While no banks are immune from the Brexit contagion, investors in Canadian banks can rest a little easier knowing that the banking system in Canada is itself a protector on the downside, and on the upside it is a license to print money.
Four words: Canada Mortgage and Housing Corporation, otherwise known as CMHC.
The government crown corporation was created in 1946 as the Central Mortgage and Housing Corporation to house war veterans and look after the government’s housing programs. In 1954, it introduced mortgage loan insurance for homebuyers willing to fork over a 25% down payment.
It has evolved since then, but thus began Canadian banks’ love affair with CMHC. And why not … especially when you can lend to homebuyers without shouldering any of the risks.
What you Need to Know About Canadian Banks
Essentially, if you want to buy a home in Canada with less than a 20% downpayment, you must purchase mortgage default insurance from either CMHC or a private mortgage insurer like Genworth Financial Inc (NYSE:GNW). CMHC mortgage insurance is backed 100% by the federal government in the case of defaults.
If a homebuyer defaults and the bank is forced to sell the home, any shortfalls between the house’s sale price and the debt owed to the bank is covered by CMHC premiums paid indirectly by homeowners (the bank pays the premiums directly but adds the amount to your mortgage) leaving the bank in the enviable position where it can’t lose.
When the financial crisis hit in 2008, CMHC held 90% of the mortgage default insurance market in Canada; today, that’s down to around 50% as private insurers have stepped in to pick up the slack. CMHC purposely gave up 40% market share in order to reduce taxpayer risk.
Currently, CMHC insures mortgages totaling $520 billion out of $1.2 trillion in the entire Canadian market — both insured and uninsured. Genworth insures mortgages valued at $365 million which the federal government backs to the tune of 90% in the case of defaults, 10 percentage points less than CMHC, but still very lucrative to the Canadian banks that make most of these loans.
So, the banks are essentially risk-free on 74% of the entire Canadian mortgage market. And, of the 4.7 million mortgages on the books of Canadian lenders, just 0.28% were in arrears as of January 2016.
Last week Moody’s came out with a report that suggested a 25% drop in Canadian housing prices wouldn’t lead to a U.S.-style housing crisis. Rather, it projected that such a scenario would result in C$17.6 billion in losses with the banks responsible for about two-thirds of those; CMHC, Genworth and Canada Guaranty (the other private mortgage insurer in Canada) would absorb the rest.
Under such a scenario, Royal Bank of Canada (NYSE:RY) and Toronto-Dominion Bank (NYSE:TD) would face the biggest projected losses at C$2.87 billion and C$2.64 billion respectively. However, Canadian Imperial Bank of Commerce (USA) (NYSE:CM), which is markedly smaller than either of its bigger peers, would see a 120 basis point reduction in its common equity tier 1 ratio.
I haven’t seen the actual Moody’s report to determine how it came up with the specific amount of losses or more importantly, why CMHC and the private insurers come out less scathed than the banks — given the Canadian system that I described earlier — but assuming these numbers are accurate, the long-term hit to the banks would be minimal.
“The majority of banks would be able to absorb losses within one quarter of earnings or, assuming the current average dividend payout ratio of 45 per cent, two quarters of retained earnings,” the Moody’s report stated. “Therefore we believe that while a U.S.-severity mortgage event would lead to substantial losses, it would not threaten rated bank solvency.”
At the end of the day, investors in the shares of Canadian banks should rest easy knowing that the oligopoly that is the five major banks — Bank of Montreal (USA) (NYSE:BMO) and Bank of Nova Scotia (NYSE:BNS) are the other two not previously mentioned — is backed by the Canadian taxpayer, and while losses are possible, they would be far less than under a U.S.-style implosion.
That alone makes them a license to print money.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.