The big five Canadian banks have limited exposure to the subprime mortgage market, and are well positioned to weather the credit quality storm, says DBRS.

The rating agency says that while the subprime market in the United States has come under increasing pressure of late, it has concluded that there are no credit rating implications for the five largest Canadian banks. “Though the Big Five do have exposure to this sector, their exposures do not affect their credit risk profile sufficiently to impact current ratings,” it says.

As participants in the U.S. capital markets, some of the Canadian banks are exposed through their market making activities, securitization businesses and the financing of participants in the U.S. subprime market, DBRS says. As such, DBRS expects some losses, but they are expected to be manageable.

The outlook for the credit risk profile of the Canadian banking industry remains strong, DBRS adds. It anticipates the magnitude of losses and write-downs to be manageable relative to earnings and capital.

DBRS says it expects the Canadian banking industry to absorb the losses and maintain its current credit ratings, as a result of: strong pre-tax earnings, which is the first line of defence to absorb higher losses; and, being well capitalized. Regulatory capital levels are at historically high levels, and earnings are reasonably diversified at all the Big Five banks, it notes.

These factors give DBRS comfort that a significant cushion of earnings and capital are available to support further write-downs, barring any unforeseen negative economic events (i.e., a U.S. recession).

DBRS’s review of information provided by each of the banks indicates that the largest exposures to U.S. subprime mortgages are primarily in the Big Five’s capital markets businesses. “Their exposure, if any, is mainly in their securities books, either in inventory held for trading or investments and in providing liquidity lines to securitization vehicles which may have some exposure to U.S. subprime mortgage lending,” it explains. “There are also modest amounts of exposure in some banking books, such as lending to subprime borrowers or to U.S. subprime mortgage lenders.”

With the deterioration of the ratings of many U.S. subprime RMBS programs, DBRS expects that some of the Big Five may need to write down a portion of the carrying value of RMBS and CDO securities that are exposed to U.S. subprime mortgages. Market conditions are expected to deteriorate further in the near term, resulting in additional losses, it points out.

DBRS expects minimal impact on the Canadian banks from higher default rates in the Canadian subprime mortgage market. The Big Five are not active direct lenders in the subprime market, given their conservative underwriting, the small size of the Canadian market and high administration requirements, as these mortgages are more labour-intensive than prime mortgage loans, it says.

The Canadian subprime market is growing, DBRS allows, but there are fundamental differences between the Canadian and U.S. Markets, it finds. “Given the lack of data on the Canadian subprime market, the only comparable default rates were 2.35% (over 90 days in arrears) in Canadian subprime as of October 31, 2006, compared with U.S. subprime adjustable rate mortgage loans past due, which were 14.03%, and subprime fixed rate mortgage loans past due, which were 9.96% for the month of October 2006,” it suggests.

According to more recent data from the U.S. Mortgage Bankers Association (March 2007), U.S. subprime adjustable rate mortgage loans past due were 16.22% and subprime fixed rate mortgage loans past due were 10.21%.

The better performance of the market in Canada is likely due to: the slow adoption of subprime mortgage products in Canada; more conservative application review; limited underwriting of low quality subprime products within the market; and, a lack of mortgage-interest deductibility, DBRS says. “At the same time, the role of mortgage brokers in the U.S. capital markets combined with low interest rates and house price increases appear to have been the key drivers for rapid growth in the U.S. subprime market,” it adds.