Canada’s banks brace for possible wave of loan defaults. Why that matters

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Earnings week for Canada’s biggest banks saw the country’s major lenders move in lockstep ahead of a projected economic downturn, with each putting more money away for a possible rise in credit losses.

Experts say the more expensive cost of borrowing in Canada and the possibility of job losses could catch up to households and push a growing number into default, though some believe the worst of the debt pain is likely at least a year away.

Canada’s big six banksTD Bank, RBC, BMO, Scotiabank, CIBC and National Bank — all reported earnings for their first fiscal quarters this week, with similar-sounding results. All reported a dip in profits as they put more money aside to handle credit losses.

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Digging into the banks’ financial filings finds a worrying economic picture at the heart of these moves.

BMO’s filings show that the jump in credit loss provisions for last quarter “reflected a deteriorating economic outlook,” though it noted continuing improvements in the business environment after the peak of the pandemic offset some of these concerns.

The Montreal-based lender also pointed to a rapid rise in interest rates — the Bank of Canada hiked rates by a cumulative 425 basis points over the past year, with its next decision coming on Wednesday — as putting strain on its customers.

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“The high-rate environment could have a direct impact on our customers through higher borrowing (e.g., mortgage rates) and debt servicing costs,” BMO wrote in filings Tuesday.

But just because the banks are preparing for higher credit losses doesn’t mean they’ll come to pass, says Angelo Melino, economics professor at the University of Toronto.

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When the banks raised their provisions in 2020 because they were expecting major losses during the pandemic, a healthy dose of government aid offset the rate of defaults for businesses and consumers, Melino tells Global News.

But some of those fears from three years ago are being realized today.

In January, total insolvency filings across businesses and consumers were up 13.5 per cent from the previous month and 33.7 per cent higher than a year earlier, according to the Office of the Superintendent of Bankruptcy. Business insolvencies were up 55.4 per cent year over year, the data shows.

Melino says banks are noticing the uptick in bankruptcies as pandemic-era stimulus dries up and businesses are forced to reckon with the new operating environment.

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“A lot of companies that have been hanging in there no longer can,” Melino says. “So, in addition to everything else going on in the economy, there’s an overhang of stuff that’s been going on from the pandemic.”

Melino says the banks’ hikes to their credit loss provisions essentially confirms the dour economic outlooks that have led to recession calls from forecasters on and off Bay Street.

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Paying down loans will get harder for Canadians this year

While credit loss provisions are on the rise amid higher interest rates and economic uncertainty, Veritas Investment Research analyst Nigel D’Souza says these figures are still below pre-pandemic levels and are currently in the process of “normalizing.”

Nonetheless, D’Souza tells Global News he sees indications that the credit situation is set to significantly worsen for many Canadians in the months ahead.

Higher interest rates are set to drive debt-servicing costs higher for many Canadians with outstanding loans, he says, adding that he expects these figures could “potentially reach a record high” later this year.

Included in the calculation for these costs is disposable income, which means a rise in unemployment — and thereby a drop in income — can also drive this figure higher.

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Canada’s labour market has yet to show significant signs of weakness, adding 150,000 jobs in January as the unemployment rate held steady at a near-record low of 5.0 per cent.

But Bank of Canada governor Tiff Macklem has cautioned that the low unemployment rate is not sustainable to lower inflation back to the central bank’s two per cent target. The Parliamentary Budget Office projected in its economic outlook this week that the unemployment rate would rise to 5.8 per cent before the end of 2023.

Melino says that if job losses start to pick up, that will translate to more losses for banks to absorb on consumer debt.

“What happens to the labour market this year is going to be very important for those consumer loans,” he says.

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When debt-servicing costs rise, credit losses historically follow within two years, D’Souza explains. That implies that a surge in debt-servicing costs this year will see a wave of credit losses follow in late 2023 and into 2024, he says.

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“That’s what I think will be an important level to pay attention to in terms of determining the risk of credit losses increasing over the next one to two years,” D’Souza says.

What will this mean for mortgages?

One significant source of debt on Canadian banks’ books is in their mortgage portfolios.

While there has been some stress in this segment already, D’Souza notes that the main pain of higher mortgage rates mainly hits the roughly 12 per cent of mortgages that are set to renew in a given year.

Even when Canadians end up delinquent on their mortgages, those losses don’t tend to make a huge dent in banks’ credit losses, D’Souza adds. Since these loans are backed by the properties themselves, they’re typically well collateralized in the event of a default, he says.

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“When you look at the losses in past cycles, the bulk of credit losses is not driven by the (mortgage) portfolio. It’s driven by everything else: auto loans, unsecured lines of credit, credit cards, commercial lending,” he says.

Melino says that the bulk of the banks’ mortgages are also guaranteed by the Canada Mortgage and Housing Corp. (CMHC), meaning if there are losses here, it’ll affect taxpayers more than the banks themselves.

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While banks may be preparing their balances to cover a possible rise in credit losses, D’Souza cautions that these impacts don’t hit suddenly — they take time to build.

While he says there are “signs of stress emerging,” such as an uptick in credit card delinquency rates and strain on variable-rate mortgage holders, D’Souza says the hit to banks’ balances — and the wider economy — could be a ways off still.

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“It’s not to say that there aren’t any signs of stress going on. I would emphasize that credit risk does take time to build,” he says. “That doesn’t happen overnight.”

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