Canadian banks start preparing for insolvency as interest rates rise.
In their third-quarter earnings reports on Thursday, TD Bank and CIBC provided updates on their variable rate mortgage balances. As a result of the Bank of Canada raising its benchmark rate by 225 basis points since March, variable rate borrowers have seen their interest payments rise. According to RBC's announcement on Wednesday, 80,000 of its variable rate mortgage clients will reach their trigger point by the end of the year. During this period, borrowers' monthly payments only cover the interest and no longer pay down any principal.
Mortgage lenders are concerned with borrowers' ability to handle significantly higher mortgage rates at renewal time, aside from the effect of rising rates on variable-rate mortgage holders. Over the next 12 months, CIBC expects to renew 26 billion mortgages, $19 billion in fixed-rate mortgages and $7 billion in variable rate mortgages.
CIBC's chief risk officer Sean Bieber says most of its variable rate mortgages have fixed payments. Therefore, they are being affected by rising interest rates through an extension of amortization, rather than an immediate change in payment. Mortgage renewals are reverted to the original amortization schedule, which may require additional payments.
At some big banks, the percentage of amortization over 35+ years has increased to 20% or more because of rising interest rates. CIBC, for instance, has seen its amortizations rise to 35+ years for 22% of borrowers, a 12% increase from the last quarter.
The way TD Bank works is a tad different. The Canadian personal banking group head at TD Bank, Michael Rhodes, says that if a customer reaches the point where they are no longer amortizing their principal, TD Bank will reach out to them and provide options. With TD Bank, a customer can increase their payment, do nothing, decide to make a lump sum payment, etc.
The provision for credit losses at TD increased by $324 million in the quarter to 351 million, compared with a recovery of $37 million in Q3 2021. A year ago, CIBC released $99 million in provisions for credit losses, compared to $243 million this quarter. As mentioned, CIBC's mortgage portfolio now has an amortization of over 35 years. As interest rates rise, more of the fixed monthly payment goes towards interest rather than principle, which just mathematically extends the amortization period. As long as that capitalization continues, it will reach the designated amount, which is 105% of the original principal amount, and immediate payment will be required. However, the 22% of the portfolio that has amortization beyond this point is actually the mathematical outcome of more monthly payments directed towards interest rather than principal.
Royal Bank of Canada's net income fell to 3.58 billion as provisions for credit losses in an alien capital market segment hit the bank hard. For similar reasons, the National Bank of Canada's net income fell 2% to $826 million year-over-year.
A provision for credit losses is an estimate of potential losses a company may experience due to credit risk. A company's financial statements treat credit losses as an expense. It is for this reason that big banks are experiencing a decline in profits. It is expected that they will suffer losses from delinquent and bad debts or other credit that is likely to default or become unrecoverable.
A surge in pandemic demand had boosted home prices across the province. As economists had predicted, instead of home prices falling due to economic uncertainty, demand surged, especially in suburban and rural areas. In the second year of the COVID-19 pandemic, global economic disruptions pushed up the price of nearly everything: groceries, gas, bikes, and cars. According to the Bank of Canada, it acted to slow inflation after it grew by 8% - the highest level in 40 years.
With low-interest rates, homeownership has become within reach for more people. This is especially true in markets like Vancouver and Toronto, where house prices have skyrocketed due to demand from young professionals who want a good life but can't afford it yet because of the higher costs associated with living there. However, experts warned these so-called " traps" would only last until another economic downturn came around again - this time much less forgiving than before.
Housing markets in Metro Vancouver and Toronto have been feeling the effects of an interest rate hike after Canada's central bank has been increasing rates steadily since March of this year. Steve Sarisky, a realtor from Vancity stated that people who recently bought homes with variable mortgages may see their monthly payments go up by as much as $1500 because they're now paying more than 4% and even 6% in the cases of those who have alternative or private loans.
What are the results? There has been a dramatic cooling in the real estate market. Prices are falling and listings have dried up. In addition, most economists agree that prices will continue to fall as long as inflation remains high since the Bank of Canada intends to increase interest rates to a correlation and bring inflation down to a target of two to three percent.
