Subprime Mortgage
The fallout from the subprime mess south of the border has been filling business pages for months with stories of foreclosure epidemics, real-estate market meltdowns, lenders and investment banks going under and a global credit crunch. But what exactly is at the root of it all, and why has Canada not caught the subprime virus like we do most other economic ailments of our largest trading partner? Forthwith, an explanation.
First off, what the heck is a subprime mortgage?
No, it's not a mortgage offered at below-prime interest rate, though that's a common misconception. The term "subprime" instead describes the borrower -- a person who doesn't meet a financial institution's criteria for a loan and so wouldn't qualify for a standard mortgage. Perhaps the client has a lousy record for paying off debts, or lacks regular employment. Subprime borrowers are often low-income people, the elderly and new immigrants. Wags have coined an acronym for those who most benefited from the subprime craze -- NINJAs, or folks with No Income, No Jobs or Assets.
To account for the risk, subprime mortgages come with hefty interest rates. However, to persuade people that they can, in fact, afford them, those rates typically kick in only after a year or two at an introductory low (or teaser) rate. The mortgages dangle other lures, such as loan amounts that exceed the value of the home (you need some cash for the furniture, after all!). Some even work like reverse mortgages, meaning the homeowner gets monthly payments that are added to the principal. The sales pitch is that the surging housing prices would allow borrowers to refinance their loans at higher values, keeping their payments affordable indefinitely.
Why did everyone fall for this?
Well, up until 2005, the pitch worked beautifully. Real estate was on a tear, with home prices in cities like Phoenix, Las Vegas and Miami rising by up to 30% a year. When you're on a roll -- especially in Vegas -- it's easy to forget that your luck could run out. So homeowners, dazzled by their homes' values on paper, enthusiastically tapped into home-equity lines of credit, jacking up their principals to the sky. The fact that mortgage interest payments are tax-deductible in the U.S. only bolstered the subprime market's growth by spurring people to become homeowners while offering little incentive for paying off the loans.
The subprime industry was getting rich as well. For those selling them, subprime loans came with cushy commissions, creating fierce competition for the business. Those issuing them, meanwhile, bundled the mortgages into complex stock market securities peddled to others, and so no longer had to fear if the borrowers defaulted. Aggressively marketed, irresistibly priced, subprime mortgages comprised an incredible one-third of all mortgages in the United States by last year.
So what ended the party?
As the real estate market started to slow and then slump, the proverbial chickens came home to roost. With values of their homes reversing course, by early this year one-tenth of American homeowners found that what they owed on their mortgages exceeded what their homes were worth. Unable to afford the higher rates kicking in after the teasers expired, more and more people defaulted. Now, as many as two million U.S. homeowners may lose their homes. In a recent report, Benjamin Tal, senior economist with CIBC World Markets, concluded, "The price appreciation in the U.S. housing market over the past two years was, in many ways, artificial -- boosted by aggressive lending and irresponsible borrowing."
Do we have subprime mortgages in Canada?
Yes, we do. More and more, in fact. They're typically called "alternative" mortgages and tend to cater to the self-employed and immigrants without Canadian credit history to qualify for loans. From no-money-down to cash-back mortgages, the volume of such exotic products has more than doubled in the past five years.
So how come the same disaster hasn't unfolded in Canada?
Because our market has developed differently due to regulation, immaturity and plain old timidity. The reasons are manifold.
Lending practices: In Canada, it's difficult, expensive and impractical to buy a home without any down payment. Anyone who puts less than 20% down on the home can't qualify for mortgage insurance by the Canada Mortgage and Housing Corp. or Genworth Financial, and such uninsured, high-ratio mortgages charge substantially higher rates. Banks and other mainstream financial institutions also won't provide a mortgage that exceeds a home's purchase price. Even alternative lenders have tended to eschew some of the worst American excesses, such as super-low teaser rates and loose income criteria for borrowers. Option adjustable rate mortgages (ARMs), which allow homeowners to change their monthly payments, sometimes not even covering the interest, haven't seen much uptake. According to Paul Grewal, head of the Canadian Association of Accredited Mortgage Professionals, "We have not seen the aggressive lending practices common south of the border." Backing his assertion is the fact that mortgage defaults are today near all-time lows, hovering around half a percent.
Subprime infancy: The subprime mortgage industry in Canada is very young. Only five percent of mortgages fall into that category, compared to about one in five U.S. mortgages. (We're more risk-averse in general; only 22% of subprime borrowers in Canada use variable-rate mortgages that are susceptive to interest rate gyrations, half the ratio seen in the U.S.) In a report, CIBC's Tal also points out that there is little connection between Canada's real estate boom and subprime loans. "Granted, some of those exotic mortgages are now being offered in Canada, but their share in the market is too small to have any material impact," he writes.
Real estate market: While most of Canada (Alberta excluded) didn't get the crazy price increases some U.S. cities saw, it's also not getting the same dramatic decline. Housing prices have been easing and most observers agree the boom is over, but continuing strong employment, a healthy stock market and low interest rates create little reason to expect the bottom to fall out any time soon. This is in part because our market has been largely driven by renters becoming owners rather than by investors looking to cash in on quick flips.
Still, could we catch the subprime bug?
According to Garth Turner, federal MP and author of a new book, "Greater Fool: the Troubled Future of Real Estate", "Absolutely, without a doubt, that contagion is spreading to the Canadian real estate market." Pointing to dropping home prices and sales volume, and tightening lending criteria among financial institutions, he suggests that signs of a real estate market meltdown are "all around us."
However, most economists and observers are more sanguine, believing a Canadian version of the subprime mess is possible but it'd take a much less severe form. Both federal Finance Minister Jim Flaherty and the Bank of Canada have recently worried aloud about the growth in long-amortization and no-down-payment mortgages. Forty-year mortgages now represent up to a third of new mortgage business at some institutions. And because such a large portion of our net worth tends to be locked in our homes, many Canadians certainly are exposed to risks if house prices plummet or interest rates soar.
Still, for once, we can take heart in the fact that our more boring, prudent ways will likely save us from the disaster down south.