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Canada’s banks in trouble when ‘housing bubble’ pops: report

Fin - Balance Sheet - CA
The entrance to a Royal Bank of Canada office is seen in Orlando, Fla.

Canada’s big banks may have sidestepped the worst of the global financial crisis, but could get tripped up by a correction in the country’s housing market that some caution is coming.

A new report from Morningstar says investors in Canadian banks should start worrying about a potential housing market downturn that could be triggered by an eventual rise in interest rates.

Higher rates would make home ownership less affordable and may lead to more mortgage defaults.

That will have a negative impact on the profitability of Canadian banks, which Morningstar says provide 75 per cent of residential mortgage credit.

Morningstar says the Royal Bank and CIBC would be most affected by a drop in home values because they have the highest percentage of residential loans to tangible common equity ratios, while Bank of Montreal and National Bank of Canada will be hurt the least.

“We think it comes down to how affordable it will be when interest rates start to rise again,” says Chicago-based Morningstar analyst Dan Werner, who has warned about Canada’s housing market in the past.

In his latest report, Werner and his colleagues predict Canada’s “housing bubble” will pop within the next five years, calling a correction “almost inevitable.” They forecast prices could fall 25-to-30 per cent from their peak.

“Ultimately, we expect a combination of factors, rather than a single key event, to drive the eventual decline,” the report states.

The Morningstar analysts are among of a growing number of financial experts, many from outside the country, calling for a Canadian housing market correction.

The warnings are piling up as the market continues to defy expectations. After a slowdown in many cities over the winter, prices and sales picked up in the spring, particularly in the largest and most-expensive markets such as Toronto, Vancouver and Calgary.

While many Canadian economists are still calling for a “soft landing” for the overall Canadian market, others are predicting something more painful.

For example, the Organization for Economic Co-operation and Development (OECD) said last year that it believes Canada’s housing market is about 30 per cent overvalued when measured by affordability (price-to-income ratio) and 60 per cent based on profitability of owning a house (price-to-rent ratio).

The Morningstar report tackles one-by-one the arguments from optimists who say the market is balanced, supported by immigration (including wealthy Chinese buyers in cities such as Vancouver) and is too distinct from the U.S. to face a similar style crash.

“Many investors believe that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now,” the Morningstar report states. “History has shown, time and again, that ‘this time’ is not different.”

It notes interest rates have fallen for the past 30 years, which has largely driven housing affordability in Canada. Morningstar says the cracks in the foundation will start to appear when interest rates inch higher, which many economists predict will begin next year.

“Affordability changes drastically if rates revert toward historical means,” the report states. “Investors in Canadian banks should be concerned as macroeconomic stimulus is eventually eased and, ultimately, reversed.”