Canada's dirty little sub prime loan secret threatens to sink housing market

VANCOUVER - While the U.S. is still suffering from the sub prime debacle, Canada's housing market is an island of tranquility.  House prices continue to rise, people are buying houses and apartments and paying their mortgages.  The banks are on a solid footing, making profits and not facing bankruptcy or asking for bailouts.

According to the federal government, the media, business economists and the real estate industry, the Canadian real estate market is balanced and healthy because of the bank's prudent lending practices and government regulation.  Unlike the U.S., the government never allowed sub primes loans and therefore no housing bubble emerged.   The health of Canadian financial institutions has been praised abroad.

However, critics are beginning to question this rosy picture of the Canadian housing market.  They point out that if you scratch below the surface, the Canadian housing market shares many eerie similarities with the US market before the sub-prime housing bubble began to deflate in 2006.  House and apartment prices have gone up more than 100 percent since 2000 and are at least double the price compared to the U.S. market.  In the U.S., the average house costs $173,000 while in Canada it is  $348,178.  In Vancouver, where the housing bubble is the most extreme, the average single family home costs $900,000 Cdn.  Buying a house or apartment has become unaffordable for most Canadian working people.

According to Garth Turner, a former Conservative Party Cabinet Minister and Member of Parliament, the Conservative government of Stephen Harper has deliberately created a housing bubble through low interest rates and down payments and long amortization periods that is beginning to deflate.   The Canadian government, through the Bank of Canada, has kept interest rates low at emergency levels.  By 2009 they were lowered to less than 1 percent.  Today it sits at 1 percent. The vast majority of mortgage holders in Canada have 5 year fixed mortgages at 3.5 percent interest. In the past, home loans were in the 8 percent range.

The Canadian government requires that buyers only pay 5 percent down payments although this rule is not enforced.   However, for buyers who do not have 5 percent, the 6 major banks offer no down payment mortgages or cash back mortgages where they loan the buyer the 5 percent down payment, offering 100 percent financing.  The banks also give mortgages to the self-employed and new immigrants without verifying income.

In the past, Canadian banks required down payments of 25 percent, but this amount was gradually lowered.  The Conservative government "embraced the sub-prime culture as nobody has done before", writes Turner on his Greater Fool Website.  After 1999, it lowered down payments from 10 percent to 5 percent.   From 2006 to 2008, Parliament even passed legislation allowing 0 percent down payments and 40-year amortization periods.

Until last year the government allowed the Banks to offer 35-year mortgages to buyers, and before that 40 years.  To cool the housing market, the federal Conservative government last year lowered mortgages to 30-year repayment periods.   Now there is speculation that Finance Minister Jim Flaherty will kill the 30-year mortgage and reduce it to 25 years.

Turner contends that 5 percent or no down payments, low interest rates and long repayment periods have expanded the number of buyers who have bid up housing prices to unsustainable levels and pushed ownership levels to 70percent of the population.  Meanwhile, for most Canadian working people, wages have stagnated or failed to keep up with inflation.  Unemployment (including involuntary part timers and discouraged workers) is around 10.6 percent, some 2 million workers, and economic growth is beginning to stall.

Many Canadians have also used their homes as ATMs, taking out additional loans using their homes as collateral to finance private consumption.   Lines of credit backed by homes made up 50percent of all consumer credit last year, largely to finance home renovation.

The federal government has insured all these low down or no down payment mortgages through the Canadian Mortgage and Housing Corporation (CHMC), a state housing agency whose 10 member Board of Governors is heavily represented by the Housing industry -- 3 developers, 1 real estate broker and 1 partner in a plumbing, renovation company.   The CHMC would be the Canadian equivalent of the US government backed Freddy Mac and Fanny Mae insurance holders.  The banks therefore can lend money to house buyers with zero risk. By removing risk from lenders who do not have to worry about the credit worthiness of the borrower, the government has encouraged imprudent lending practices, according to Turner.  The Harper government even increased the agency's insurable loan limit to $600 billion in 2009, an amount larger than the national debt.

Like in the US, Canadian banks are bundling these risky mortgages into securities and selling them to unwary investors.

