Canada's Financial System Regulator: "we now consider CRE to be a higher risk item" "Elevated inflation puts pressure on retail, corporate, & commercial borrowers' ability to service debt."

Today, Canada's Office of the Superintendent of Financial Institutions (OSFI) released its fall update to the April publication of its 2023-2024 Annual Risk Outlook. This semi-annual update prioritizes the most significant risks facing Canada’s financial system. It also provides an overview of its near-term guidance priorities for federally regulated financial institutions and federally regulated pension plans.  

In particular, the update highlights the impact of elevated inflation and signs of weakening credit quality, particularly in the commercial real estate market.

Higher interest rate environment

Although  the rate of inflation has slowed in 2023, a prolonged period of inflation remaining above the Bank of Canada’s target range has led to a sustained increase in interest rates over the past 18 months. This has put pressure on retail, corporate, and commercial borrowers’ ability to service debt. For example, we have observed a deterioration in the credit quality of variable-rate, fixed payment mortgages. When interest rates rise, these VFM loans reach a “trigger rate” when the fixed payment only covers the interest but none of the principal. If rates rise beyond the trigger rate, the fixed payments do not cover the interest payments and mortgage principal outstanding grows. There is a common misperception that these mortgages’ amortization period extends, largely because monthly mortgage statements calculate a transient amortization period based on the amount of principal paid down in that month.

In fact, the contractual amortization period does not change. And mortgagors will have to make up the deferred principal paydowns when they renew. This means they are at risk of suffering a significant payment shock.

Lending institutions are currently well-capitalized and have proven to be financially resilient in previous downturns. However, as the impact of higher rates continues to be absorbed, the ability of consumers and businesses to adapt to the current rate environment will be tested as loans mature over the next few years in residential real estate secured lending (RESL), CRE, and corporate loan markets. We remain vigilant and continue to monitor for indications of increased borrower defaults, increased fraud, credit losses, and any broader credit led softening of the economic environment.

More difficult CRE environment

While office, and construction and development are the riskiest CRE segments, all commercial property types are facing increased risks due to higher interest rates. Construction markets show signs of a slowdown. Office CRE valuations have come under pressure as the industry grapples with rising vacancies. The outlook remains difficult as seen through an increasing number of strategic defaults in the office space, falling real estate investment trust values relative to their historical net asset value estimates, and rising U.S. commercial mortgage-backed securities delinquency and special servicing rates, especially in the office segment. In addition, negative rating migration seems to be lagging changes to the risk environment. This indicates that risk assessments, risk rating models, and collateral valuations may not appropriately reflect the risk environment.

We have noticed evolving practices in the CRE market. In particular, an increase in the use of “participation” agreements and other co-lending arrangements such as layering in other subordinated debt arrangements whereby the risk is tranched between multiple lenders and entities. These agreements don’t always have standardized contractual language and therefore can present additional risk to lenders based on legal, operational, and structural complexities. They can affect lenders’ rights and remedies thereby impacting the probability of default and level of recovery values. Within this context, we now consider CRE to be a higher risk item than was reflected in the April ARO as conditions remain challenging.

Woah, these are some whoppers of quotes:

• "a prolonged period of inflation remaining above the Bank of Canada’s target range"  
• "This has put pressure on retail, corporate, and commercial borrowers’ ability to service debt."
• "There is a common misperception that these mortgages’ amortization period extends, largely because monthly mortgage statements calculate a transient amortization period based on the amount of principal paid down in that month."
• "In fact, the contractual amortization period does not change. And mortgagors will have to make up the deferred principal paydowns when they renew. This means they are at risk of suffering a significant payment shock."
• "All commercial property types are facing increased risks due to higher interest rates."
• "The outlook remains difficult as seen through an increasing number of strategic defaults in the office space, falling real estate investment trust values relative to their historical net asset value estimates, and rising U.S. commercial mortgage-backed securities delinquency and special servicing rates, especially in the office segment."
• "In addition, negative rating migration seems to be lagging changes to the risk environment. This indicates that risk assessments, risk rating models, and collateral valuations may not appropriately reflect the risk environment."
• "In particular, an increase in the use of “participation” agreements and other co-lending arrangements such as layering in other subordinated debt arrangements whereby the risk is tranched between multiple lenders and entities."
• "These agreements don’t always have standardized contractual language and therefore can present additional risk to lenders based on legal, operational, and structural complexities."
• "They can affect lenders’ rights and remedies thereby impacting the probability of default and level of recovery values."
• "Within this context, we now consider CRE to be a higher risk item than was reflected in the April ARO as conditions remain challenging."

TLDRS:

1. Canada's Office of the Superintendent of Financial Institutions (OSFI) released its fall update.
2. Inflation is Elevated & Entrenched: putting pressure on retail, corporate, & commercial borrowers' ability to service debt.
3. Mortgage Misunderstanding: Some people think that if they pay less on their house loan (mortgage) one month, they can just stretch out the time they have to pay it back. But that's not true. If they pay less now, they'll have to pay more later. This can be a big surprise for them.
4. Bad Signs in the Office Space: More businesses are choosing not to pay their office rents, and the value of some real estate investments is dropping. In the U.S., there's also a rise in office loans not being paid back.
5. CRE Risk Assessments Off: The tools and methods people use to judge how risky CRE is might not be catching up with the actual risks out there.
6. Complex CRE Loan Agreements: Some lenders are teaming up to give out loans, but the rules they're using are all over the place. This makes things confusing and more risky.
7. Lenders' Rights: Because of these confusing rules, when someone can't pay back a loan, it will be harder for the lender to get their money back...
8. It's Getting Rough: "Within this context, we now consider CRE to be a higher risk item than was reflected in the April ARO as conditions remain challenging."
9. Reminder, while banks have the liquidity fairy, 'we' get the promise of more rate hikes this year, Atlanta Fed President Raphael Bostic yet again enrichens himself inappropriately from his position.
10. To fix one end of their mandate (price stability) from the inflation problem they created, the Fed will continue sacrificing employment (the other end of their mandate) to bolster price stability by continuing to raise interest rates--causing further stress to businesses and households.
11. I believe inflation is the match that has been lit that will light the fuse of our rocket.

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