Monday, 13 May 2013

Equity Isn't Fool-Proof Protection for the Canadian Banks & CMHC

The future looks gloomy for Canada's real estate market and for its banks. If the interest rates return to their 30 year average of 9%, a financial Armageddon would level out the housing market, CMHC and major Canadian banks. At the moment, a 0.25% hike in interest rates seems highly unlikely, so the chances of  a return to the long term average is unimaginable. Nevertheless all it takes is a spike in inflation to prompt the central bank to raise its benchmark rate. No matter how small the risk of inflation is, it is still like passing a double yellow line into oncoming traffic in front of blind curve.

Some say that Canadian banks are the best in the world and that they are invulnerable to the mess that hit the US financial system.  Yet not everyone agrees. Some analysts have come to the conclusion that equity built into residential loans is not enough to fully protect Canadian financial institutions.

We compared loan/value ratios for both the U.S. housing market leading up to the collapse in 2008-09 and the Canadian market for 2006 and 2013. The median U.S. loan/value just before the housing bust is very similar, at 54%-55%, to the current ratios at Canadian banks. 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. We think this demonstrates higher risk to the CMHC and banks' capital levels. In fact, the Canadian banks' proportion of loans with loan/value ratios greater than 80% is higher than for U.S. banks in 2007, just before the housing bust.

CMHC's Reserves Could Prove Insufficient to Cover Insured Mortgage Losses
We have estimated the potential losses for CMHC coverage claims for each Canadian bank, on average, in its residential loan portfolio. While many Canadian mortgages have low loan/value ratios because of recent home price appreciation, 28% of insured Canadian mortgages have ratios of 80% or greater. We worry that this creates a risk that CMHC's liabilities could exceed its equity if Canadian home prices were to decline. We estimate that if home prices were to decline 20%, and if 20% of underwater loans defaulted and had 60% recovery rates, the resulting CAD 12 billion of losses would consume more than 90% of the insurance fund's CAD 13 billion of capital. If 100% of underwater loans were to default, we calculate that even a modest 10% decline in prices would more than exhaust CMHC's capital.

Uninsured Mortgage Losses Could Eat Significantly Into Bank Capital
For the uninsured residential loan portfolio, we think the potential losses directly to the banks could be meaningful and impair their capital bases. Again, we assume a 60% recovery of the uninsured loan balance, assuming 100% losses of the uninsured balance with losses directly impairing tangible capital. If 20% of the uninsured underwater residential loans are losses, the impact on tangible capital levels becomes meaningful with a 30%-40% reduction in pricing. In a worst-case scenario, if all of the uninsured loans were losses and residential prices fell 30%, we think nearly half of most banks' tangible equity would be affected.

Equity Isn't Fool-Proof Protection
Most bankers in Canada like to point to the equity built into the residential loan portfolios as protection to the banks' capital from significant losses. Based on the experience of the U.S., we think this argument is not fool-proof in protecting the Canadian banks or CMHC from losses. We think the distribution of the loan/value ratios is much more important to determining the impact a housing bust will have on the Canadian banks. We will continue to monitor the developments regarding Canadian residential real estate. However, we are not convinced that equity built into residential loans is enough to fully protect the banks or Canadian taxpayers.

Interesting! Does this mean that one day CMHC may need a bailout? Well, according to Flaherty CMHC had morphed into one of the largest financial institutions in Canada. In other words, CMHC is too big to fail!  On top of that, Flaherty is slowly replacing the current CMHC executive staff with people who have experience in finance. I wonder why? After all, CMHC insures over $500 billion worth of mortgages. 



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