Canada’s Subprime Crisis?
Canadian lenders are loosening standards, offering mortgages similar to U.S. subprime loans that pose an “emerging risk” to financial institutions, according to the country’s banking regulator.
Banks and other lenders are becoming “increasingly liberal” with mortgages and home-equity credit lines that don’t require individuals to prove their income, according to 152 pages of documents obtained by Bloomberg News under freedom of information law from the Office of the Superintendent of Financial Institutions. The mortgages, typically granted to the self-employed and recent immigrants, “have some similarities to non-prime loans in the U.S. retail lending market,” the documents show.
“It just speaks to the general easing in lending standards, which has contributed to a booming housing market,” said David Madani, an economist in Toronto with Capital Economics, which estimates that Canadian housing prices may fall 25 percent over the next few years. “The problem is sort of baked in now, so I’m not sure there’s a way to prevent a weakening of the housing market.”
Canada’s housing market has surged since the 2009 recession as near-record low mortgage rates fueled prices and home purchases, unlike the U.S., where sales and values have fallen since 2007. Bank of Canada Governor Mark Carney has said record consumer debts are the greatest domestic threat to the country’s financial institutions, even as the central bank has held the benchmark rate at 1 percent since September 2010.
While there are differences with U.S. mortgage practices, the Canadian housing market is displaying classic signs of a bubble, with a run-up in prices, high ownership rates and overbuilding, said Madani of Capital Economics.
“The biggest concern is taking extreme levels of debt for those who are most vulnerable,” Carney told reporters Jan. 18. The bank estimates the proportion of Canadian households “highly vulnerable” to an economic shock - those with a debt service ratio of 40 percent or more - remains above the average of the past decade. Canadians’ debt reached a record 153 percent of disposable income in the third quarter, according to Statistics Canada data.
Most mortgages in Canada are funded through deposits, followed by mortgage-backed securities and bonds guaranteed by Canada Mortgage and Housing Corp., a federal agency known as CMHC.
CMHC had an outstanding balance as of Sept. 30 of C$132 billion ($132 billion) in mortgage-backed securities and C$202 billion in Canada Mortgage Bonds. The agency’s financing arm issued C$41.3 billion in debt last year, up from C$6.5 billion in 2001.
Covered Bond Sales
Banks are also cutting their funding costs by selling covered bonds, a form of corporate bond backed by assets such as home loans. Bank of Montreal and Bank of Nova Scotia (BNS) sold $4.5 billion of the securities this month, according to data compiled by Bloomberg, after a record $25 billion of sales in 2011.
Relative yields for Canadian covered bonds average 91 basis points, or 0.91 percentage point, more than government benchmarks compared with 102 at the end of last year, according to Bank of America Merrill Lynch index data. That compares with a premium of 306 basis points for covered bonds issued by euro- region lenders.
Canada’s banking system has been rated the soundest in the world for four straight years by the World Economic Forum, and none of the country’s lenders needed a bailout, unlike U.S. banks, which suffered losses on securities backed by sub-prime mortgages.
U.S. nonprime mortgages - which include both subprime and “alt-A mortgages” - accounted for slightly more than a third of originations at the peak of the market in 2006, according to Inside Mortgage Finance, a Bethesda, Maryland-based company that tracks residential mortgages. Loans that required little or no documentation of income accounted for 46 percent of all U.S. subprime mortgages that year, according to a Credit Suisse Group AG report at the time.
While there is no common definition of subprime mortgages in Canada, the proportion of such loans has probably fallen from about 5 percent of the market since the financial crisis, said Benjamin Tal, deputy chief economist at CIBC World Markets in Toronto.
“If you look at the overall story and marginal borrowers, it’s a very small segment of the market,” said Tal.
Mortgage terms are also typically shorter in Canada than the U.S., and lenders can pursue defaulting borrowers for full reimbursement even after foreclosure. As well, mortgage interest isn’t tax deductible in Canada, unlike the U.S.
OSFI head Julie Dickson said in a Sept. 26 speech the agency is “very focused” on mortgages and home-equity lines of credit, which allow individuals to borrow against the equity in their homes.
In a Nov. 2 letter to Canadian financial institutions, the agency encouraged them to follow mortgage underwriting principles recommended by the Financial Stability Board, including limits on the ratio of loans to property values and regular stress testing of mortgage portfolios. OSFI regulates Canada’s biggest banks, as well as smaller loan providers and credit unions.
Home buyers usually qualify for “non-income-qualified” mortgages because they make a large down payment, according to the August 2011 analysis by OSFI. Lenders typically waive the requirement that buyers prove their income, OSFI says, which identified such loans on a list of issues to be considered by its “emerging-risk committee.”
Home-equity credit lines without income verification have become “an increasingly popular option,” OSFI says in the analysis, adding that they “pose greater risk” than mortgages because the credit lines are offered at floating interest rates.
Slackening lending standards were one of the early warning signs of the subprime crisis in the U.S., said Joshua Rosner, managing director at research firm Graham Fisher & Co. in New York. “U.S. history should be a guide to the irrationality of that practice,” he said by phone, referring to granting mortgages to borrowers without verifying their income.