Turner argues that the 5percent down payments are Canada's version of US sub prime loans.   Many new buyers have bought expensive homes for 5 percent or less at low interest rates that will eventually reset to higher levels, at least double the current low interest rate today of 3.5 percent.  The Bank of Canada has been warning over the last year that it will eventually raise interest rates and has been urging Canadians to pay down debt before rates go up.  Recently, federal finance Minister Jim Flaherty told reporters that, "interest rates are going to go up.   They have nowhere to go but up.  So people must make sure that they can afford higher mortgage interest."

"We've systematically lowered mortgage-lending standards, encouraged banks to take excessive risk, eliminated the need for money when buying real estate, and turned what used to be an accomplishment and a privilege into a right and an entitlement.  Now that 70percent of us have swilled the kool - aid, pushing prices house prices and debt levels to historic highs, a melt in both sales and prices seems inevitable", writes Turner.

Turner warns that when interest rates go up, mortgage payments will increase and housing prices decline.  Many Canadians will face negative equity where they are left paying mortgages that exceed the value of their properties, as in the US, causing economic distress, hardship and a wave of foreclosures.  Turner says this is beginning to happen in smaller towns and cities across Canada.   A decline in housing prices will also hit the economy hard, as housing spending constitutes 20percent of the Canadian economy.  For mortgage owners who cannot pay their mortgages that are insured by the CHMC, the Canadian taxpayer will be on hook to pay the banks, states Turner.

Lax lending practices and climbing house prices have increased household debt to their highest levels.   Canadians now have higher per-capita debt levels than Americans and British.  For every dollar of income, Canadians owe $151.  Debt levels continue to increase each month, much of it mortgage debt, and show no sign of halting.   Bank of Canada Governor Mark Carney calls these debt levels "the greatest risk to the domestic economy."

Financial analyst Ben Radiboux shares many of Turner's concerns about the Canadian housing bubble.  "In real terms, prices have risen higher and for a longer length of time than at any point in time over the last 40 years [as far back as there is data on house prices].  Relative to underlying fundamentals, things have never looked so ugly", writes Radiboux   on his website Economic Analyst.  "The balance of probabilities leans strongly towards a housing price correction."

Radiboux argues that there are similarities between US sub prime lending before 2006 and Canadian lending practices today.   US lenders gave mortgages at low fixed teaser interest rates for 2 years before resetting to a higher rate adjusted every 6 months for the rest of the mortgage.  Canada's fixed mortgages, carrying an average interest rate of 3.5percent, reset every 5 years, exposing borrowers to interest rate fluctuations.  A Bank of Canada stress test last year showed that a 0.5percent increase in interest rates would put 1.1 million households " under significant financial pressure."

High loan-to-value mortgages were another feature of sub prime lending in the U.S. where debt is greater than 90percent of the value of the home itself.  Yet, CMHC insures mortgages where loan to value is 95percent  (5 percent down payment).  In addition, Canada's 6 large banks offer 100 percent financing for home purchases with no down payment mortgages and cash back mortgages where they lend the buyer the 5percent down payment.

Radiboux is critical of the CHMC for not being forthright in disclosing the makeup of their insured portfolio, exposing the Canadian taxpayer to great risk in the event of a housing crash.

Another factor that will help depress housing prices is demographics, claims Radiboux.  Nine million baby boomers will be retiring in the next few years and many of them will be selling their houses to help finance retirement or simply to downsize into a smaller living space.

It is not just Turner and Radiboux who have been ringing the alarm bells about the Canadian housing bubble.  The Bank of Canada said that Canadians are becoming increasingly vulnerable to a housing correction, exposing them to a perfect storm of high debt and falling assets.  The International Monetary Fund has also warned that Canada could face a price correction if house prices and debt levels do not come under control.

Capital Economics, a British macro research consultancy that provides independent economic analysis to the global corporate and financial sector, is predicting that Canadian housing prices will crash by as much as 25 percent when the Canadian housing bubble falls.

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  • Great discussion guys – it appears I’m a little late; hope you are still tracking the thread.

    I don’t disagree with the sentiment that US sub-prime is significantly different than our alternative lending market (non-prime includes the wealthiest segment: self-employed) however, isn’t the behaviour by financial institutions vaguely similar? Originate as many mortgages as possible using questionable appraisal techniques – and shuttle it off-balance sheet - isn’t the CMHC capacity nearly tapped? And if defaults were to increase – would we not begin to see forced selling by them as they repossess collateral ...thereby exacerbating the price decline? I have asked many friends at the CMHC what happens if defaults explode – nobody has an answer except for government bailout.

