide solutions to deal with higher payments. This is a temporary solution until interest rates begin to decline, which will then get these borrowers back to paying down principal. In a variable-rate mortgage with variable payments, the payments fluctuate with interest rates; if interest rates go up, so do monthly mortgage payments.

Chart 1

Leading up to spring 2022, variable-rate mortgages were more popular, given more attractive rates than those on fixed-rate mortgages. However, more recently, mortgage holders have been switching to fixed-rate mortgages (including new borrowers) to protect their payments should interest rates rise further.

D-SIBs' proportion of owner-occupied mortgages to total mortgages is in the 75%-90% range, which supports the banks' conservatism in mortgage underwriting. We identify the combined mortgage loans and home equity line of credit (HELOC) product (CLPs) as potentially a higher credit risk. CLPs, however, continue to exhibit a stronger credit profile compared with the rest of the banks' residential mortgage portfolios.

Here, we've focused on the six Canadian D-SIBs with numbers/ratios reflecting first-quarter 2023, unless otherwise specified. They are Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada (RBC), and Toronto-Dominion Bank. The big six banks represent about 75%-80% of domestic systemwide deposit market share.

Canada's Economy To Slow, But Housing Market Seems To Have Bottomed Out

After the Canadian economy proved resilient in the first quarter, helped by a mild winter and better economic conditions in the U.S. at the start of the new year, first-quarter 2023 economic data came in better than we anticipated. S&P Global Economics expects economic activity to drop in the second quarter as consumer spending decelerates. However, we forecast a 0.8% increase in full-year real GDP, with the country likely to avoid a recession (chart 2). High-frequency real-time economic data point to gradual improvement in operating conditions in recent weeks. The drop in long-term inflation expectations indicates that interest rate hikes by the BoC and the decline in oil prices are swaying household expectations for consumer prices; the recent OPEC decision to cut production, putting upward pressure on oil prices, complicates things.

Chart 2

We believe that the housing market has neared its trough. Mortgage rates inched down to 5.8% on average in March after rising to 5.9% in December 2022 (see table).

S&P Global Ratings developed its forecasts amid the recent financial turmoil stemming from U.S. bank failures, which adds downside risk--particularly for the U.S. economy, with knock-on effects for Canada. Our forecasts assume recent measures by regulators to stabilize the financial markets are successful. A rate cut by the BoC may be on the table sooner than expected if global financial disruptions spread to the real economy, but this isn't built into our March forecast. We expect the BoC's policy rate will hold at 4.5% until early 2024 and then will likely start easing.

Mortgage NCOs Would Have To Rise Substantially To Breach Capital Ratios

S&P Global Ratings reviewed the potential impact on D-SIBs' regulatory Tier 1 capital ratios by assuming various hypothetical residential mortgage NCO levels in their domestic residential mortgage portfolios. In a downturn, the banks' other loan portfolios would also be affected. Mortgage NCOs would have to exceed 500 basis points (bps) or 5% (from the current very low average of 1 bp) to breach D-SIBs' regulatory Tier 1 capital ratios, translating to about C$71 billion in losses, all else being equal (chart 3).

Chart 3

For the purpose of this article, we have isolated our stress test to D-SIBs' domestic residential mortgages as they represent, on average, a significant portion (about 37%) of the banks' loan portfolios. We have assumed that NCOs happen all at once without an offset from ongoing pre-provision net revenue. Under this scenario (500 bps in NCOs), D-SIBs' average regulatory Tier 1 capital ratio would drop to 12.5%, the minimum requirement. The banks' average Tier 1 capital ratio was 15.4% at first-quarter 2023. In the early 1990s when house prices in Canada fell up to 30% in some areas, the large Canadian banks' residential mortgage NCOs were only in the high single-digit bps area. Since then, their capital positions have strengthened and so they have more cushion to absorb losses.

