Written By: Amit Shteyer

The issue at hand

With COVID-19 and the current lockdown, Canada’s economy is in a state of shock; lines to go grocery shopping, businesses going bankrupt, job losses and a negative inflation rate. Money troubles and fear obstruct the lives of consumers and businesses alike.

Consequently, many relief programs have been put in place to help consumers financially. One of these being the Mortgage Payment Deferral option offered by banks. This is an option that allows individuals to postpone their monthly mortgage payments by up to 6 months, depending on the financial institution. With over 3 million additional Canadians facing unemployment between February and April, this relief program is meant to lend a helping hand to households (1). A great solution, right? Well, maybe not for all.

These deferrals actually end up costing Canadians more money in the long term. Further investigation into the program reveals that the interest of the deferred payments will be added to the outstanding mortgage balance – meaning that the principal will grow, leading to higher monthly payments and accruing additional interest on top of the deferred interest. For example, in a CBC article, the Merles family stated that $7,400 of deferred interest would be added to their balance (2). That’s a lot of money.

The long term fear is something called the “deferral cliff”. This refers to the moment when households will be facing even higher levels of debt as individuals may still be unemployed by the time their 6 months deferral period is up. So, are these programs really helping? Or will they end up causing a greater burden for both banks and consumers?

Households during COVID-19

The COVID-19 induced financial crisis has hit many households who were already low on cash and highly indebted. In fact, the central bank predicts that 20% of mortgage borrowers will only be able to cover 2 months of regular payments before defaulting (3). This begs the question – how exactly are they supposed to be able to pay even higher monthly amounts after deferring their mortgage?

Consumer insolvency is becoming a major concern. According to the Bank of Canada, the amount of households that require over 40% of their income to cover their debt payments will rise after the mortgage deferral period is over. To top it off, many people are being laid off or fired. The unemployment rate in April 2020 was actually worse than that of the 2008 financial crisis. It’s a cycle. Renters tend to work in COVID-19 affected industries and are missing many of their rent payments. As a result, pressure is placed on their landlords who have mortgages to pay. With the escalating financial pressure on mortgage borrowers, there is uncertainty in whether the deferral period of up to 6 months will give individuals enough time to recover.

Mortgage arrears, even with the deferral program, are predicted to be worse than in the 2008 Financial crisis. In the graph below, the “with policy” scenario includes the effects of the mortgage deferrals which are containing the otherwise large impact from the “no policy” scenario. The peak in mortgage arrears of 0.8% in 2021, when households who haven’t fully recovered their income will be unable to meet payments, is almost double the peak of the arrears rate in 2009 (4).

Figure 1. Rise in mortgage arrears with and without the effect of mortgage deferral programs. Retrieved from Bank of Canada (2020).

Although the amount of mortgage arrears will be high, it is expected that it will be significantly lower with the deferral programs in place. As households continuously have a hard time fairing the current economic conditions, only time will tell whether these programs will actually help consumers and banks.

The banking industry during COVID-19

While COVID-19 has had some impact on the big banks, their strong earnings and capital position have allowed them to weather the storm. One example of a bank’s state during this economic downturn is Scotiabank, which reported a decline of 41% in profits this quarter compared to prior year’s. However, their net income remained at a high of $1.32 billion. In addition, their shares gained 7.4% in the last week of May showing that the effects on the industry aren’t as bad as may have been expected (5).

Banking is a highly profitable sector, even in a crisis. The profits of the Canadian banking industry are one of the highest in the world. Total profits of the big six amounted to $46 billion in 2019, and have been increasing for the past ten years2. As demonstrated in the graph below, their revenues have also seen consistent growth since the year 2014 (6).

Figure 2. Growth in big six banks’ revenues. Retrieved from Consulting Canada (2019).

These high revenues allow the bigger banks to be as strong as ever entering this crisis. An article by the Financial Post mentioned that policymakers ran a test on the big six to deduce whether they would survive Canada’s worst-case economic scenario. This involved a 30% downfall in GDP and two years of worse than pre-crisis levels of output in the economy (3). Even in this scenario, the Banks’ capital remains above requirements.

