The Bank of Canada’s recent interest rate hike and the possibility of further increases have raised concerns about the risks faced by mortgage lenders. As homeowners grapple with higher mortgage payments or struggle to even cover the interest portion of their loans, investors and analysts are highlighting the potential dangers.
To address these risks stemming from rising borrowing costs, Canada’s main banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), has proposed stricter capital rules for lenders. The aim is to prevent consumers from defaulting on their mortgages or falling into negative amortization, a situation where borrowers’ monthly repayments are insufficient to cover the interest, resulting in the outstanding loan amount being extended.
The proposed capital rules reflect the recognition that there is stress in the system, according to Greg Taylor, Chief Investment Officer of Purpose Investments. The concern is that the Bank of Canada’s tightening measures could be the tipping point for a system already under strain.
Unlike in the United States, where borrowers can secure a 30-year mortgage, Canadian borrowers must renew their mortgages every five years at prevailing interest rates. With the central bank now projecting inflation hitting its two percent target by mid-2025, it suggests that interest rates will remain elevated for a longer period.
Since October 2021, when interest rates hit a record low, the cost of a floating rate mortgage has increased by about 70 percent. This presents a significant challenge for the estimated C$331 billion in mortgages up for renewal in 2024 and C$352 billion the following year.
However, for now, consumers are able to make their mortgage payments, largely due to robust employment rates. Additionally, borrowers have undergone stress tests to ensure they can handle higher interest rates.
Among the country’s big six banks, Bank of Nova Scotia and National Bank of Canada do not offer mortgage extensions. As a result, each interest rate hike from the Bank of Canada leads to an increase in the payment owed by borrowers. The lack of flexibility in their products could also result in these banks losing market share.
Royal Bank of Canada (RBC), on the other hand, does not offer negative amortization but has already increased payments by as much as 40 percent for its variable rate mortgage customers to accommodate higher interest rates. Bank of Montreal (BMO), CIBC, and TD Bank allow for negative amortization as interest rates rise.
The recent proposal by Canada’s banking regulator to increase capital requirements could pose manageable challenges for BMO and TD, according to KBW analyst Mike Rizvanovic. However, CIBC may face more significant challenges depending on how much of its portfolio ends up in negative amortization.
Mortgage forbearance is playing a crucial role in maintaining persistent demand for housing. By keeping monthly payments unchanged, consumer behavior and spending patterns remain stable. This counters the objectives of the Bank of Canada as it tries to address potential risks in the housing market.
Overall, the record tightening campaign by the Bank of Canada has exposed lenders to potential mortgage risks. While consumers are currently managing their mortgage payments, the challenges of higher interest rates and upcoming mortgage renewals create uncertainties for both borrowers and lenders. The effectiveness of the proposed capital rules in mitigating these risks remains to be seen.