D-SIBs have ample capital to sustain even outsize NCOs in their mortgage portfolios, which we consider to be a positive factor because we expect the bank's mortgage portfolios to weaken over the next several quarters. Their conservative underwriting, the structure of mortgages in Canada with limits set on LTVs, and the strong recourse that the banks have to borrowers in default support our view (chart 4). Naturally, we would assume that all loan portfolios would exhibit credit quality deterioration in a downturn, which would then result in a lower level of NCOs (than the 500 bps we estimate for the domestic residential portfolios) to breach the minimum Tier I capital ratio of 12.5%.

Chart 4

D-SIBs Maintain Prudent Underwriting Standards

Although we expect to see some credit quality weakness in D-SIBs' domestic residential mortgage portfolios, prudent underwriting standards will likely help limit mortgage NCOs in deteriorating economic and credit conditions. Potential future revisions to the Canadian bank regulator, the Office of the Superintendent of Financial Institutions' (OSFI's) B-20 Residential Mortgage Underwriting Practices and Procedures, which D-SIBs underwrite to, could further tighten mortgage underwriting requirements.

We view D-SIBs' residential mortgage underwriting as sound. Our opinion reflects conservative LTVs in the range of 48%-57% in banks' uninsured mortgage portfolios, which provides ample cushion should home prices decline substantially. In addition, about 29% (on average) of D-SIBs' Canadian mortgage portfolios are government insured. More than 50% of these mortgages are in Ontario, where LTVs, on average, are about 50%. This is because borrowers in general hold high levels of equity in their homes, which further improved from the significant rise in house prices during the COVID-19 pandemic through March 2022. D-SIBs' average customer credit scores were over 780, which points to the quality of mortgages on their books.

Insured mortgages at origination cannot be underwritten with LTV over 95%. Banks also have full recourse in default to borrowers' assets (in eight of the 10 provinces).

In the past several years, OSFI has been proactively tightening mortgage underwriting rules. To mitigate risks related to elevated and rising household and consumer debt, it is considering revising parts of its B-20 Residential Mortgage Underwriting Practices and Procedures, which could lead to more robust mortgage underwriting in Canada.

OSFI's B-20 practices include the following:

• Due diligence regarding borrower identity, background, and willingness to service debt obligations;
• Assessment of borrower capacity to service debt obligations on a timely basis. This includes a stress test, applicable to uninsured residential mortgages for which the minimum qualifying rate paid by the borrower must be the greater of the five-year benchmark rate published by the BoC or the contractual residential mortgage rate plus 200 bps;
• Sound collateral management and appraisal processes; and
• Effective credit and counterparty risk management practices and procedures.

OSFI has undertaken to clarify its B-20 practices with respect to the CLP (combined mortgage loans and HELOC product). Its updated expectations require that a CLP with greater than 65% LTV needs to be B-20 compliant by Oct. 31, 2023.

Other key factors of the Canadian mortgage market:

• The standard mortgage is renewed every five years or less with typical amortization of 25 years, meaning the loan balance must be refinanced at the end of five years, exposing the borrower to changes in interest rates;
• Interest payments on mortgages are not tax deductible, increasing the incentive to pay down the mortgage;
• Canadian banks typically do not sell mortgages to other financial institutions; they keep them on their balance sheets. This discourages banks from being overly aggressive in originations as they keep the risk; and
• Canadian banks have full recourse (except in Alberta and Saskatchewan) in default to mortgage borrowers' other assets and income and hold the homes against which there is borrowing as collateral. This means there is little incentive for borrowers to walk away from their mortgages.

It is mandatory to purchase mortgage insurance for certain mortgages in Canada. For example, borrowers with a down payment of less than 20% toward a purchase of a home must hold mortgage insurance. There are three main mortgage insurers in Canada: CMHC, Sagen MI Canada (formerly known as Genworth Canada), and Canada Guaranty Mortgage Insurance Co. For newly originated government-insured mortgages, the minimum down payment is 10% for homes between C$500,000-C$999,000, and 5% for homes below C$500,000 with a refinancing cap of 80% on non-insured mortgages. For non-owner-occupied investment properties, the minimum down payment is 20%.

