The Globe and Mail, Christina Pellegrini, 6 September 2017
Home prices in the Toronto area slid again in August, but the top executive at Royal Bank of Canada is not worried about what a market slowdown would mean for his bank's lending business.
Dave McKay, chief executive officer at RBC, offered a rare glimpse on Wednesday into how he sizes up the potential risks lurking in the bank's residential loan book. At an industry conference hosted by Bank of Nova Scotia, Mr. McKay said only a tiny portion of RBC's roughly $260-billion residential portfolio could be at risk for losses if home prices collapse.
For years, a small number of short-sellers have been betting against Canadian bank stocks in the belief that a housing bust would crush their profitability. But Mr. McKay's back-of-the-envelope math suggests RBC's loan book could weather a correction.
To start, Mr. McKay suggests removing RBC's roughly $100-billion in insured mortgages from the discussion since they don't pose a real credit risk to the bank, leaving about $160-billion in uninsured mortgages to assess.
Mr. McKay then eliminates those uninsured loans that are for less than 70 per cent of the value of the property. He estimates that's about $140-billion of the bank's mortgage book. "That's quite significant," he said.
The remaining mortgages are those that are uninsured and have a loan-to-value ratio between 70 and 80 per cent. But even within this sliver of the loan book, there are different variables that make some loans riskier than others, according to Mr. McKay.
Firstly, he says that households that earn at least $150,000 a year pose much less risk of defaulting. "Families with income greater than $150,000 have much greater flexibility to manage shocks to cash flow, job loss, illness, divorce than families under $150,000," said Mr. McKay.
Next, he says homeowners who spend more than 35 per cent of what they earn each year on debt payments "have a much higher history of defaulting" on their loans. He said he also considers credit scores.
In the end, he's left with a pool of $6-billion in mortgages that are uninsured, have a loan-to-value ratio between 70 and 80 per cent, have a total debt service ratio higher than 35 per cent, generate less than $150,000 in annual income and were originated in the last few years when the price of homes really started to skyrocket.
By Mr. McKay's math, that's just $6-billion of risky loans in a portfolio worth almost $260-billion.
"We focus on that portfolio and we start to stress it" against job loss and potential default, he explains. Mr. McKay estimates that even with a default rate of 10 per cent and if home prices corrected by, say, 50 per cent, "you might lose 30 per cent of that $600-million."
"So you're talking about a couple hundred million dollars of that cohort of risk that you should concerned about," he added.
Mr. McKay said RBC is increasingly conducting full appraisals on these properties, doing "full walk-throughs to make sure that we're more confident of the value of that home – particularly in a rising house price environment." The bank is then flowing these higher-risk files to its most-senior adjudicators, who do a manual review of the properties, as well as verify the income of the borrower.
"For the first time, I think, I've articulated how that waterfall works and how we think about segmenting that risk and why you can break it down pretty quickly to a more focused area that you manage," Mr. McKay said.
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Home prices in the Toronto area slid again in August, but the top executive at Royal Bank of Canada is not worried about what a market slowdown would mean for his bank's lending business.
Dave McKay, chief executive officer at RBC, offered a rare glimpse on Wednesday into how he sizes up the potential risks lurking in the bank's residential loan book. At an industry conference hosted by Bank of Nova Scotia, Mr. McKay said only a tiny portion of RBC's roughly $260-billion residential portfolio could be at risk for losses if home prices collapse.
For years, a small number of short-sellers have been betting against Canadian bank stocks in the belief that a housing bust would crush their profitability. But Mr. McKay's back-of-the-envelope math suggests RBC's loan book could weather a correction.
To start, Mr. McKay suggests removing RBC's roughly $100-billion in insured mortgages from the discussion since they don't pose a real credit risk to the bank, leaving about $160-billion in uninsured mortgages to assess.
Mr. McKay then eliminates those uninsured loans that are for less than 70 per cent of the value of the property. He estimates that's about $140-billion of the bank's mortgage book. "That's quite significant," he said.
The remaining mortgages are those that are uninsured and have a loan-to-value ratio between 70 and 80 per cent. But even within this sliver of the loan book, there are different variables that make some loans riskier than others, according to Mr. McKay.
Firstly, he says that households that earn at least $150,000 a year pose much less risk of defaulting. "Families with income greater than $150,000 have much greater flexibility to manage shocks to cash flow, job loss, illness, divorce than families under $150,000," said Mr. McKay.
Next, he says homeowners who spend more than 35 per cent of what they earn each year on debt payments "have a much higher history of defaulting" on their loans. He said he also considers credit scores.
In the end, he's left with a pool of $6-billion in mortgages that are uninsured, have a loan-to-value ratio between 70 and 80 per cent, have a total debt service ratio higher than 35 per cent, generate less than $150,000 in annual income and were originated in the last few years when the price of homes really started to skyrocket.
By Mr. McKay's math, that's just $6-billion of risky loans in a portfolio worth almost $260-billion.
"We focus on that portfolio and we start to stress it" against job loss and potential default, he explains. Mr. McKay estimates that even with a default rate of 10 per cent and if home prices corrected by, say, 50 per cent, "you might lose 30 per cent of that $600-million."
"So you're talking about a couple hundred million dollars of that cohort of risk that you should concerned about," he added.
Mr. McKay said RBC is increasingly conducting full appraisals on these properties, doing "full walk-throughs to make sure that we're more confident of the value of that home – particularly in a rising house price environment." The bank is then flowing these higher-risk files to its most-senior adjudicators, who do a manual review of the properties, as well as verify the income of the borrower.
"For the first time, I think, I've articulated how that waterfall works and how we think about segmenting that risk and why you can break it down pretty quickly to a more focused area that you manage," Mr. McKay said.
