What Happens to Canadian Banks and Mortgage Companies if the Real Estate Bubble Pops?

The Canadian Real Estate Bubble

Canada’s housing market is red hot; it’s so hot that many believe that the country is in a housing bubble. Should that real estate bubble break, like it did in the U.S. in 2008, what will happen to Canadian banks and private lenders with a large exposure to the housing industry? Or how will Canadian lenders react if the Canadian housing market starts to cool?

There’s no denying the Canadian housing market is on fire. In March, the national average price for homes sold increased 8.2% year over year to $548,517. Toronto and the Greater Toronto Area (GTA) are fuelling that growth though.¹

In March, housing prices in the Toronto area soared by 28.5% to $899,452.  The price of a detached home soared 33.4% to $1.21 million while the price of a semi-detached home was up 34.4% at $858,202.²

With housing prices rising so quickly, many are questioning whether the housing market is on the cusp of another bubble. Back in the late 1980s, the average price for a home in the GTA more than doubled in three years. The bubble popped in 1989 and housing prices fell for seven consecutive years. Housing prices didn’t recover until 2002.

If the current real estate market bubble bursts, what will happen to Canadian banks and private mortgage lenders that have a high exposure to the housing market? It’s pretty hard to see the Canadian housing market not taking a tumble.

Housing prices were up 8.2% across the country, but wage growth is almost non-existent and gross domestic product (GDP) is almost at a standstill. In fact, if you take housing out of the equation (construction, finance, insurance and real estate), the Canadian economy contracted in February. Soaring housing prices in the midst of an economic slowdown is unsustainable.³

The Impact to Stocks with High Exposure to Mortgages

We don’t need to wait until the real estate bubble pops to see how it will affect Canada’s big banks and other lenders. In April, the share price of private mortgage lender Home Capital (TSX/HCG) tanked after it was announced that the brokers associated with the company falsified documents in order to help homeowners secure a mortgage.

Investors got spooked and withdrew hundreds of millions in savings in just a few days. Despite the fact the company continues to have a solid balance sheet, Home Capital’s share price plunged more than 70% from around $24.00 per share to a low of $5.68 per share.

What will happen to the company’s bottom line if people were approved for mortgages they otherwise wouldn’t have been able to qualify for? Should the Canadian economy stall and people are unable to make their mortgage payments, what will happen to Home Capital’s bottom line?

While this reaction is not tied directly to any troubles related to the health of Canada’s housing market, it goes to show how quickly investors can react even if things are not as bad as they may appear.

In the midst of the Home Capital sell-off, how would Canada’s big banks fare if the housing bubble popped? Yes, Canadian banks are well-capitalized but, should the average housing price experience a 25% decline and markets in Toronto and Vancouver slip 35%, losses would total more than $17.0 billion.⁴

Canada’s big banks could recoup those losses in a few quarters, but what does that mean for investors? Share prices would take a hit and dividend payouts could freeze. During the 2007-2009 credit crunch, the average peak-to-trough decline for Canada’s big banks was about 60%. Over the same time frame, the S&P/TSX composite index tumbled 50%. Those who held pipelines and utilities saw their portfolio decline just 28%.

Canada’s banks fell more than the broader market and most banks froze their dividend payments for three years. The Bank of Montreal waited five years to announce the resumption of increases to its common share dividend. Utilities and pipelines on the other hand, continued to raise their dividend yield.

The sell-off of Home Capital illustrates just how uncertain investors are about the housing market and what should happen to banks with exposure to the mortgage industry if the housing bubble bursts.

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Sources:

• “Canadian home sales edge higher from February to March,” Canadian Real Estate Association, April 18, 2017; http://www.crea.ca/news/canadian-home-sales-edge-higher-from-february-to-march/.
• “GTA Realtors Release Resale Housing Market Figures,” Toronto Real Estate Board, April 5, 2017; http://trreb.ca/files/news_releases/news2017/nr_market_watch_0317.htm
• “Gross domestic product by industry, February 2017,” Statistics Canada, April 28, 2017; http://www.statcan.gc.ca/daily-quotidien/170428/dq170428a-eng.htm.
• “Why it’s time for a bank-stock checkup,” The Globe and Mail, April 28, 2017; http://www.theglobeandmail.com/globe-investor/investor-education/why-its-time-for-a-bank-stock-checkup/article34851611/