Simply put all homebuyers are vulnerable to rising interest rates but there are three groups most likely affected by higher mortgage payments and they are people who get their loans from private lenders, condo buyers pre-selling assignments with no property value guarantee and homeowners currently facing the trigger option their variable rate mortgage.
Basically, a trigger rate is when your lender approaches you or mails you a notice that your monthly mortgage payment is now only allocated towards interest-only payments. The Bank reminds you that the interest rate has dramatically increased since the loan was originally taken out. As a result, the bank will ask for more money each month, which could result in a large amount of insolvency and default risk for many people.
These policies that include funnelling billions of cheap money into the economy and then taking it out rapidly via rapid rises to the overnight lending rate at unprecedented intervals, actually work to make the rich super rich and inadvertently push many people below the poverty line when the trigger on inflation is finally pulled.
The latest data from the Canadian real estate Association showed prices hit $629,971 in July, down 5% from $662,924 last July. And on a seasonally adjusted basis, it amounted to $650,760, a 3% drop from June. When pandemic lockdowns began in March 2020, the average national price was $543,920.
While the Canadian real estate association expects the average home price to rise by 10.8% annually to $786,252 by 2023, most economists expect an even greater price drop.
DesJardins Economists predicted that between February's high of $817,253 and the end of 2023, the average national Humphries would fall by 15%. Since we are almost there, they adjusted their prediction to predict a drop between 20 and 25 percent.
Many sellers are having difficulty accepting the fact that their homes won't fetch as much money as they would in February or March earlier this year.
Who benefits from higher interest rates? Despite growing economic unease, two of Canada's largest banks reaped the benefits of higher interest rates by increasing loan margins in the third quarter of their fiscal year.
Inflation and rising provisions for loss led to Toronto Dominion Bank's lower third-quarter profit compared with a year ago. Due to the same headwinds, Canadian Imperial Bank of Commerce also saw earnings dip in the quarter.
It is expected that margins will continue to increase in the coming quarters but at a slower pace. In addition, they acknowledged that as inflation runs high, borrowing costs rise, and economic uncertainty remains high, demand for new loans - especially residential mortgages - may decline. Banks expect loan defaults to begin creeping higher from unusually low levels.
As CIBC's chief financial officer stated in an interview, if all the forecasts are accurate about what will happen in the economy, including rising rates and a slowing credit demand, you will see an offsetting effect. Although margins are expanding and credit demand is cooling, CIBC is confident that net interest income will continue to grow.
In general, most banks, like TD Bank Group for example, reported a profit decline because they are preparing for a possible recession ahead, despite loans continuing to grow and consumer savings rates remaining high. One of the dominant trends so far this earnings season has been the return to climbing provisions for credit losses, which are counted against income. Bank of Montreal has the last report to come out next week. Having unwound parts of their provisions built up in the early days of the pandemic, banks rode a wave of profit beats last year, and are now experiencing the reverse as they build reserves due to rising central bank interest rates.
On September 7, the Bank of Canada will raise interest rates again. The Big Six banks are likely to increase the prime rate by half-a-point this time. As HELOC charges increase with each CB hike, we'll get closer to an imminent trigger rate when monthly payments on tens of thousands of variable mortgages soar by $200 each month. So expect no declines in mortgage loans during these times because things are simply still tightening up!
Even as prices decline, housing affordability has not declined. About 80% of buyers in Canada rely on mortgage financing, so this is still a barrier for them to get into the market. But there are still many potential homeowners who can get in the market easily and for a bargain!
Is it time to sell or should you wait for the market to increase in value again?
Two of history's most significant property flops occurred in the Canadian and American housing markets. In these countries, prices dropped on average by 32%. In 1989, 1991 here, and 2005 - 2008 in the US, it took 24 to 36 months until each market bottomed out, then ten years or more before prices could reach their former peak levels.
Sarah A. Colucci, Senior Mortgage Agent
Sherwood Mortgage Group, Broker 12176
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By: Sarah Colucci
Senior Mortgage Agent, Lic. M14000929