    I’m not old enough to remember the Toronto housing collapse in the late 80’s – any good references?



    Posted by VDesai, 07/09/2013 4:34pm (3 years ago)

  • Frank, the U.S. never stooped to the level of 40 year amortizations, although we did have interest only mortgages (but so does Canada). We never had 2.5% cash back mortgages (i.e. 5% "down" 7.5% cash back).

    Your rude wake up call is going to come when you realize that subprime is just the marginal buyers abused by the system (in any manner) to drive prices up another 33% and home ownership over 70%. You always catch long-term unqualified buyers when you do that. It's a mistake. Prices are set on the margin, which means distress in that percent of "owners" (money renters) will drive prices down fast.

    Posted by AG, 07/10/2012 8:51am (4 years ago)

  • "Like in the US, Canadian banks are bundling these risky mortgages into securities and selling them to unwary investors."

    I know they did this in the U.S., but I think (and correct me if I'm wrong) that in Canada these securities are GUARANTEED by CMHC or the government. Yes, that is what I've previously read.

    No loss for investors - only loss for the taxpayers.

    Posted by backwardsevolution, 03/20/2012 7:27pm (4 years ago)

  • Wrong Frank, the official line is that the banks adhere to strict qualifying criteria, but that has been severely fudged. I know people that had stated income loans. I also know people that were offered up to 900k mortgages, one based on a $80k salary, because they made the case that they were going to live in the basement, rent out the top floor of the house and rent out the garage.
    The USA housing bubble popped at 70% homeownership levels. That includes all of the subprime loans to get to that 70% home ownership level. We in Canada are at 70% home ownership now.
    There is too much evidence pointing towards a decline. Cash out now, lock in at the high, and wait to buy back in at the low.
    Come on now, everyone knows buy low sell high.
    Don't get greedy.

    Posted by GRY, 03/11/2012 4:45pm (4 years ago)

  • I think he says there are SOME comparisons between canada and the US. Your right in eveything you stated about who they are giving out loans to... to some extent, im only 25 and i have a lot of friends who have fallen for this. they are fudging what they make a year (most people i talk to dont look at there t4, they look at there week to week checks... and with so many people in seasonal work... it never adds up to what they think in the end) but the banks will take a few months pay as proof.. and give out the loan with almost no questions asked.

    I know people who are making (combined) 70ishk taking on a 350000+ houses. It doesnt matter that they are going to be fine for 5 years, because they wont have anywhere close to the full amount of their house paid by then. and when they sign up for another 5, say the rate is 1.5 higher then it is now (i thinks thats on the fair to conservative side) they are going to be screwed, even if they can afford it, it is going to cut there spending in every other area.

    at the end of the article it even states that they predict a 25% correction (i think 15 -25 for houses, 25 - 30 for condos) which is nowhere near what the US dropped to.

    It doesnt have to be as bad as the US for it to be bad. A lot of people have accidently wrote the next 21.5 years of their lives (who doesnt do accl biweekly)

    this isnt even taking into consideration the world market is shit and people have pulled their usual investments to buy property in canada, regardless of what happens here, when the other markets imporve and become "buyers" markets and the investments look better then canada.... ppl are going to sell.

    Posted by mx420, 03/10/2012 5:51pm (4 years ago)

  • again another Turner advocate. I tend to agree that there are certain geographical areas in Canada that housing is overvalued and potentially facing a housing downturn. Maybe 10-15%?, who knows. Overall this will be a good wake-up call for those who are bidding on another "investment" property, and hopefully stabilize the Canadian housing market. Secondly, rates are low and they will increase at some point in the future, we get that. But for those who are locking into a 5yr fixed at 2.99% today will not be affected for 5 years, or those who locked into 3.49% last year will not be affected for 4 years..etc... However, what I am getting sick of hearing is the comparison between the "US Subprime Mortgages", and the "Canadian High Ratio Mortgages". There is simply no comparison other than the fact that they are both loans secured against a residential property. The US Subprime were loans for people with poor credit, no credit, no provable income, or no income period, and ended up having to pay a high interest rate just to acquire a home.
    The Canadian High Ratio 5% or no money down purchase had to adhere to strict qualifying criteria, good credit, and good provable income. I could go on and on but now just tired of typing. All I can say is that there is no comparison between the two, they are completely different, and the risks associated are not what Turner and others think.

    Posted by Frank Loan, 03/09/2012 2:43pm (4 years ago)

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