A few months ago, Toronto-based alternative mortgage lender Home Capital Group’s stock dropped by 60 percent in a single day, falling to an all- time low of $5.99 on April 26 from a high of $55.24 in mid-2014. Why? Lack of liquidity, caused by the withdrawal by customers of $591 million from high-interest savings accounts. The free fall had ominous echoes of the United States’ subprime mortgage crisis of 2007, which was foreshadowed by a liquidity crunch for subprime lender New Century Financial Corp. This sparked the American, and then global, recession.
Home Capital’s woes were also rooted in its subprime lending operations. Its subsidiary, Home Trust Company, provided uninsured mortgages to clients who couldn’t obtain home loans from conventional financial institutions. A crisis in confidence in Home Capital led to the withdrawals, which the company tried to mitigate with a $2 billion line of credit.
The ripple effects across Canada are still being assessed and will likely only impact less credit-worthy borrowers. Nonetheless, Home Capital’s challenges came at a time when Canada’s credit unions are heavily invested in expensive mortgages. The mortgage landscape itself is also in flux, with a Toronto housing bubble threatening to burst due to recent decreasing sales and soaring new house listings. Even red- hot Vancouver’s home price growth has slowed. (At least short term.)
In such an environment, it might be prudent, as the saying goes, to hope for the best but expect the worst. “There will be another crisis, with new things that we have not seen before,” predicts David Finnie, chief risk officer at Central 1 Credit Union. Finnie has been monitoring such bubble-like characteristics in a variety of asset classes, growing global debt levels and other possible triggers. “Credit unions have shown great resiliency for almost a hundred years. The key is to have effective risk management approaches which build in proactive response plans,” Finnie says. Sheila Judd, executive-in-residence at the Global Risk Institute in Toronto, agrees that there are risks in the system but notes the challenges facing credit unions differ from those facing the banks. “Credit unions focus more on consumers and small businesses and are generally seen as more stable and predictable,” says Judd. “But their smaller size and regional and sectoral focuses leaves them more vulnerable.”
“There will be another crisis,with new things that we have not seen before.” – David Finnie
There are, indeed, vulnerabilities. The average price for homes sold in Canada this past March was $548,517. That was up 8.2 percent from a year earlier, according to Canadian Real Estate Association data, and is part of a long-time secular trend. This number is disconcerting when compared to other global markets. For example, the Economist’s house price indicators index from March suggest that the average Canadian home is 112 percent overvalued relative to rents and 46 percent overvalued relative to household incomes. These are near the highest levels of overvaluation in the global survey. Even public officials have expressed concern. Governor of the Bank of Canada Stephen Poloz stated at a press conference following the release of the Crown corporation’s quarterly Monetary Policy Report that the Toronto housing market “is divorced from fundamentals.”
Yet, while housing has attracted considerable public attention, it’s not the only risk facing credit unions, says Finnie. Signs of trouble abound throughout the global financial system. Canadian and US stock market indexes traded near record highs this past May. Increases in household wealth — the so-called wealth effect — are global in nature and acknowledged as a stimulus on consumer spending.
While no one is predicting huge job losses in Canada, a worry for Canadian credit unions today is, as Finnie says, the weak financial positions of many households and the challenge many would face should interest rates rise.
Shadow banking presents a threat
Another concern, says Judd, is that the world’s financial systems are now so interlinked that in a crisis, challenges in one country or sector could quickly spill throughout the system, affecting credit unions. One such worry is the “shadow banking” system, Judd says. The US Financial Stability Board estimates that this growing category, which includes mortgage investment corporations, non-bank broker dealers and credit hedge funds, had amassed $36 trillion in assets by the end of 2014. A report by the Global Risk Institute released earlier this year suggests that the risks in these entities are particularly high as they are not regulated to the same degree as banks and credit unions.
Financial sector officials cite a variety of factors that differentiate current events from those of the 2007-2010 recession, however, they also cut a strong distinction between the situation in Canada and the rest of the world. “Many of the riskier activities that banks were involved with in the past, such as complex off-balance sheet securitizations and credit derivatives, have been sharply reduced,” Judd
says. The former banker also notes that Canadian financial institutions now have higher liquidity coverage ratios than they did pre-recession and have been quick to adhere to tough Basel III reserve targets. “The biggest challenges come more from outside the (banking and credit union) system rather than from within.”
“Credit unions have strong levels of capital and liquidity.” – Frank Chong
Sector proponents also argue that Canadian financial institutions have full recourse to a lender’s assets to guarantee their loans. (This contrasts with the US during the subprime mortgage crisis, when homeowners walked away from their mortgages without penalty, a key factor in the country’s recession.) Loan quality is higher north of the 49th parallel where, as of August 2016, $514 billion worth of residential real estate debt was guaranteed by the Canada Mortgage and Housing Corporation, which can sue an owner for any losses it has to cover for a lender.
Governments are taking steps to stabilize housing markets. Foreign buyers of homes in the Vancouver area are now subject to a 15 percent tax. Other measures protect BC credit union members, says Frank Chong, acting superintendent at Financial Institutions Commission (FICOM), a regulatory agency of the province’s Ministry of Finance. “Credit unions have strong levels of capital and liquidity,” Chong says. Furthermore, FICOM recently oversaw liquidity-related testing on BC credit unions in consultation with the Office of the Superintendent of Financial Institutions (OSFI), which considered a variety of calamitous scenarios, including the effects of a 40 percent drop in house prices. FICOM is also currently working on new liquidity risk management guidelines to further increase stability.
In Ontario, Premier Kathleen Wynne looked to BC when she introduced the province’s Fair Housing Plan several months ago. This included a 15 percent tax on foreign speculators in order to cool the Toronto housing market. At the federal level, new mortgage borrowers are also now subject to personal financial “stress tests” to make sure that their budgets can accommodate a rise in interest rates.
A complex regulatory environment
Complicating matters is a regulatory environment composed of an array of agencies at various levels of government. This leaves the system open to cracks. To allay this, Central 1, for example, hired Finnie, the Global Risk Institute’s former managing director, as chief risk officer to monitor the credit union’s financial statements and early-warning triggers and to oversee depth system and liquidity reviews. Finnie is also creating a new crisis-management plan and preparing to run a new series of stress tests.
“Credit unions focus more on consumers and small businesses and are generally seen as more stable and predictable.” – Sheila Judd
Adding to the anxiety is the down-grade given Canada’s six big banks this past May by Moody’s Investors Service.The downgrade reflected concerns about housing prices and consumer debt, which could reasonably weaken future asset quality. (TD Bank’s long-term rating was downgraded to Aa2; the five other banks fell to A1.)
Grounding the Canadian economy are several positive factors, says Jimmy Jean, an economist at Desjardins Group (seven million members, $261 billion in assets.) Jean cites strong consumer spending, positive first quarter gross domestic product growth numbers and a turn in Alberta’s energy sector as bullish indicators going forward. “Currency traders often regard Canada as an energy and resources economy but that is not really totally true anymore,” says Jean. “For example, we currently have the world’s third most educated work force and many automatic built-in stabilizers that helped us make it through the recent plunge in oil prices relatively well.”
None of us, unfortunately, has a crystal ball. Given the speculation and worry about the future
of the Canadian housing market, which was worsened with the plunge in Home Capital’s stock, it is safe to say that the mortgage industry — including credit unions — should buckle up for a more challenging environment in the coming year. ◊