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(Reuters) - Debt-ridden Canadian consumers and a cooling property market are leaving the country's stalwart banks vulnerable, credit rating agency Standard & Poor's has warned, fanning a growing national debate on whether Canada is facing a U.S.-style housing debacle.
While S&P reaffirmed the high ratings of Canada's biggest banks, it dropped its outlook to "negative" from "stable." It was a shot across the bow for banks still considered among the healthiest in the world but now facing the risks of a pullback in consumer borrowing and a downturn in a booming housing market - reminiscent of the forces that derailed their U.S. rivals four years ago.
The warning to Canada's three largest banks -- Royal Bank of Canada (RY.TO), Toronto Dominion Bank (TD.TO), and Bank of Nova Scotia (BNS.TO), as well as smaller rivals National Bank of Canada (NA.TO) and Laurentian Bank of Canada (LB.TO) -- cited rising consumer debut and elevated housing prices in Canada, as well as economic risks abroad.
"In our view, this poses a risk for Canadian banks given the importance of each bank's consumer credit loan portfolio," S&P said in explaining the shift to a negative credit outlook.
While Canadian economists and bank analysts alike agree -- by varying degrees -- that the housing market looks set to cool and consumers are likely to pull back on borrowing when it does, they said the deleveraging will affect the profitability, not the stability, of Canada's big lenders.
"It's not the same as the United States," said Peter Routledge, a banking analyst at National Bank and himself a former analyst at credit rating agency Moody's.
Canadian home prices rose to a third straight record high in June, but a slowdown in the pace of price increases suggested the red-hot housing market was cooling, data showed last week. Consumer debt has also risen to record highs similar to levels reached in the United States prior to 2008, prompting policymakers to rewrite rules in July to make it harder for homebuyers to take on too much housing debt.
While many experts predict indebted consumers will soon have to pull back, the move will hurt bank profits, not their ability to service or pay back loans, Routledge said.
"If all of a sudden consumers start to deleverage and pay down loans, and loan balances contract, bank revenues will contract and so too will earnings. But we are not going to have a massive wave of credit losses impacting the balance sheets of Canadian banks, because of the prevalence of mortgage insurance."
Unlike U.S. banks before the 2008-2009 financial crisis, Canadian banks have the explicit backing of the federal government by way of mortgage insurance issued by the Canadian Mortgage and Housing Corp, which insurers all mortgages with a loan-to-value ratio above 80 percent.
In additional to farming out the risk of such mortgages where homebuyers made low downpayments, banks have also purchased extra CMHC insurance on low-ratio or less-risky mortgages to assuage the concern of regulators that their mortgage holdings are sound.
The prudence of the Canadian banks in insuring their mortgage portfolio means even a wave of mortgage defaults is unlikely to dent their balance sheets. The bigger risk is that customers stop asking for loans if the housing market crashes, a thrift that would cut into bank profits.
Canadian banks also have recourse to pursue unrelated assets of borrowers who default on their mortgages, making it less likely for homeowners to walk away from home debt.
"In Canada it would make it a little less likely that Canadians would pursue tossing the keys back - we saw a lot of that activity here," said Tom Lewandowski, an analyst of Canadian banks with Edward Jones in St. Louis.
Still, Lewandowski said the negative outlook imposed by S&P -- which, like many rating agencies, failed to warn of the U.S. crisis -- adds to the valid chorus of concern about Canada's housing market and consumer indebtedness.
"Considering what we went through here in the States, I'm not surprised they have an impetus to bring risks to light ahead of time, as opposed to waiting for them to play out should we see housing prices decline or the economy turn over," he said.
Canada's big banks are also buffered by their oligopoly in the market, with the five biggest banks stretching from coast-to-coast and two smaller regional players plugging the holes. The relative lack of competition compared with the hundreds of U.S. regional banks will allow them to raise fees or cut expenses if loan growth slows as consumers tighten their belts.
Still, clouds on the global economic horizon were also cited by S&P in its outlook for the Canadian banks, a caution that bears attention, said Finn Poschmann, vice-president of research at the C.D. Howe Institute, a think-tank.
"There are three major global economic threats. One is the euro and the sovereign debt situation there. Two is the state of the U.S. economy and both their looming fiscal problems and their sluggishness emerging from recession. And three is the slowing pace of growth in China," Poschmann said.
"These are significant economic threats ... (that make it) unwise not to pay attention to. For the moment however, Canada's banks are in extremely strong balance-sheet positions."
Reporting By Andrea Hopkins; Editing by Frank McGurty