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A recession and a deteriorating housing market will hit Canada’s financial sector, but banks are generally equipped to weather the stress, says DBRS Morningstar in a new report.

The rating agency said that high household debt levels and elevated housing prices represent “key vulnerabilities” to the Canadian financial system, particularly as debt-laden households stretched their finances to buy homes at high prices during the pandemic.

Certain households took on larger mortgages, longer amortizations and variable-rate mortgages, which are more exposed to rising rates. Now, as interest rates rise, the housing market is weakening, the report said.

DBRS noted that national housing prices have dropped for three straight months. In June, prices suffered their largest monthly decline since 2005.

These trends are expected to continue as rates head higher.

“Although the magnitude of the impact of monetary policy tightening on the housing market is still unclear, rising rates will continue to erode housing affordability at current price levels, further depressing demand and putting downward pressure on housing prices,” the report said.

Additionally, rising rates will hit housing market speculators.

“Once highly leveraged investors must renew/refinance at higher rates, they may start to experience negative cash flow on their investment properties and decide to sell,” the report said.

Despite these trends, the report indicated that the big Canadian banks are generally well positioned.

The labour market remains strong and the financial system is “well-regulated with solid balance sheets, robust levels of internal capital generation, and capital buffers that should be capable of enduring a material fall in home prices,” it said.

DBRS said it expects banks to start building up provisions for credit losses on performing loans in the coming quarters “to account for economic uncertainty and rapidly increasing interest rates.”

“The biggest risk, however, is that a slowdown leads to unemployment shocks, as a surge in unemployment would lead to a steeper drop in housing prices,” it added.