With very few exceptions (uninsured mortgages from provincially regulated lenders for example), residential mortgage borrowers must pass a debt servicing test when obtaining a mortgage. The test includes gross debt service (GDS) and total debt service (TDS) ratios with maximums of 39% and 44%, respectively, of gross annual incomes. GDS includes principal amount, interest, taxes, and heating costs. TDS includes all components of GDS plus other debt obligations. These tests are part of OSFI's B-20 principles.

Moreover, in a bid to limit the surge in household leverage and to slow mortgage loan growth, in December 2022, OSFI increased the Domestic Stability Buffer by 50 bps to 3%, leading to a higher requirement for the Common Equity Tier 1 ratio to 11% from 10.5% for D-SIBs. It also expanded the maximum range of the buffer to 4% from 2.5%, giving OSFI the capacity to raise minimum capital levels even higher.

Demand For Mortgages Continues To Moderate

We expect declining demand for housing due to high interest rates will likely further slow demand for mortgages. We expect mortgage loan growth will be in the low single digits for the balance of 2023. Potential home buyers are sitting on the sidelines waiting to re-enter the housing market. We expect that once interest rates begin to fall, demand for mortgages will pick up, although that may not be until late 2023 or early 2024.

In first-quarter 2023, D-SIBs' residential mortgages increased 6.6% compared with about 8% and 12% at year-end 2022 and 2021, respectively. The high demand for residential mortgages during the pandemic reflected the need for additional living space: people wanted larger homes as they adopted remote and hybrid work models and when interest rates were ultra-low, making borrowing cheap. Since March 2022, however, mortgage loan growth has been moderating as interest rates rose rapidly (chart 5). We believe it will further moderate, particularly if interest rates remain at their current high levels through 2023. We see the BoC possibly cutting rates in early 2024. Inflation, although down to 4.3% in March 2023 from its peak of 8.1% in June 2022, is still above the bank's targeted rate of 2% so high interest rates for longer may be necessary to continue to battle inflation. House prices are beginning to stabilize after falling since March 2022 (chart 6). We believe that increasing immigration flows and serious house supply shortages will keep house prices elevated.

Chart 5

Chart 6

Borrowers' Capacity To Service Mortgage Debt, Although Strained, Should Still Be Manageable

We believe mortgage holders' ability to continue to service their mortgage debt will be strained for those currently renewing their mortgages for reasons discussed below.

We expect Canada's unemployment rate will rise modestly in 2023. Demand for labor remains robust, particularly because businesses are still looking to fill positions following the pandemic. This could change as some companies have started to lay off employees as profit margins are being squeezed; to date, the technology sector has been most affected. There is no evidence of broad-based layoffs across industries. Still-low unemployment will help borrowers facing higher borrowing costs. Wages overall have kept up with inflation and more recently are being adjusted closer to higher inflation rates, which also is helping manage higher borrowing costs.

We believe that mortgage holders' increased vulnerability to higher interest rates is somewhat contained because of several other factors as well. According to Statistics Canada, Canadian households' net worth peaked in first-quarter 2022 at C$16.3 trillion, which included an accumulation of C$4 trillion in wealth during the pandemic, reflecting robust house price appreciation, rising equity and capital markets, and higher household savings. Although the household savings rate fell to 6% by fourth-quarter 2022, it is still above 2.8% at year-end 2019. The still-higher savings rate than pre-pandemic will help mortgage holders manage higher monthly mortgage payments. The transfer of intergenerational wealth, particularly in the latter half of the last decade and the early 2020s, is also an important factor, as are higher wages. Canadians hold high levels of equity in their homes, as evidenced by the conservative average LTVs in the 50% area for D-SIBs' uninsured residential mortgage portfolios.

Higher interest rates have led to mortgage rates currently above 5.25% (the average rate for a five-year conventional mortgage was about 5.8% in March 2023), which is the minimum qualifying rate (MQR). OSFI maintains the MQR, which is the stress test D-SIBs follow to qualify insured and uninsured mortgage borrowers. The stress test equals the contract rate plus 2%, or 5.25%, whichever is greater. As the BoC's overnight rate increased eight consecutive times since March 2022 (when it was 0.25%) and is 4.5% (effective January 2023), the stress test has become more onerous for potential mortgage borrowers qualifying for a mortgage and for those renewing their mortgages as borrowers need to qualify for a mortgage at a rate of 7.8% (chart 7). The average conventional mortgage rate does not reflect potential discounts that D-SIBs offers to clients.

