Investors in Canadian bank stocks have enjoyed a very pleasant start to the new year as bank stocks rose by nearly 10% in January. Equity analysts point to the upswing in bank stocks as a case of reversion to the mean, especially after the dramatic swoon in stock prices in December. Canadian investors have had a long love affair with their major banks and tend to look for any opportunity to buy shares at attractive prices.

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Ironically, the mainstay of Canadian banks is mortgage loans and these have been shrinking from early 2018 to the present. Canadian banks have dominated the mortgage business and currently underwrite nearly 75% of all household mortgages. On the whole, mortgages (including home equity lines) amount to C$ 1.5 trillion or about 65% of total bank assets. By comparison, personal (non-mortgage loans) account for about 20%, business loans about 9% and the balance is comprised of non-residential mortgages and other smaller loan categories. The mortgage business has been very stable, very profitable and has been managed by a very effective regulatory environment. During the U.S. mortgage market collapse in 2008, the Canadian mortgage industry exhibited no cracks and business was as usual.

Now, the banks are shying away from writing new mortgage business in part due to the introduction of tougher lending rules and their own internal risk management policies. The Bank of Canada data for December shows residential mortgage growth rose just 3.1 percent from the prior year, the slowest pace in 17 years, and half the growth rate from two years ago. More significantly, this rate is less than the nominal rate of GDP growth, an indication that mortgage lending is no longer supportive of economic expansion, but is acting as a moderate drag on the economy.

This fall-off in lending was largely orchestrated by the Federal government efforts to slow down the growth in household debt. Especially, it introduced a series of measures, referred to as the “B-20 regulations” which toughened mortgage-qualifying standards. In addition, the commercial banks have taken upon themselves to reduce their risks in the largest segment of their business.

As a result, housing prices and sales in the Greater Toronto and Greater Vancouver areas have dramatically cooled over the past 12 months. This government-engineered slowdown is viewed with quite mixed results. Industry participants point to the virtual disappearance of the first – time home buyer. Many suburban housing projects have been put on hold, as first -time buyers are unable to meet these new lending standards. More importantly, government officials are now concerned that these buyers will turn to the unregulated mortgage market with the prospects of some de-stabilizing effects should housing prices fall much further. Others argue that reining in mortgage lending activities makes for a healthier market for housing and it is the right dose of medicine at this time.

Back to the bank stocks. If the banks are going to back away from growing their mortgage book, then the foregone bank profits will have to come from other lending activities. However, corporate lending cannot make up the difference. And, personal lending is also scrutinized since much of it is unsecured credit cards and credit lines. The question remains: where will the banks generate profits now that mortgage lending is being reined in?