How housing could hit the banks, eventually

ANALYSIS

Canada’s l argest banks, which begin rolling out their latest earnings on Tuesday, are often seen as insulated from a potential housing downturn because about half the $ 1.6 trillion in total mortgage debt in this country is supported by government-backed insurance.

But the big banks would not be immune to a steep drop in prices, something that seems within the realm of possibility given early indications of cooling in Vancouver’s red hot market.

In a report Monday, equity analysts at National Bank Financial said softening house prices in Vancouver are expected to translate into weaker retail spending in B.C. this fall, which could trigger a cascade of events leading to rising household credit losses for the banks.

“As home prices drop, households will spend less. As consumption falls in Vancouver, so too will employment,” the report said, concluding that a weakening job market “will in turn lead to rising household credit losses.”

The National Bank analysts, led by Peter Routledge, expect the Vancouver market will continue to be dampened by the additional property transfer tax levied this month on residential properties purchased by foreign buyers.

Analysts don’ t expect much fallout to be visible when Canada’s largest banks report third-quarter earnings this week, beginning with Bank of Montreal on Tuesday. As one veteran banking analyst put it: “Certain things need to happen before this becomes a big issue, and we are not there yet.”

But regulators are clearly concerned about heated pockets of Canada’s real estate market, including Vancouver and Toronto. The Office of the Superintendent of Financial Services has made a handful of recent moves intended to put greater scrutiny on mortgage underwriting practices, increase the amount of capital held against mortgages in markets where prices are rising rapidly, and impose more conservative stress- testing for real estate at smaller financial institutions.

Ratings agency Fitch also zeroed on housing in a report Monday, placing particular emphasis on the recent decline in home sales in Vancouver. Fitch said the trend “suggests that the city’s market may already have begun to cool and is increasingly vulnerable to price declines if there is a rise in the unemployment rate.”

There is no question a significant slowdown could put more at risk than the banks’ mortgage portfolios, says Jason Mercer, an assistant vice-president at Moody’s Investors Service who penned a report in June that pegged losses in a severe housing downturn at close to $12 billion for the country’s seven largest lenders including the big banks.

Mercer said Monday that any scenario that leads to a household “cash flow shortage,” such as a rapid rise in unemployment, would trigger a “hierarchy of credit sacrifice” with mortgages at the end of the line.

“Credit cards and autos would go first,” he said, adding that credit card debt is unsecured, which provides less recourse for banks.

The whole consumer credit picture is on the minds of analysts when they assess Canada’s big banks, and anything that could trigger widespread unemployment, even regionally, is closely watched because of the impact of unemployment on unsecured credit and other debt that isn’t backed by government guarantees.

This week, as bulk of the major banks report earnings, the focus is expected to be on the performance of the energy portfolios. Several banks took larger provisions for energy- related losses in the second quarter as a result of persistent low oil prices. And though sequential performance is expected to be somewhat flat, year-over-year comparisons should reflect the tough environment.

Analysts will also be watching how the banks respond to expected tighter net interest margins, which reflect the difference between the cost at which they lend and borrow money, and how they might cut costs to protect their bottom lines.

In a report late last week, Barclays analyst John Aiken noted that the spread between the government Canada’s two- year and 10- year bonds is “the narrowest it has been since the financial crisis,” which is bound to put pressure on the banks’ margins.

The reporting season will be capped next week by Bank of Nova Scotia, which releases earnings on Aug. 30.