Top Canadian Banks at Risk of an S&P Downgrade Amid U.S.-Style Housing Woes

Record consumer debt and a housing market that’s vulnerable to a correction has weakened the earnings prospects of seven top Canadian banks and exposed them to the risk of a credit downgrade.

“Standard & Poor’s cut its outlook to negative from stable on seven Canadian banks July 27, including Toronto-based Royal Bank of Canada and Toronto-Dominion Bank, citing a prolonged increase in housing prices and consumer indebtedness,” Bloomberg reported this week, adding that: “The debt of Canadian financial companies is the second-worst performer this month after Japan among 35 global peers, according to Bank of America Merrill Lynch data.”

Some worry that Canada is facing a housing crisis similar to what the U.S. has endured.

“Debt-ridden Canadian consumers and a cooling property market are leaving the country’s stalwart banks vulnerable, credit rating agency Standard & Poor’s has warned, fanning a growing national debate on whether Canada is facing a U.S.-style housing debacle,” Reuters reports.

While S&P reaffirmed the high ratings of Canada’s biggest banks last Friday, it also dropped its outlook to “negative” from “stable.” Now, Canadian banks, which have been viewed as some of the healthiest in the world, are now facing the risks of a pullback in consumer borrowing and a downturn in a booming housing market.

S&P’s move represents a warning to Canada’s three largest banks—Royal Bank of Canada, Toronto Dominion Bank and Bank of Nova Scotia, as well as smaller rivals National Bank of Canada and Laurentian Bank of Canada—at a time of rising consumer debut and elevated housing prices in Canada, as well as economic risks abroad.

“In our view, this poses a risk for Canadian banks given the importance of each bank’s consumer credit loan portfolio,” S&P said in explaining the shift.

Also included in the outlook downgrade were Home Capital Group Inc. and Central 1 Credit Union.

Profitability Hit—Not Stability

How will this impact job seekers? Probably not much in the near term. While Canadian economists and bank analysts alike say the housing market looks set to cool and consumers are likely to pull back on borrowing when it does, they said the deleveraging will ultimately affect the profitability, not the stability, of Canada’s big lenders.

“It’s not the same as the United States,” commented Peter Routledge, a banking analyst at National Bank and a former analyst for Moody’s. Canadian home prices rose to a third straight record high in June, but a slowdown in the pace of price increases suggested the red-hot housing market was cooling, data showed last week. Consumer debt has also risen to record highs similar to levels reached in the United States prior to 2008, prompting policymakers to rewrite rules in July to make it harder for home buyers to take on too much housing debt.

While many predict indebted consumers will soon have to pull back, the move will hurt bank profits, not their ability to service or pay back loans, Routledge said.

“If all of a sudden consumers start to deleverage and pay down loans, and loan balances contract, bank revenues will contract and so too will earnings," he explains. "But we are not going to have a massive wave of credit losses impacting the balance sheets of Canadian banks, because of the prevalence of mortgage insurance.”