Banks to weather capital impact of risky mortgages

Federal banking regulators’ move to impose higher capital charges on mortgages with negative amortizations is a positive for the Canadian banking industry, says Fitch Ratings.

In a new report, the rating agency said the Office of the Superintendent of Financial Institutions’ (OSFI) rule change, which will take effect in early 2024, would treat certain negative amortization balances as exposures that don’t meet mortgage underwriting standards.

“In general, the rule would likely require an additional 15-25 percentage points in risk weights to affected mortgages,” Fitch said.

The change should only have a modest downward impact on banks’ capital ratios, it said, projecting that common equity tier 1 ratios will be reduced by between seven and 22 basis points at the big banks that will be affected.

Fitch said the change will most affect banks that offer fixed-payment variable rate mortgages, including Bank of Montreal, CIBC, Royal Bank of Canada and Toronto-Dominion Bank.

Bank of Nova Scotia and National Bank of Canada will be “largely unaffected given their variable-rate offerings have payments that adjust upward with rates, thus not resulting in amortization periods that stretch beyond their original terms,” it said.

At the four affected banks, negative amortization mortgages comprised about 24% of total mortgage portfolios as of July 31, up from virtually zero a year ago, the report said.

The increase in these exposures has been driven by the sharp rise in interest rates.

“Variable-rate mortgages were popular for borrowers who purchased or refinanced homes during the pandemic when interest rates were at historic lows,” it said. “When trigger rates are breached for variable-rate, fixed payment loans, all payment amounts go towards interest, with any deficiencies causing principal balances to rise and amortization periods to stretch.”

When these mortgages are renewed at higher rates, and with larger principal amounts, payment shocks may occur, it noted.

Mortgage rates doubled to an average of nearly 6.5% in 2022 and are projected to average 6%-7% in 2023 before falling slightly in 2024, as the Bank of Canada eventually starts trimming rates.

“We expect nominal housing prices to fall by 0%-5% in 2023 from record highs, with a slowing economy, rising rates, and declining affordability, before rebounding in 2024 with moderate growth likely due to the housing supply/demand imbalance,” it said.

Additionally, mortgage delinquencies are forecast to increase from record lows of 0.14% in 2022 to 0.20%-0.25% for 2023 and 2024, it said.

The big banks’ mortgage portfolios “are expected to withstand the pressures from rising rates and higher delinquencies, given significant homeowners’ equity, low unemployment, high immigration levels, and supply/demand imbalances that support home prices,” Fitch said.