By definition, such mortgages should be considered “nonprime,” added Rosner, who warned of the risks of a U.S. housing crash as early as 2001.
“As part of OSFI’s regular supervisory process, OSFI identifies areas that may require an increased level of monitoring,” OSFI spokesman Brock Kruger said in an e-mail, adding that regulators in many other countries have stepped up monitoring and oversight of residential mortgages and home- equity lines of credit.
OSFI hasn’t imposed new requirements on banks in this area, Kruger added. “When OSFI identifies areas for heightened supervision, we work to ensure that we understand the issues and pressures driving that area before making decisions.”
OSFI officials assessed Canadian banks’ potential losses from defaults on home-equity lines of credit last year, the documents show. The results were blacked out under legal provisions that allow the government to withhold commercially sensitive information.
Bank of Montreal, the country’s fourth-biggest lender, has “prudent credit criteria, and we regularly review our credit qualifications,” spokesman Paul Gammal said in an e-mail. Other banks declined to comment on their mortgage lending standards, referring questions to the Canadian Bankers Association, an industry group.
Canadian banks “carefully manage risk in their mortgage portfolios,” said Rachel Swiednicki, a spokeswoman for the Canadian Bankers Association. Mortgages in arrears were 0.39 percent of the total outstanding home loans in September, she said, calling the figure “extremely low.” In the U.S., the rate was 3.5 percent in the third quarter, down from 5.02 percent in the first quarter of 2010, according to the Mortgage Bankers Association. In the first quarter of 2007, the U.S. arrears rate stood at 0.98 percent.
Falling borrowing costs are driving home sales, which increased 9.5 percent to C$166 billion ($166 billion) last year, the Canadian Real Estate Association said this month. Home prices rose 7.2 percent. Toronto-Dominion Bank (TD) estimated in a Dec. 22 report the average Canadian home is overvalued by about 10 percent, and the heads of Bank of Montreal and Royal Bank of Canada warned that condominium markets in Toronto and Vancouver are at risk of correction. By contrast, the median price of previously owned homes in the U.S. plunged about 30 percent from a 2006 peak.
Non-income-qualified mortgages aren’t necessarily riskier than conventional loans, said Jim Murphy, head of the Canadian Association of Accredited Mortgage Professionals, which represents mortgage brokers, lenders and insurers.
“There’s no data out there that I’m aware of that says these sorts of mortgage products have a higher arrears rate or a higher default rate,” Murphy said by telephone.
Finance Minister Jim Flaherty has tightened mortgage lending rules three times since October 2008, most recently last January, when he limited the period over which mortgages can be amortized to 30 years, capped the amount people can borrow by refinancing their mortgages, and eliminated government insurance on home-equity lines of credit that are not amortized. Flaherty said Jan. 17 he’s prepared to intervene again if necessary, though the government has no plans to take immediate action.
Mortgage insurance plays a role in protecting Canadian banks from losses. Federal regulated lenders must insure mortgages to borrowers who make a downpayment of less than 20 percent of the loan, a requirement that doesn’t exist in the U.S. Most mortgage insurance in Canada is underwritten by the CMHC. The OSFI documents refer to both insured and uninsured mortgages.
While CMHC validates the income of all borrowers whose mortgages it insures, the agency “may accept non-traditional means of income validation” from newly self-employed borrowers with an “acceptable” credit history, spokesman Charles Sauriol said by e-mail
CMHC’s policies “help ensure that newcomers and others without a Canadian credit history have access to CMHC mortgage loan insurance products through the utilization of alternatives to validate a borrower’s credit history,” he added.
Reuters just ran an insight piece on how the growth of household debt in Canada to levels approaching those seen in the United States before the 2008-2009 crash seems to be keeping a lot of people awake - from central bankers to economists, lenders, real estate agents and the indebted consumers.
All this confirms my worst fears, namely, Canada's housing market is a disaster waiting to happen. When the great Canadian housing bubble bursts, watch out below, it will take years to repair. And that's when we'll find out just how solid Canada's mortgage monster really is.
When you see BMO's Sherry Cooper coming out telling us that the housing bubble is really a balloon, you know the top is in. "Stick a fork in it Jerry, it's cooked!" (any Seinfeld fans out there?) Just like CMHC's risk models are cooked and grossly underestimate the real risks that lurk if this so-called 'balloon' pops, leaving many people stuck paying off mortgages that are worth more than the actual value of their houses (underwater mortgages).
It's going to get ugly folks, just remember the few of us have who have been warning you all along. Whenever you hear some economist telling you that "Canada's fundamentals are strong" and that "we can never suffer the same fate as the U.S.", start running for cover.
Below, Bank of Canada Governor Mark Carney talks about the potential impact of the so-called Volcker rule on the trading of government bonds, the European Central Bank's efforts to ease the region's debt crisis and bank capital regulations. He speaks with Bloomberg's Erik Schatzker on the sidelines of the World Economic Forum's annual meeting in Davos, Switzerland.