May 24, 2024

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Bank of Canada warns renters showing financial strain

7 min read

Share of borrowers with credit card balance at 80% and higher continues to climb

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The Bank of Canada is raising concerns about the impact of higher interest rates on renters while acknowledging that, even as most households appear to be managing increased debt servicing costs, there are still many mortgage holders who will face large payment increases when they renew over the next two-and-a-half years.

The adjustment to higher interest rates “continues to present risks to financial stability,” Bank of Canada governor Tiff Macklem said Thursday as the bank released its annual report on stresses across the financial system.

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Senior deputy governor Carolyn Rogers, who has previously raised concerns about renters, said the data compiled suggests there is stress in these households.

“After hitting historical lows during the pandemic the share of households without a mortgage that are behind on credit card and auto loan payments has come back up to — or surpassed — typical levels,” she said. “And over the past year, the share of borrowers without a mortgage who carry a credit card balance of at least 80 per cent of their credit limit has continued to climb.”

Other issues flagged in the report included “stretched” valuations of some financial assets, a sharp rise in the use of leverage by the non-bank financial sector and risks due to the exposure to commercial real estate, where weaker demand has pushed the national office vacancy rate up to around 20 per cent.

Since the Bank of Canada began to increase interest rates in March 2022, payments have increased for about half of all outstanding mortgages. Over the next two-and-a-half years, a big share of remaining mortgages will renew and these borrowers will face even larger payment increases.

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“Over the coming years, more borrowers will face pressure as they refinance existing mortgages at higher rates,” the report said. “Higher debt-servicing costs reduce a household’s financial flexibility, making them more financially vulnerable if their income declines or they face an unexpected material expense.”

The report showed that the median increase in monthly mortgage payments will be more than 20 per cent at renewal in 2025 and more than 30 per in 2026, compared with origination. For variable rate mortgages with fixed payments, the median increase will be more than 60 per cent in 2026.

“The financial pressure will increase most for households that took out a mortgage in 2021 and early 2022 when house prices were close to their peak and mortgage rates were very low,” the report said. These buyers generally took on large mortgages relative to their incomes and have seen very little increase — and potentially a decrease — in their home equity.

By the end of 2023, more than a third of new mortgages had a debt-service ratio greater than 25 per cent, double the share in 2019.

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Credit arrears climbing

The Financial Stability Report said large banks with healthy capital cushions are handling the stresses in the mortgage market so far, but some smaller lenders have already seen a sharp uptick in credit arrears.

“Increased provisions for loan losses are impacting profitability but also enhancing banks’ resilience,” the report said, adding that funding for banks remains stable, though costs have increased.

The report said small and medium-sized lenders are likely seeing more mortgages in arrears because their borrowers tend to have higher risk profiles. In addition, with typically shorter terms, nearly all these borrowers have renewed. In contrast, about half of the mortgages at large banks have yet to renew.

The Financial Stability Report suggested that with conservative wage increases, most borrowers should be able to manage, and that some are increasing savings and adjusting payments, including making lump-sum contributions. A bigger shock to the financial system, including the banks, would be felt with a hit to wages from rising unemployment.

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Appetite for risk rising

With many central banks considering cutting interest rates after sharp increases over the past couple of years brought down inflation, speculation about when rates will be cut, and by how much, is increasing the risks of sudden swings in asset prices, according to the Bank of Canada’s report.

“This has driven a renewed appetite for risk,” the Financial Stability Report said, adding that, in addition to pushing up the prices of a range of financial assets, it has driven down risk premiums and credit spreads in both Canada and the United States. This leaves them vulnerable to sudden repricing if the conditions on which they are predicated do not materialize.

Corporate credit spreads are now at or below levels seen on average since the 2008-09 global financial crisis, the report said.

Macklem said stretched asset valuations of some financial assets, such as market prices rising beyond fundamentals, increases the risk of a sharp correction that could generate system-wide stress.

“The recent rise in the use of leverage in the non-bank financial sector could amplify the effects of such a correction,” he said.

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The report noted that the use of leverage through borrowing in the repo market has risen considerably in the past 12 months, particularly among pension and hedge funds. For hedge funds, repo leverage has increased by about 75 per cent. This appears to be driven by relative-value trading strategies including an increasingly popular cash-futures basis trade in the Government of Canada bond market.

“I think it’s traders arbitraging anticipated changes in interest rates,” Rogers said in an interview. “As long as there’s a bit of room to speculate on where interest rates are heading, that trade is going to probably stay popular.”

She added that leverage is used to amplify profits, but it can work the other way around to amplify losses and volatility.

Commercial real estate exposure

The Financial Stability report said both bank and non-bank financial entities are involved in the commercial real estate sector in Canada, though there are “substantial data gaps” for non-bank financial intermediaries. For banks, this is mostly in the form of loans, including commercial mortgages and loans to real estate developers.

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The commercial real estate sector accounts for about 10 per cent of the loan books of large banks in Canada, and about 20 per cent for small and medium-sized banks. This is much lower than their counterparts in the United States, where exposure of small and medium-sized lenders is around 36 per cent.

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Canada’s largest life insurance companies hold about 12 per cent of their total invested assets in the global commercial real estate sector and 70 per cent of that is held in commercial mortgages. For large pension funds, the percentage of total invested assets is 15 per cent, but about 90 per cent of the exposure reflects ownership stakes. Both hold about three per cent of their invested assets in the office subsector.

The Bank of Canada report said some pension funds and insurers have written down their exposures, but there may be more to come, particularly in the office sector, as private valuation adjustments have lagged declines in public market valuations.

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