Consumers and businesses will find credit more difficult and expensive to acquire in the coming year.
Why? One reason lies in the global securitization market. Securitization involves pooling various types of debt into investment products that can then be sold off to investors. Historically, banks did this to get loans off their balance sheets, which allowed them to make new loans to other customers. The global financial crisis has significantly impacted the securitization market; lenders must now absorb more loans on their own balance sheets, leaving less money available for new loans. Meanwhile, banks have seen their cost of funding increase.
Another reason is the struggling U.S. economy. Though Canada enjoys a better fiscal and economic position than its southern neighbour, the U.S. recession will cast a long shadow. Combined, these factors mean Canadian consumers will likely face higher interest rates, tighter lending terms and lower credit limits in 2009.
The good news is, Canada’s banking system is strong and has received government support, primarily in the form of increased liquidity. The Bank of Canada, for example, is now accepting a larger range of assets as collateral, and has introduced new term-loans for financial institutions. The Canada Mortgage and Housing Corp. purchased $75 billion in mortgage-backed securities. Jim Flaherty, the minister of finance, announced that deposit-taking institutions will be able to obtain government guarantees for new issuances of certain types of debt. Despite uncertainty in global markets, Canadian banks can still access funding, including common and preferred equity issuances.
Moreover, Canada has a more conservative borrowing culture. Consider loss rates on credit cards, the amounts banks have to write off. They’re typically a full 2% higher in the United States than in Canada, and far more volatile. This prudence extends to the housing market. Less than 25% of residential loans are securitized in Canada; most loans by far are on-balance-sheet and banks are accountable. Also, higher-risk sub-prime loans account for just a little more than 5% of the Canadian market, compared with more than 25% in the U.S.
Canadian house prices are healthy. We expect them to contract by 10–15%. In the U.S., they’ve already fallen 24% and will ultimately correct by 35–40%. It helps that mortgages are not tax-deductible in Canada; this tax advantage in the U.S. led to a rapid rise in home prices there.
All this means lenders will not shut their doors to Canadian consumers. But for small to medium-sized businesses, borrowing in a recessionary environment will be much more difficult. Such enterprises will be at higher risk of a liquidity problem, even bankruptcy, and will have to scale back growth expectations. Efficient operations and adequate financing will be imperative for small businesses, as their ability to access even existing liquidity could be in jeopardy. Relying on lines of credit might be hazardous, as banks can reduce them. Overall, the cost of borrowing for all small businesses will likely increase, despite prevailing low interest rates, as banks increase risk premiums associated with lending.
Similarly, given recent investor losses, risk premiums associated with corporate debt will continue increasing. Virtually every large corporation in Canada faces significantly higher borrowing costs. These costs will be largely absorbed through cost-cutting and lower profit margins, ultimately resulting in widespread job losses. Those corporations with exposure to the United States will be most at risk to negative credit-rating action and the possibility of default. The market is pricing in significantly higher risk for non-investment-grade corporate issuers. Investment-grade credits will also face difficult times, but are much better positioned.
Canada is in better shape than many G7 countries. It has the lowest debt relative to its GDP, and is the only one to enter this recession with a budgetary surplus. Canadian banks are envied worldwide. But we live in a connected world, and the long arm of global financial and recessionary forces will have a dampening effect on Canada. This will be felt in tighter lending terms, higher cost of borrowing, and lower amounts for both consumers and businesses.
Peter Bethlenfalvy is co-president of DBRS Ltd.