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Paul Bagnell

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Has the time finally come when overheated real estate markets in Canada pose a real threat to profit growth at Canada’s big banks?

Increasingly, experts across the country are saying “Yes.”  Residential mortgages make up a huge portion of banks’ loans outstanding, and for years have kept domestic retail banking profit growth humming along. But higher interest rates or a real-estate slowdown, experts told BNN this week, could change that.

Andrew Pyle of Scotia Wealth said he’s certain we’ll see some level of real estate stress on the banks over the next year or so.

“The question of whether higher interest rates impact Canada’s housing market in a negative way is not a question of if, but a question of when,” he said in an interview on Monday.

The banks themselves are growing wary of sky-high real estate values in Toronto and Vancouver.

Consider Greg Bonnell’s interview with Brian Porter, chief executive officer of Bank of Nova Scotia, on Tuesday.

“It’s not healthy. It’s not sustainable,” Porter said of soaring house prices in the two cities. “There’s a bit of an aberration here.”

The importance of residential mortgages to banks’ bottom lines cannot be overstated.  Consider the most recent results from Royal Bank of Canada and Toronto-Dominion Bank.   At Royal, $246 billion was outstanding in residential mortgages during the fiscal second quarter; that’s 46 per cent of the value of all loans and acceptances at Royal.  At TD, the figure is 47 per cent.

“I think investors should be cognizant of the fact that about fifty per cent of the loans on the industry’s balance sheet is residential real estate secured between insured, uninsured and HELOCs (home equity lines of credit),” said Sohrab Movahedi, the banking analyst at BMO Capital Markets, who characterized the banks’ loan growth as “breathtaking” and “unhealthy.” 

But the worry is not that large numbers of those mortgages will be written off as bad loans. Losses booked on Canadian mortgages at the banks are tiny - $10 million at Royal and $3 million at TD in the most recent quarter.  Bank chief financial officers use the word “de minimis” to describe numbers like that.

The concern is higher rates will scare away would-be homebuyers, causing loan demand to fall. That would hurt profit growth in the crucial Canadian retail banking businesses at the banks. 

The mortgage businesses are “obviously a fairly profitable source of earnings and revenue for the banks,” said Movahedi, when I spoke to him on Thursday morning.

Pyle sees it the same way.

“When interest rates rise, margins for the banks will improve, but not enough to make up for the drop in consumer and mortgage loans,” he told BNN.

“If that were to happen, you take away a key pillar we saw in last week’s earnings – that’s resilience in domestic lending.”