Nonetheless, while the big banks possess sufficient capital to fund the missing deferral payments, small and medium sized banks may lack the capacity to endure this pandemic. Due to the current economic environment and the uncertain duration of COVID-19, liquidity may become an issue for big banks but will most definitely produce a significant impact on small and medium size ones. Banks have allowed more than 700,000 Canadians to defer their mortgage payments as of May 25, 2020. This makes up approximately 15% of the number of total mortgages in their portfolios (7). With all of these deferred payments, they lack a constant stream of cash flows. So, is the accumulating deferred interest a way for them to make up for these current losses?

The big banks seem to have the confidence that they will make it through. Scotiabank reported that over 134,000 of its customers have signed up for their mortgage payment deferral program, amounting to $38 billion in payments outstanding. That’s a lot of people that have stopped paying their regular payments. Either way, Scotiabank’s management still believes that these customers will be able to manage the extra costs of about $60 per payment and that damages will be reasonable5.

At this very moment it may appear as if banks could afford to not charge the deferred interest in this program, but what happens when the alleged “deferral cliff” is reached in the fall? Banks, both big and small, will need some influx of cash to survive in the long run.

What does this all mean?

The hardships of consumers will not simply disappear at the end of the 6 month deferral period. What banks fear, the deferral cliff, is coming and it may have a major impact on the  banking industry. Thus, any situation, with or without deferral programs, will cause financial burden to both sides.

This leaves the question of whether there is a way to avoid this likely downfall. Banks could possibly require members of the program to only pay the interest of the payments for the deferred months. This way, it isn’t being added on to the balance, the bank is still making some money and payments are smaller during the deferred period.

There are other solutions, however. Consumers can take action to minimize their own losses. Households should speak with their lenders to look into other sources of funding and programs that could help during this time, since mortgage deferrals come with a cost. For example, a personal line of credit or a home equity line of credit may aid in providing a small amount temporarily. It’s important that consumers realise the long term consequences of the mortgage deferral program and speak with their lenders first (8). This method ensures loss is limited for both consumers and banks in the long run.

But for those more than 700,000 households who have already taken advantage of the deferral programs, we are waiting to see the consequences that will creep up in the fall. We all want to know, is the “deferral cliff” actually coming? And if so, how big will the effects be?

 

1. Government of Canada, Statistics Canada. (2020, June 05). COVID-19 and the labour market in May 2020. Retrieved June 21, 2020, from https://www150.statcan.gc.ca/n1/pub/11-627-m/11-627-m2020038-eng.htm
2. Johnson, E. (2020, April 11). ‘It feels greedy’: Big banks charging interest on interest for deferred mortgage payments | CBC News. Retrieved June 21, 2020, from https://www.cbc.ca/news/business/banks-charge-interest-on-interest-for-mortgage-payment-deferral-1.5529399
3. Carmichael, K. (2020, May 14). Big banks able to weather Bank of Canada’s worst-case scenario, but risks higher for households and businesses. Retrieved June 21, 2020, from https://business.financialpost.com/news/economy/bank-of-canada-warns-of-excess-business-household-debt-from-covid-19
4. Bank of Canada. (2020, May 7). Financial System Review-2020. Retrieved June 22, 2020, from https://www.bankofcanada.ca/2020/05/financial-system-review-2020/
5. Zochodne, G. (2020, May 26). Mortgage ‘deferral cliff’ avoided: Scotiabank says requests to delay loan payments have peaked. Retrieved June 21, 2020, from https://business.financialpost.com/news/fp-street/scotiabank-profit-drops-41-5-on-higher-loan-losses
6. Canadian banks see revenue grow 6.1% to $159 billion in FY18. (2019, January 31). Retrieved June 21, 2020, from https://www.consulting.ca/news/835/canadian-banks-see-revenue-grow-61-to-159-billion-in-fy18
7. Zochodne, G. (2020, May 25). Big banks to report results as mortgage ‘deferral cliff’ starts to loom, loan loss expectations rise. Retrieved June 21, 2020, from https://business.financialpost.com/news/fp-street/big-six-banks-report-earnings-mortgage-deferral-cliff-loan-losses
8. Brown, J. (2020, April 08). What could COVID-19 mortgage payment deferral cost? Retrieved June 22, 2020, from https://www.ratehub.ca/blog/what-mortgage-payment-deferral-costs/