Real estate secured lending and escalating mortgage payments are two of the top risks facing Canada’s financial system as high borrowing costs continue to put pressure on homeowners, Canada’s top banking regulator says.
As 76 percent of outstanding mortgages come up for renewal by the end of 2026, homeowners could potentially face “payment shock” due to higher interest rates compared with when they secured their interest rate, said Superintendent of Financial Institutions Peter Routledge in his annual risk outlook. Homeowners who took out mortgages when interest rates were lower in 2020 to 2022 will be especially susceptible.
“Households that are more heavily leveraged and have mortgages with variable rates but fixed payments will feel this shock more acutely,” Mr. Routledge writes in the Office of the Superintendent of Financial Institutions (OSFI) report.
“We expect payment increases to lead to a higher incidence of residential mortgage loans falling into arrears or defaults.”
Variable-rate mortgages with fixed payments account for roughly 15 percent of outstanding residential mortgages in Canada and are a “specific concern” for the OSFI because some of these mortgages are negatively amortizing. That means the mortgage payments are no longer covering the full interest costs or the principal.
“In these situations, lenders offset the shortfall by increasing the remaining outstanding principal. While most institutions report the shortfall as extended amortization periods, the contractual mortgage term does not change unless and until the mortgage is refinanced,” the report reads.
This means borrowers with uninsured fixed variable-rate mortgages will be forced to deal with “higher outstanding principal balances, and are, therefore, at risk of suffering a significant payment shock.” Borrowers can either make large lump sum payments or endure large monthly payment increases in the mortgage to return to their original contract term.
With higher mortgage payments taking up larger parts of some households’ income that could lead some homeowners to default on other loans and debts as well, affecting banks and other financial institutions, the report points out. Banks could also be affected if residential real estate markets weaken, leading to higher defaults and lower recovery rates.
Other OSFI Concerns
Other top concerns are wholesale credit risk, including risk from commercial real estate lending, as well as corporate and commercial debt, and funding and liquidity risks.“Corporate credit and commercial real estate (CRE), particularly construction and development, and office sectors, continue to face stress and a high degree of uncertainty,” Mr. Routledge writes.
“While market-based and core funding liquidity sources are available, prior downturns and stress events have demonstrated that these conditions can change quickly.”
The regulator says it has noticed a “marked change in investor and depositor behaviour and expectations as deposit competition increases,” adding that this could draw deposits away from traditional savings accounts.
The report also points to risks associated with social and political conflict.
A major geopolitical event could disrupt markets and create instability for institutions, the report says, adding the escalation of political tensions and the polarizing effect of geopolitical issues have the potential to make Canadian institutions a target for politically motivated attacks.
