As interest rates soared above six percent over the last seventeen months, four of the big five Canadian banks have allowed floating-rate customers to extend and pretend by making the same mortgage payments as when floating rates were sub-2%. This has compounded solvency problems as unpaid interest adds to the debt and extends amortization periods beyond prudence.
In their latest quarter ended in July, Canadian banks reported between 23 and 29.8% of their mortgage books with amortizations greater than 30 years, up from virtually zero in 2022. Bank of Nova Scotia is the only of the big five that wisely has not allowed variable payments for floating rate mortgage customers.
Last month, the Office of the Superintendent of Financial Institutions (OSFI) proposed changes to make banks hold more capital to address risks “related to mortgages with growing balances.” Starting in 2024, lenders will hold more capital against mortgages with growing balances and loan-to-collateral values above 65 percent.
Higher capital requirements reduce lender profits and are particularly unattractive at a time when banks are also increasing their loan loss provisions.
Canadian banks are alerting customers that they must bring mortgages into conventional 25-year amortization periods by increasing monthly or lump sum payments—easier said than done for the masses. An estimated C$331 billion in home loans are due for renewal next year alone.
Higher debt-service payments are a headwind for debtors and the overall economy. Royal Bank CEO Dave McKay connected the dots last week: “The industry has a significant portion of mortgages maturing in 2024, 2025 … If rates hold, we’ll pull more disposable income out of the economy and slow it even faster.”
Less spending leads to rising unemployment and more people skipping payments of all kinds. That negative loop is underway now. Defaults and forced sales are growing.
The Canadian financial index (XFN) is, to date, -18% since peaking with Canadian home prices in February 2022. During the 2000-02 and 2007-09 downcycles (where Canadians were much less indebted and property prices much less inflated), the financial index lost about 50% of its market value.
The financial sector’s whopping 31% weight in the broader Canadian stock market (TSX) magnifies capital risk for all of the funds and portfolios designed to track it. But most overlook these dynamics until it’s too late.
Valuable investment opportunities come for those prepared and disciplined enough to wait for them. Such is the test.