Monday, April 7, 2008

Canada's Overprime Problem

Many of the housing bulls correctly point out that Canada does not have a huge exposure to US style subprime mortgages. This is true as Canada's Big 6 banks which dominate Canada's mortgage market, did not do much (or any) US style subprime lending.

However, what the bulls won't point out is that we have our own version of subprime: 0% down and the 40 year amortization. I'll call it "overprime" as it is due to mostly prime borrowers overleveraging themselves and due to overly long amortization periods.

Ellen Roseman wrote a good article in the Toronto Star recently about 40 year amortization:

"About 60 per cent of first-time buyers are opting for a 40-year mortgage," says Craig Alexander, deputy chief economist at TD Bank. His explanation: Houses are now less affordable because prices have grown faster than household incomes.

There's a "huge adoption" of 40-year mortgages in Toronto, Calgary and Vancouver, where people stretch for affordability, says Catherine Adams, vice-president of home equity financing at Royal Bank of Canada. "I think it's given the housing market a boost and allowed prices to go up further than they would have otherwise."
Ellen Roseman also pointed out another potentially disturbing piece of news:

Competition in mortgage insurance has accelerated new product development by lenders.

Canada Mortgage and Housing Corp., a federal government agency, used to have the market to itself.

Now it has three private-sector rivals from the United States (Genworth Financial, PMI Group Inc., AIG United Guaranty).

Another big U.S. firm (Mortgage Guaranty Insurance Corp.) has applied for a licence, Murphy says.

Is there too much innovation in lending? And is Canada headed down the same road as the United States?

A free market is supposed to be better for everyone in the long run, as innovation can lower prices and better match buyers and sellers, while generating healthy profits for lenders. The other side of that is that it can lead to a greater boom/bust cycle as lenders compete for business by lowering prices (interest rates) or overlending (lower downpayments, poor documentation). Buyers borrow more than they can afford and drive up prices to unaffordable levels
In the 1980s, home buyers had to put down at least 25%. Then in the 1990s, it was reduced to 5% (albeit with insurance). Then in recent years, no money down and the 40 year amortization (25 years was the previous maximum) were introduced.

All these "innovations" along with low interest rates have allowed buyers to buy a bigger house for the same monthly payments or to save on their payments. There is no free lunch, however, and all these buyers pursuing the same strategies have driven housing affordability to the lowest since the top of the last bubble in 1990 (according to RBC Housing Affordability March 2008) . Most 40 year amortization buyers are simply paying interest on their debt, not completely dissimilar from the US subprimers.

Most new buyers have little equity in their house. I was watching Warren Buffett on CNBC recently and he pointed out that a homeowner with 20% equity has seen most or all of their equity wiped due to the sharp fall in home prices. Scary to think what could happen if you had a huge drop in housing prices here, especially with most buyers putting much less than 20% down. Take Vancouver for example, where the average house price is north of $800K. If you manage to scrape up 10% down (80,000) and house prices fall by a mere 10%, you've just lost $80,000. Even worse, you are on the hook for a near million dollar mortgage.

The recent data has not shown any alarming trends (I will discuss this in my next post) but I believe that this is going to get real ugly in the coming years.

Longer payback loan fuels housing market (Toronto Star, Ellen Roseman, Apr 02, 2008)

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