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Mortgage Rules, Margins & Risk

Housing-and-mortgage-trendsRegulatory changes are keeping RBC’s Canadian banking head, David McKay, up at night.

And funny enough, his competitor, TD, has been one of the parties lobbying for regulatory changes—so says McKay’s TD counterpart, Tim Hockey.

These were among the facts shared by the two executives at a recent Barclays investor conference.

Below we summarize some of their other insights into mortgage rules, mortgage pricing and housing risk (our comments in italics)…

David-McKay-RBCHere are comment highlights from David McKay, Group Head, Canadian Banking, RBC:

On mortgage rules…

  • “…Regulatory changes certainly are top of my list when I think about what keeps me up at night.”
  • “The B-20 rules on the Canadian mortgage industry will slow (mortgage) growth.”
  • “…Having an amortization no greater than 25 years will cause first-time homebuyers to delay purchases. It will suppress some of the bidding intensity out there as it requires more cash flow to service that new home.”
  • “Much of this (regulatory tightening) is coming at us because we remain in a stimulative monetary environment with the inability to raise rates to slow the growth in consumer debt.”(Many quarters from now, the question will shift to whether regulators are willing to loosen the noose on mortgage underwriting if rates rise and/or housing demand fizzles more than expected.)
  • “…We’re seeing some prudential regulation…that could become permanent regulation in the form of these B-20 rules or whatever other rules we’re forced to look at…What will be the long-term drag on the business is unknown.”

On mortgage growth…

  • “I would expect to see (annual industry-wide) mortgage growth come off at least a hundred or maybe a couple hundred points to a mean of 3% to 5%…”
  • “…The HELOC side will probably look like 6% next year…or around there, versus 7% or 8% this year.”(With the new 65% LTV limits and stricter qualification rates, 6% HELOC growth projections seem somewhat aggressive.)

On online banking…

  • “Unfortunately, we’re not yet in the world where you can have a virtual presence and grow. It still requires a physical presence.”(Small competitors of RBC seem to have far more confidence in the viability of the online direct-to-consumer channel.)

On debt-to-income…

  • Debt-to-IncomeThe national debt-to-income ratio (which was near 150% at the time of this interview, but has since been restated to 163.4%) is “a mean, and it’s very misleading.”
  • It “is not really indicative of who’s borrowing and what their (debt) service capability is.”
  • “All it says is, (it takes) one and a half years (of income) to pay off your debt, on average, in Canada—well, no one has to pay off their debt in one and a half years.”
  • “You have to dig into the distribution, and you have to dig into total debt service, which is how we make decisions on consumers—on TDS, total debt service.”

On debt servicing…

  • “…Our policy and most banks’ policy cuts off (mortgage applicants) at 40% total debt service.”
  • “If you have more than a 40% debt service ratio, that’s usually a decline, unless there’s an exception.”
  • “But it’s not sufficient just to say 40%. Where the tail has an exponential default probability increase is when a household or a customer makes less than $60,000 and has a debt service above 40%. That’s when you start to see exponential default, where there’s not enough cash flow absorption capability from a stress event.”

On stress events and defaults…

  • “…The stress events that create consumer default are three, really.
    • Number one, first and foremost, is unemployment. You lose your job. Your cash flow stops. You default.
    • The number two, a close second, is divorce. Now, that ratio has been stable. And that is a very severe cash flow stress and life stress event.
    • And the third one is illness.”
  • Risk-and-housingSo, when you have lower income and you have high debt service, you have no ability to absorb those three stress events.”(We’ve never seen lenders be so conservative with debt service ratios as they are today.)
  • “Where you get into trouble and where the U.S. got into trouble is they blew out the tail. Through option ARMs and not checking income, they actually created a very large, high-probability tail distribution that had only one way to correct. And, in Canada, if you look at the stability of the tail, it has not grown as a proportion of our book.”
  • “…The systemic correction that would have to happen is so far out in the tail that the probabilities just don’t justify [insuring our conventional mortgages].”(Many of RBC’s competitors have no choice but to insure their low-ratio mortgages, in order to securitize those mortgages and manage their capital.)
  • Canada “doesn’t exhibit any of the characteristics that the US market exhibited—you don’t have this speculative overbuild. You don’t have the deductibility of interest driving demand and price increases. You’ve got a balanced supply/demand condition. You’ve got affordability, for the most part, across almost all markets, with the exception maybe of mainland Vancouver.”

