* While mortgages are insured, some credit risk remains
* Diversity of banks helps insulate them from bad loans
By Andrea Hopkins
TORONTO, Dec 16 When the Bank of Canada warned Canadians last week about household indebtedness, observers saw it as a cautionary rebuke to spendthrift consumers.
Mostly overlooked was an equally strong warning to Canada's big lenders, which may face rising credit losses next year when many expect interest rates to rise. [ID:nN10171691]
Analysts say defaults are likely to rise next year as mortgage payments are adjusted higher and more homeowners have trouble keeping up. That's sure to have a knock-on effect on the ability of consumers to cope with credit card debt and other loans.
As a consequence, the big banks may not be out of the woods yet even though loan losses appear to have peaked.
"What we've seen is the banks in the fourth quarter illustrated improving consumer credit metrics ... but I think this may be a plateau (in loan losses), not necessarily the peak," said Barclays Capital banking analyst John Aiken.
"It's one of those concerns that is still lingering, particularly with the outlook for the economy," he said.
Canadian banks emerged from the financial crisis relatively unscathed compared with global rivals, having accepted no government bailouts. There were no major financial industry bankruptcies, and the nation's biggest lenders have build huge piles of cash to offset losses from bad loans.
Even so, with consumer indebtedness climbing to a record high in the third quarter and low interest rates luring more Canadians into hefty mortgages, the central bank is worried that banks may be opening themselves up for future losses -- though nothing on the scale of those spawned by the U.S. housing crisis.
"Financial institutions need to carefully consider the aggregate risk to their entire portfolio of household exposures when evaluating even an insured mortgage, since a household defaulting on an insured mortgage would likely be unable to meet its other debt obligations," the Bank of Canada warned.
In other words, banks are unlikely to be hurt by the mortgages themselves, as happened in the United States when homeowners walked away from loans. Canadian mortgages are secured, and loans greater than 80 percent of a house's value are insured by the Canadian Mortgage and Housing Corp.
But consumers who can't pay their mortgages are also likely to default on unsecured debt -- including credit cards and credit lines.
In their fourth quarter earnings reports, the banks mostly acknowledged the risks they face on consumer credit.
"In Canada, we expect credit quality to remain under pressure with some improvement in the latter half of 2010 as we anticipate the unemployment rate will peak early in the year," Morten Friis, chief risk officer at Royal Bank of Canada (RY.TO), the country's largest bank, told analysts this month.
Still, the Canadian Bankers Association said statistics show prudent lending is still protecting banks, with the percentage of mortgage arrears just 0.43 percent in September.
Indeed, lending in Canada is not like lending in the United States was in the heady days of the housing boom. Canadian banks tend to keep loans on their balance sheets, a strong motivation to pursue sound debts. ( To see a facbox on difference between the markets, click on [ID:nN15228943])
"There has been a stronger tendency in other markets, including the U.S., to securitize mortgages, where we have tended to hold the assets on our books. Our lending criteria ... emphasize the customer's ability to manage the debt, even if rates increase," said Ann DeRabbie, spokeswoman for Bank of Nova Scotia (BNS.TO), Canada's No. 3 bank.
Canada's big banks are also diversified by sector and region -- with branches from coast to coast and in other countries -- which means weakness in one part of their loan books is unlikely to make any of them stumble.
"The diversity of the Canadian banks' balance sheet and their lending portfolio is a lot stronger than your typical regional bank in the U.S.," Aiken said. "(Bad) consumer lending is not going to topple them or erode capital. What's at risk is earnings and earnings growth." (Additional reporting by Randall Palmer in Ottawa; Editing by Jeffrey Hodgson)