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Puzzling Trends in Arrears Baffle Analysts in the Canadian Mortgage Market

Updated: Sep 9, 2023

As we find ourselves eighteen months into one of the most robust hiking cycles in history, it's surprising to note that 90-day prime mortgage arrears remain historically low, lingering at just 15 basis points. A year ago, experts across the board predicted these figures would be higher by now.


However, the enigma of why 90-day arrears are less than half of the 36 basis points long-term average is no longer elusive. Factors such as low unemployment, solid equity positions, government interventions, supportive banks, accumulated savings, rigorous underwriting, and other elements are ensuring that Canadians are maintaining their residences and steering clear of "jingle-mail."


Anticipating a significant surge in arrears at this juncture would essentially entail expecting a housing market collapse, a drastic rise in unemployment, or a combination of both. Thanks to ongoing household formation and the stability-focused approach of our government, neither scenario seems likely without a chaotic global crisis.


Canadian Prime Rate and Arrears Rate Over Time

Transformations in Arrears Patterns

In Canada, the standard gauge for defaults is the Canadian Bankers Association's (CBA) 90-day arrears indicator, which tracks serious delinquencies at financial institutions—those borrowers who have missed three or more payments.


The CBA acknowledges that "mortgage arrears are considered a lagging economic indicator because they typically relate to events that have happened in the past," such as job loss, divorce, and illness. These life-altering events require time for their financial ramifications to take effect.


Until recently, though, arrears used to exhibit more pronounced lagging characteristics. The CBA's data used to be delayed by several months.

Fortunately, a pivotal modification has been made to the data release, a change that industry experts, including us, have advocated for years. Presently, arrears are being reported with only a five-week lag. We extend our gratitude to the CBA for this positive update.


How was this remarkable change achieved?


"The association has bolstered its staff capacity, enabling us to process information and data from our members more expeditiously," explains Megan Shay of the CBA. Recognizing the significance of this data for policy and analysis, the association's aim is to "better serve our members," she affirms.


Delinquent Loan

Underlying Drivers of Widespread Arrears

Several overarching macro factors correlate with widespread arrears, including:

  • Employment

  • Income levels

  • Credit trends

  • Interest rates (to a lesser extent)

Key Points about Arrears:

  • Default rates exhibit cyclical patterns. Increases are normal and foreseeable during market downturns. However, for default rates to surge dramatically, research indicates the necessity of a "severe" economic or financial crisis.

  • The relationship between high interest rates and arrears is intricate. Contrary to common assumptions, the Bank of Canada's researchers assure us that these two variables don't always move in tandem. They state, "We do not observe increasing delinquencies or a contraction of credit supply for borrowers who adjust their rates to higher levels."

  • While high loan-to-income (LIT) ratios serve as significant predictors of defaults for uninsured mortgages, the same does not hold true for insured mortgages.

  • Interestingly, certain studies uncover an unusual phenomenon: banks with high capital adequacy tend to exhibit worse loan performance. It appears they may take more risks or adopt a more relaxed approach compared to regulated lenders with less available capital. However, in some jurisdictions, this "worse" performance might only translate to arrears that are 5-15 basis points higher, as has historically been observed in Canada when comparing banks to prime mortgage finance companies and credit unions.




In Summary...

Expecting a substantial surge in canadian mortgage arrears without a concurrent spike in unemployment, soaring interest rates, or a catastrophic housing collapse is akin to banking on the sight of flying pigs.


Putting jests aside, our market does indeed harbor a certain risk category. If unemployment were to surge by 150 to 250+ basis points, individuals burdened with substantial mortgages, high loan-to-values, and elevated debt ratios could find themselves in a precarious situation. This becomes especially pertinent if home values decline, leaving them unable to recover their investment through a quick sale.


While almost no economists publicly predict that home prices will plummet to their lowest point of January 2023 during this cycle, it's prudent to approach such predictions with caution.

 
Considerations for Mortgage Professionals:

Should "higher-for-longer" interest rates adversely impact employment and the real estate market, mortgage advisors can play a pivotal role by maintaining communication with high-TDS (Total Debt Service) borrowers. By offering proactive solutions, even if they are not directly tied to mortgages, or by simply being a professional contact to confide in, mortgage experts can establish themselves as trusted advisors. They become the primary resource for clients when their circumstances improve or when friends and family seek referrals.

 

Ultimately, historical trends indicate that if the chart depicted below experiences an upward trajectory, arrears will experience an uptick as well. A recent economist survey by Reuters suggests that this will be the case, with unemployment projected to peak at 70 basis points by Q3 of the following year. (We hold a more optimistic stance, expecting the figure to surpass +70 bps, by the way.)

Canadian Unemployment Rate

The consensus forecast from this survey would only raise unemployment to a modest 6.2%, which is 70 basis points below the long-term average. This doesn't constitute a recession; it's more of a punchline.

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