Moody’s has doled out another round of credit rating cuts, this time downgrading six major Canadian banks. Bank of Montreal, Scotiabank, TD Canada Trust, Caisse centrale Desjardins, CIBC and National Bank of Canada each found their rating slashed by one notch. It’s one of several such Moody’s downgrades since June of last year, when the ratings agency cut RBC’s grade from Aa1 to Aa3.
Moody’s stated the cuts were due to the banks’ exposure to the “increasingly indebted Canadian consumer” – meaning our household debt levels have left our banks vulnerable to potential risks facing the Canadian economy.
What is the Moody’s Rating System?
Moody’s Investor Services is a globally-renowned debt rating agency that ranks lending institutions according to a standardized system. These ratings determine the level of risk posed to investors, for example if a bank is likely to default, or whether it’s exposed to less stable methods of generating revenue. Simply put, banks that base their funding on good, old fashioned customer deposits are considered the most stable, while lenders that rely on fees, trades, short term financing and equity advisory are considered to be of higher risk.
Additional external factors that pose a threat to the economy can also affect a bank’s rating, which is the case here; overextended Canadian borrowers stand a lot to lose should our economy experience a shakeup – and so do our banks.
The Effect of the Housing Market
When the banks refer to high levels of household debt, they’re mainly referring to mortgages taken out by Canadian consumers. Decades of inflating housing prices have pushed homebuyers to take on larger mortgages, as increased financing is required for them to keep up with the market. This leads to higher average debt levels – and the banks awaiting the repayment of billions of mortgage dollars from borrowers who could potentially default. In fact, the average household income-to-debt ratio these days is 165 per cent. To put that into perspective, 160 per cent was the toxic number that prompted the economic downturn in the U.S. and UK. It also led the Bank of Canada to impose affordability-limiting mortgage rules to dissuade borrowers from biting off more than they could chew with their home purchases.
While it’s true that a large part of this risk is mitigated by homeowners under CMHC mortgage insurance (mandatory for high risk borrowers and those putting less than 20 per cent down on their home), should a softening housing market cause en mass value depreciation, everyone takes a hit. A loss of equity will in turn lead to decreased consumer spending, and could even lead to less construction in cities – a major economic driver for Canada’s urban centres.
The Global Economic Impact
Risks facing our economy aren’t all home grown – global economy instability is also partly to blame. As the U.S., our largest trading partner, continues to struggle against their fiscal cliff, and European and Asian slowdowns create hurdles for our export industry, Canada is less of a safe haven than initially thought.
So… Should We Be Worried?
Despite the ominous news, markets continue to throw their weight behind bank stocks, which have increased five per cent since June. It’s a sign that most are positive there won’t be a housing crash – and that we’ll be spared the gloomy economic chain of events. While a downgrade traditionally means that it’s more expensive for banks to borrow short term loans from one another (responsible for the liquidity of funds in the Canadian banking system), the cost of borrowing is currently low enough that it won’t make much of a dent. And that means a credit crunch isn’t in the cards… for now.