Photo: James Bombales

An overheated housing market could be bad news for Canadian banks, according to a new report.

“Canadian banks are increasingly sensitive to adverse economic developments that could result if house prices were to slump,” reads a report from Moody’s Investors Service.

According to the report, Canadian home prices jumped 115 per cent between 2000 and 2016, while household debt also rose. Mortgage debt made up 39 per cent of total loans in Canada in 2017.

If a Canadian housing bubble were to burst, it would leave Canadian banks exposed to what Moody’s calls “second order effects.” In the event of a drastic correction in housing prices, banks would experience an extremely high default rate on consumer and commercial real estate loans as Canadian homeowners — with their assets largely tied up in their property — came under severe financial stress.

But not everyone thinks the banks have something to worry about. According to CIBC Deputy Chief Economist Benjamin Tal, major steps have been taken in 2017 to ensure that even a serious housing correction won’t sink Canadian banks.

“I think what’s interesting about this report is that instead of looking at mortgage defaults — which is what most people look at when it comes to a possible correction — they correctly identify the secondary order effects as a potential impact,” Tal tells BuzzBuzzNews. “But we’ve taken some major actions this year to ensure a drastic correction won’t happen.”

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Tal is referring, in part, to new mortgage rules which will come into effect on January 1. A stress test will require all uninsured mortgage borrowers to qualify against the Bank of Canada’s five-year benchmark rate, or at their contract mortgage rate plus an additional 2 per cent.

The revisions are intended to ensure that uninsured borrowers can withstand higher interest rates. The overnight rate — which influences mortgages and sat at a historically low 0.5 per cent earlier this year — has been raised 50 basis points by the Bank of Canada since July, with a third hike predicted in 2018.

“The new mortgage stress test is a move that is designed to avoid a very violent crash,” says Tal. “So while Moody’s is correct that a crash would have serious second order effects, I don’t think we’re at risk of that scenario right now.”

Moody’s predicts that house prices will continue to climb over the next year, but at a slower rate than the record increases seen in March. The report also notes that Canadian banks’ capital levels are “strong to adequate,” which means that they would be able to absorb increased loan losses.

“Any impact on their capital levels would likely be limited,” reads the report.

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