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February 26, 2009

Credit contagion spreads to Canada

It was only a matter of time before credit losses spread across the USCanada border, and a new report from business advisory firm Deloitte is highlighting that the pace of the downturn is taking many issuers by surprise The credit quality contagion has spread from the United States into Canada, as a new study paints an increasingly grim portrait of that nations card market.

By Verdict Staff

It was only a matter of time before credit losses spread across the US/Canada border, and a new report from business advisory firm Deloitte is highlighting that the pace of the downturn is taking many issuers by surprise. It is also urging them to take pre-emptive action, as Charles Davis reports.

The credit quality contagion has spread from the United States into Canada, as a new study paints an increasingly grim portrait of that nation’s card market.

Toronto-based business advisory and consultancy group Deloitte Canada recently released the report Uncharted Waters For Credit Card Issuers, based on interviews with approximately half of all Canadian credit card issuers.

The issuers told Deloitte that while they have only recently begun to feel the affects of increasing delinquencies and charge-offs, the pace of the downturn is increasing. Issuers are responding by tightening credit standards and looking deeply at the health of their portfolios, but the report urges them to do even more, anticipating heightened economic uncertainty in the months to come.

Most respondents said they started seeing a 5 percent to 10 percent increase in delinquencies during the fourth quarter of 2008 compared with the same period a year earlier. Charge-offs increased 50 to 100 basis points, according to the report.

Losses set to escalate rapidly

The upper end of the range represents annualised losses of over C$800 million ($642 million) to the industry as a whole, where the total value of outstanding balances is in excess of C$80 billion, according to the report. Even in a more conservative scenario, losses could be in the C$500 million range in 2009.

Canadian credit card issuers have typically seen loss rates of less than 4 percent, a rate much lower than that of the American average of 6 percent. But with Canadian consumers increasing their debt-to-disposable-income ratios to more than 130 percent – a rate currently higher than that of the credit-crazy US – Canadian issuers face unprecedented risks. Canadian credit card balances have increased almost 40 percent since 2004, according to the country’s central bank, the Bank of Canada. As a result, Canadian credit card issuers are taking action to avoid the costly write-downs now common in the United States.

The Deloitte report found that Canadian issuers have reacted to those risks by tightening credit standards for new accounts, implementing credit limit decreases and paring back such acquisition efforts as balance transfer programmes.

The price of aggressive growth

The report found that although many of the Canadian credit card issuers that have aggressively grown their portfolios in the last few years will suffer higher credit losses in the months ahead, there are measures all credit card issuers may take to more effectively manage their portfolios, decrease risk and plan for future growth and profitability. The report recommended that issuers intervene quickly when accounts become delinquent, actively review the credit quality of existing customers, monitor cash advances and credit line usage and stop or reduce automatic credit limit increases.

It also suggested that issuers adjust operating costs to reflect current realities and upgrade their approach to forecasting with scenario planning, or risk runaway delinquencies as Canadian debt ratios soar.

“Traditional forecasting models based on historical patterns are proving unreliable predictors of future risks,” the report said. “You may need a more comprehensive approach that injects advanced scenario planning into your decision-making. Since the future is inherently uncertain, particularly now, scenario planning allows you to examine a number of possible future outcomes and to develop appropriate responses.”

Deloitte said that planning models must take into account the possibility that the recession deepens before any improvement is seen, and noted that there are potential regulatory changes on the horizon. Other areas of uncertainty may include customer use of other forms of payment such as debit or cash, or competitors entering or exiting the market.

Stressing precautions that Canadian issuers already are instituting, the report said that cash advances often indicate that a cardholder is in financial difficulty. The report recommended creating a watch-list of accounts with unusually high cash advance activity – and managing them continually.

“Also, there is a high correlation between the percentage of the credit line being used and the likelihood of default,” the report said. “Monitor accounts with high utilisation as an early warning for troubled cardholders. When you do encounter accounts that may be in trouble, review the other lending relationships that the cardholder may have with your institution to assess your full exposure. Taking a holistic view of the cardholder and their relationship with your institution is even more important in these times.”

Risk of high debt levels

The Canadian central bank’s figures show that consumer credit, on a seasonally adjusted basis, was C$412.8 billion in November 2008, up 9 percent from the same month a year ago. The risk of high debt levels was evident in December 2008, when personal and business bankruptcies surged 47 percent from the same month a year earlier, according to government figures released in February.

A related report by Moody’s Investors Service only adds to the worries in Canada, as all five measures Moody’s uses to determine the performance of the credit card market deteriorated in the third quarter of 2008.

Customer delinquencies, payment rates, and credit card company losses resulting from unpaid balances all worsened compared with the third quarter of 2007. The resulting losses to credit card companies rose to 3.08 percent in the third quarter of last year, up from 2.77 percent the year before, Moody’s said.

Canadian authorities are not as deeply concerned as US bankers and officials, in large part because a US-style mortgage crisis is not on the cards thanks to the fact that most of the home loans issued in Canada are backed by the government. That guarantee means a sudden crush of foreclosures wouldn’t force banks to alter their lending habits.

Also in Canadian issuers’ favour are its tighter lending standards and more stringent credit requirements, compared with the United States and the UK, Moody’s said.

This means the magnitude of the increase in credit card payment delinquencies is still likely to remain much lower in Canada than in the United States, even as the Canadian recession begins to really sink in.

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