On pricing…

  • rates-discocunting“We compete on advice and convenience and value…For so many of our customers, we don’t even get to the price discussion. It doesn’t become meaningful if you do a very good job on advice and bringing advice to customers.”(Big banks like to think their advice is better than the competition’s. As a general statement, it’s usually not. No one has a monopoly on great advice and advice cannot easily be quantified in the minds of consumers. More and more, mortgage shoppers will get their own advice and place greater emphasis on rate, mortgage features and conditions. RBC, like all banks, will find itself increasingly engaged in the “price discussions” McKay brushes off. Canadians can now access market intelligence on mortgage rates at the click of a mouse. The days of consistently selling mortgages at 15-20+ basis points above the market are coming to an end.)

On mortgage margins…

  • Renewals and refinances are pulling down margins at the major banks.
  • “Spreads were very high in 2009. Our yield on mortgages was probably 200 basis points higher, at least 150 basis points higher, than the…spread on five-year mortgages [being sold] at 3.09% or 2.99% today…”
  • Today’s mortgage spreads are “well below the historic average. So you’re looking at 150 points of compression on those term loans that are being refi’d.”
  • “Only half our book are term mortgages, fixed-rate mortgages.”
  • “The other half are variable-rate mortgages…(and) the spread we earn is a prime-BA spread. And that spread is…well above the long-term average. Prime-BA spreads in Canada have averaged about 162 to 165 basis points, (but have been) running at about 175 basis points for the last five or six quarters…”
  • “There’s a risk…that (the prime-BA spread) corrects in a rising rate environment…but, right now…our variable book is enjoying healthy margins…That’s offset some of the spread compression we’ve seen coming out of the mortgage book.”


tim-hockeyWhat follows are statements from Tim Hockey – TD’s Group Head, Canadian Banking, Auto Finance and Credit Cards & President and CEO, TD Canada Trust:

On housing risk…

  • “We actually did quite a bit of work and some lobbying efforts [to say] that the best way to handle this as a country is actually to take a little bit of the heat off the boil, if you will.”
  • “So our Finance Minister over the course of about four years, pretty much on schedule once a year, implements a number of changes that are absolutely taking effect. It might not seem like it when you still see some of the pricing increases that you have year over year, but when we model out the alternative of not having had these [rule changes], then you would have had a much higher debt-to-income ratio (and) much higher housing costs.”

On mortgage growth…

  • “…When you project forward all of the…years of (mortgage rule) changes, our belief is that (the recent amortization reduction on high-ratio mortgages) will have probably the most curtailing effect, which is why we are all expecting to have lower loan growth going forward.”

On OSFI’s B-20 mortgage guidelines…

  • OSFI’s B-20 policies are a “stringent set of guidelines…”
  • Banks now have to implement things like changes to “exception management practices” and changes to “equity lending.”(We all know that the banks have emasculated their equity lending programs. Therefore, “Exception management” is the more interesting point here. OSFI’s B-20 guidelines require “Limits on any exceptions to residential mortgages underwritten and/or acquired.” Federally regulated lenders, and those who receive funding from federally regulated lenders, will most certainly ration fewer exceptions going forward. Mortgage applicants will find it noticeably tougher to get fringe deals approved at the banks.)

Quote source: Barclays 2012 Global Financial Services Conference – September 11, 2012. RBC Presentation, TD Presentation