Chart 7

The cohort of mortgage holders that is most vulnerable to the sharp rise in interest rates is the one where renewals are occurring now. We believe that a high percentage of the variable-rate mortgage balances have more than 30 years of remaining amortization, which will reset at renewal. If we overlay this with cash flow insights from clients' deposit accounts, and high interest rates remain sustained over a prolonged period, only a very modest portion of the banks' mortgage books presents risks related to a potential cash flow and collateral issue (chart 8). We estimate that about 15%-25% of banks' mortgage portfolios have 100% of payments allocated to interest. A modest percentage of the cohort will mature by the end of 2024. This is a risk to D-SIBs in terms of potential future losses but because the portion is modest, we view this risk as manageable. A higher percentage of mortgages will mature in 2025 and 2026. At that time, interest rates will likely be lower than they are today and so borrowers will be in a more comfortable position at renewal time.

Chart 8

OSFI is considering adopting a "high loan-to-income threshold" of 4.5x on mortgages and debt service coverage restrictions, which would limit increases in leverage to a share of income.

D-SIBs have acted early in contacting their borrowers by offering various solutions such as extending mortgage amortization, increasing payment amount, encouraging pre-payment of mortgages (up to 10% of principal mortgage amount once a year), and providing other special payment options to help mortgage holders with the strain on debt service. This should help minimize the level of mortgage delinquencies in a down market. Mortgage insurers are also supporting mortgage holders who are facing difficulties. For instance, Sagen has decided to provide lenders more leeway to bail out cash-strapped borrowers. It is allowing lenders to extend amortizations up to 40 years to help borrowers manage payments. CMHC and Canada Guaranty are also providing short-term payment relief to help struggling borrowers.

DSIBs' Mortgage Credit Quality Metrics Are Likely To Deteriorate Although Remain Manageable

D-SIBs' credit quality metrics, including those for mortgages in 2021 and 2022, improved due to benign credit conditions helped by low interest rates (chart 9). We believe that the recent sharp rise in interest rates will put some pressure on credit quality metrics in 2023 and 2024. We expect mortgage delinquencies and NCOs likely will normalize in 2023 and 2024 from very low levels as higher interest rates work through the system and begin to affect borrowers' capacity to pay their monthly mortgage payments and other personal debt while high inflation continues to eat into savings. Overall, we expect D-SIBs to weather the weaker credit environment supported by strong underwriting practices, sound balance sheets, and capital levels that could withstand even large loan losses.

Chart 9

In our base-case scenario, we expect mortgage delinquencies, which are about 12 bps on average, to normalize in 2023 (chart 10). D-SIBs' average mortgage NCOs are about 1 bp, which we expect will rise very modestly. In addition, delinquencies are likely to rise further in 2024 because a higher proportion of mortgages will renew at rates that are likely to be higher than pre-pandemic rates and perhaps remain at or near current levels into the early part of 2024. Asset quality would deteriorate further if unemployment rose more than we expect.

Chart 10

After third-quarter 2022, DISBs' total reserves to total loans began to rise, reflecting a weaker economic outlook; this was after six quarters of allowance reversals. In first-quarter 2023, D-SIBs' reserves to loans were 60 bps, up from 58 bps in third-quarter 2022. We believe that the banks will likely continue to build reserves should the economic outlook deteriorate more than what is expected (chart 11). Similarly, provisions for loan losses reversed from first-quarter 2022, picking up speed in third-quarter 2022 (chart 12). We see provisions for loan losses rising significantly in 2023 from their very low levels of 2022 but remaining below their peak of 2020. As of first-quarter 2023, D-SIBs' average provisions for loan losses were 26 bps of gross loans, up from 4 bps in first-quarter 2022.

Chart 11

Chart 12