Fitch Ratings has finalized its new model for estimating losses on prime Canadian residential mortgage pools, noting that it sees the Canadian market as 20% overvalued and house price growth at unsustainable levels.
In a report detailing the final model, which was proposed earlier this year, Fitch notes that Canadian household indebtedness remains at record highs, as the level of borrowing continues to outpace increases in income.
Indeed, borrower leverage is roughly 80% higher than it was during the recession of the early 1990s, it notes. “As such, Canadian consumers today are more vulnerable to external economic shocks such as a sustained increase in unemployment or sharp rise in interest rates,” it says.
While the historically low interest rate environment has kept consumer debt service payments relatively low, Fitch reports that the Bank of Canada estimates that more normal interest rates, which would have to rise of 3.25 percentage points, over the next three years “would result in the percentage of borrowers with debt-to-income ratios in excess of 40% reaching about 20%, nearly double that of 2011.”
Still, while Fitch sees the Canadian market as 20% overvalued, it says that it does not expect that prices would drop by this amount. “If growth halted tomorrow and prices began to drop, it would be expected to take several years to revert to their sustainable values, depending on a number of factors such as government support and credit availability. With this timeframe, the observed nominal decline in prices could be as low as 10%,” it says.
It also sees some regional variation in the Canadian housing market, with Ontario, Alberta, BC, and Quebec overvalued in real terms by 21%, 15%, 26%, and 26%, respectively. “Actual nominal declines could range from the low single digits (for Alberta), up to more than 15% (for BC and Quebec) over the next several years assuming values start falling immediately and taking into account inflation and other market dynamics,” it says.
Fitch also points out that if price growth halts, “the economy could be at risk from retrenchment in the housing and construction sector”, which it says currently represents more than 7% of the workforce, and has been a driver in rising incomes over the past decade.
“Furthermore, a halt in growth could restrict the inflows of foreign investment into the Canadian housing market, which has benefited from a perception as an international safe harbor in times of global stress,” it says. “In the absence of continued growth, support could wane from external sources, putting additional pressure on the market.”
In the meantime, Fitch says it plans to review its existing portfolio of Canadian covered bonds under the new criteria and publish research disclosing updated expected losses by the end of June. However, it does not expect any negative rating impact based on the implementation of the new model to existing covered bonds. It will also apply the new model to ratings supporting asset-backed commercial paper (ABCP) facilities and residential mortgage backed securities.
Fitch notes that it received feedback from a number of market participants on the proposed model during the consultation period, most of which considered its approach to be overly conservative. However, the final model is effectively unchanged from the draft version, it says.