Have Canada's big banks mortgaged their future?

• Canada’s mortgage market
• Canada’s resilient banks
• Should investors be worried?

The Canadian housing market has been resilient in 2023 despite relatively high mortgage rates. These rates increased to 15-year highs this summer as the Bank of Canada (BoC) continued to increase the overnight rate by 50bp (0.5%) over the past two months.

Rate increases affect not only mortgage holders but also lenders such as banks, and regulators are paying very close attention. In its Annual Risk Outlook published this past April¹, the Office of the Superintendent of Financial Institutions (OSFI) ranked the potential for a housing market downturn as the most significant risk facing Canada’s financial system in the upcoming year.

So, what does all this mean when looking at banks as an investment?

Canada’s mortgage market

Residential mortgages are the largest segment of loans and assets on the balance sheets of Canada’s Big Five banks². In aggregate, these banks have total outstanding mortgage loans of close to $1.5 trillion dollars, which represents approximately 40% of their combined loan book³.

Mortgages are broken down into insured and uninsured. If a home buyer has less than a 20% downpayment, mortgage insurance is required. Banks are not exposed to potential losses on insured mortgages as the risk is transferred to the mortgage insurance companies.

Homeowners can choose between two different types of mortgage rate options – variable or fixed. The interest on a variable rate mortgage typically moves in step with rate changes made by the BoC, hence its variability. In contrast, the interest on fixed rate mortgages is fixed at the time the mortgage originates or is renewed, for a period of time between six months and ten years. (The most common duration of a fixed-rate mortgage in Canada is five years.)

Mortgage rates have increased rapidly and significantly over the past 18 months due in part to the BoC increasing its target for the overnight rate from 0.5% to 5%, which has caused both variable and fixed rate mortgages to increase to levels not seen since 2008 (see figure 1). The BoC estimates that mortgage borrowers who renew their loans over the next few years will see a 20% to 40% increase in their monthly payments.

Figure 1: Historical discounted 5-year mortgage rates



Source: ratehub.ca 
Note: Best posted rate in Canada for an insured mortgage, which requires the homeowner to purchase mortgage insurance.

These increases have intensified investor concerns with Canadian banks’ mortgage businesses. The concern, specifically, is with variable rate mortgages, and fixed rate mortgages that will renew at higher rates, causing some homeowners mortgage payment shock.

Canada’s resilient banks

Significant declines in Canadian real estate have historically challenged Canadian banks’ earnings (e.g., the early 1990s). However, the BoC and OSFI conduct annual stress tests on the banks to make sure they are able to withstand a severe economic downturn. In 2022, OSFI concluded that even in the event of a severe and prolonged recession, “the capital position of major Canadian banks would be weakened but would not breach minimum requirements.”⁴

There are many reasons underpinning this confidence. In our view, those reasons include strong and prudent banking regulations, greater diversification, increased sophistication in risk management, a conservative culture, and the ongoing strong demand for housing. In addition, OSFI uses its authority to reduce the risk in Canadian banks through a variety of means. OSFI is an independent federal government agency that regulates and supervises Canadian banks and is a world leader in adapting and implementing banking reforms.

Looking at the banks themselves, they have become more diversified over time. They are now some of the largest wealth managers in Canada and have prudently expanded outside of Canada. This increase in diversification typically reduces earnings volatility during a recession. As well, risk management by the banks has improved over the last couple of decades, increasing senior management’s ability to effectively deal with risk in various scenarios. This approach reflects the longstanding conservative nature of Canadian banks.

Should investors be worried?

The demand for housing in Canada has never been stronger. Rents have increased by double digits over the past two years in some cities, and immigration has been a tailwind for housing. These and other factors, including the enduring pride of home ownership and the tax-free nature of principal residences when sold, suggest that Canadians will try to stay in their homes as long as possible, even if they get into financial trouble. Our history bears this out as Canadians have historically paid their mortgages and banks have enjoyed very low loan losses on mortgages. Loan losses generally increase during a recession, but we believe those losses would be manageable if Canada were to move into a recession.

Employment is also a factor to consider. As long as homeowners are employed, the risk of mortgage defaults are low. This is why we closely monitor the unemployment rate which is currently low. In addition, salaries typically increase over time, which should help offset higher mortgage payments.

So, back to the question: where does all this leave banks as an investment?

We believe that while higher mortgage rates and a potential recession in general may affect Canadian banks over the short term, banks will continue to be good investments for investors seeking growing dividend income and those looking for capital gains.

Sources: Bank of Canada, OSFI, Canadian Bankers Association, Canadian Banks disclosure documents

¹ https://www.osfi-bsif.gc.ca/Eng/osfi-bsif/med/Pages/nr20230418.aspx

² Big Five refers to CIBC, Bank of Nova Scotia, Bank of Montreal, TD Bank, Royal Bank

³ Canadian Banks’ Annual Reports 2022

⁴ “How well can large banks in Canada withstand a severe economic downturn?” Bank of Canada Staff Analytical Note No. 2022-6 (May 2022).

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