Velocity

Don’t let the title confuse you – I speak not of the mortgage origination software some use in this business – but the facts in this article may slow down mortgage origination in your business.

Today was a great day – up until Scotia reported Q4 earnings!!! To say Scotia scared the crap out of people would be the understatement of the year. So bad was their report, that the stock sank 4.48%, hitting a price it hasn’t seen since the depths of the COVID pandemic.

So what was the problem? Well, in case you haven’t noticed the Canadian economy is starting, to, well, ……suck! Anyone who speaks with me regularly knows I am not shocked by this, but the report from Scotia today has me even a little more worried that I was yesterday.

I have argued at length with people about arrears and defaults. They tell me ” defaults are at historic lows” “arrears are well accounted for in bank earnings”, and the like. Of course anyone could put on the rose coloured glasses and agree, but today smashed those glasses. Scotia, and we could presume other banks ( we will know more once the rest report in the coming week ) seem to have a problem with loans on their books.

Let’s take a look at some of the numbers:

Mortgage arrears increased a staggering 78% year over year!!!

Personal loans arrears increased 41% year over year

Line of credit arrears we up 71% year over year.

Not too long ago, there was a large chorus of people that were happy to spin the narrative of ” Canadians will eat grass, and drink rainwater before they will default on their mortgage”. I called Bullshit then, and the numbers from Scotia call bullshit now. The largest growth of arrears was actually mortgages. And before we start arguing ” it is off of a low base, and the percentage of total mortgages matters ” – news flash – I call bullshit on that too.

The number doesn’t matter – the velocity matters. One of the most important factors in the economy is the velocity of money. The SPEED at which it occurs, is more important that WHAT occurs. We saw in 2020 what happens when money stopped moving all at once – the economy hit stall speed and we saw the worst financial problem since the great depression – until governments started spending money like drunken sailors on shore leave. If I get hit by a car, the speed the car is going matters more than the hit itself. If I get hit at 2 miles per hour, or 200 miles per hour has a lot of impact on the outcome. Right now we are seeing the problem pick up speed, and we are a lot close to 200 than 2.

For the record, the Scotia numbers are for people 90 DAYS past due!!! Not 30 days, not 60 days, but a full 90 days. So, the quarter ended on Oct 31, so this goes back to August 1st. That means that someone who was late on August 31 is only counted in this statistic. People who fell behind in late August, September or october aren’t even counted in this. I witnessed this same phenomenon in 2008 when banks simply started changing what the term “arrears” meant. It was 30, then it pushed to 60, then it went to 90 days, then it went to 120 days, then a full 6 months. It made things look better. Personally, if someone is 30 days behind on their bills they are in arrears. How many people are in the 0-30, and 31-60 days area? We don’t know, as Scotia didn’t disclose. Why? I think we know the answer. Ask yourself – did things get worse over the last 2 months?

Scotia has always been a little more risk averse, so if they are experiencing these type of growth rates on arrears, god say a prayer for CIBC.

Moving along, Scotia also released their loan loss provisions, and I am afraid to report – it doesn’t get any better. Loan loss provisions are basically insurance for the bank. They put aside funds from profits to cover off exposure to loans that go bad. It helps to smooth out earnings, and ensure that banks remain well capitalized. If they did not do this – they would report higher profits, and they could use those profits for expansion, share buybacks, and dividends to shareholders. All well and good, but if the loans don’t pay and they have spent all the profits – they are now short capital. Loan loss provisions are closely watched, and banks are required under OFSI ( and international banking requirements called ‘Basel 3’, but that is well beyond the scope of this article ) to set aside funds based on what they are seeing in real time.

In Q4 of 2022, Scotia allocated around 500 Million to loan loss provisions, and in Q4 of this year a WHOPPING 1.37 BILLION. To make matters worse, only 6 months ago Scotia put 600 Million into loan loss accounts, and only 6 months later ( 2 quarters ) they had to more than DOUBLE that amount from 600 Million to the 1.37 Billion. Scotia is literally telling you how bad things got in the last 6 months. I remember not too long ago ( or so it seems ) when banks made 1 billion a year in profits, and now Scotia is putting 37% more away PER QUARTER – just to cover bad debt. I may not be a member of the mensa society but I know trouble when I see it.

Let’s also not forget that rate hikes take a while to filter through the economy. So, 6 months ago we were just starting to see the effects of the first few rate hikes. Over the last 3 and 6 months, we got into the more meat and potatoes of the rate hike, but the quarter ended Oct 31 doesn’t even really represent the last few hikes we have seen. How much will Scotia and their brethren have to allocate once all the rate hikes are affecting their clients?

Is Scotia just plain bad at risk assessment? Possibly, but not likely. I have always felt that Scotia did a good job pricing and assessing risk. ( For the record I am not a big Scotia supporter, so I have no horse in the race here ). My guess is that we see similar reports from BMO, RBC, CIBC, Big Green, and National. The only one I question there is National Bank. National was always super tight on underwriting, and they generally allocate a lot to Quebec. Quebec has a better economy the last couple of years than the B.C. and Ontario focus of the other large banks.

No matter how you slice it, Scotia’s earnings report should really have you examining your opinion of the economy. If you are of the belief that the default rate is low as a percentage, and that is the hymn book you have been signing from, now might be a good time to let the facts change your mind.

I witnessed times like this in 2008, when it was clear that something was amiss, and yet people ignored it. Don’t be so stubborn, and change your opinion when the facts change. During the GFC ( great financial crisis ) I really started to hone in on something that I was witnessing, and I will share it below, and why it matters.

During the GFC we saw massive defaults of mortgages, land etc. The housing crisis is what led the US, and really the world into the problem, so it made sense. However, people kept current on their lines of credit, credit cards, car loans etc. No one could figure it out at first. However, when you start to think about some things, it really makes sense. Lets look below:

Let’s say you are struggling to afford life right now. You aren’t alone. You need your car to get to a job every day. If you skip your car payments, they repo it in about 30 to 60 days. No car means no way to get to work to pay for anything. So, you keep the car payments going. You also pay your credit card, because if you don’t – then they shut it off. You have a 10K limit on the credit card, even though you only have a 2K balance. You will make the minimum payment to keep that extra 8K available in case you need it. It is an insurance policy. You pay the $60 a month minimum to keep 8K available. If you fall behind on your mortgage, realistically it is going to take the bank 6 to 8 months before they appraise it, talk with legal, get a judge to evict you, and list and sell it. So, you still have a few months. These type of reasons are the drivers behind why I feel that mortgage arrears will start to outpace other credit arrears. Below are others:

You can live in your car, but you cannot drive your house to work

You can couch surf, live with parents, move in with friends, etc, but no one will loan you a car full time.

Mortgages ( especially right now ) have work-out solutions through banks and CMHC. Car loans, credit cards etc do not.

There is a good chance you are underwater on your house. Why continue to pay and pay and pay when you are 300K, 400K 500K underwater? It is like throwing good money after bad.

It will be super interesting, and very important to see what the other banks report, and unfortunately I think it will be more of the same, however hope is always in the air.

This matters to you and your career because banks are going to tighten up all lending if they are witnessing spikes in arrears, defaults, and general economic contraction. You think underwriting used to be tight in 2021? You got another thing coming. Banks are going to be tighter than ever if this default rate and speed of defaults holds.