by Dustan Woodhouse
Many Canadians, particularly those in Vancouver and Toronto where real estate is spoken of like a sport, will gravitate to the film The Big Short over the coming weeks. It is an adaptation of an excellent book written in 2010 by Michael Lewis. As a Canadian Mortgage Broker who read the book when it came out to better understand the differences between the two countries' mortgage markets, I was into a theatre within the first few days of its release.
Ryan Gosling is the only significant Canadian content in this film.
This is an American tale about an American debacle that takes place due to American finance policies; a tale, a debacle, and policies vastly different from their Canadian counterparts. As with most things Canadian, our finance system is in fact far more conservative and quite sedate.
Five key differences between the US and Canadian housing markets
1. In 2006 U.S. ‘subprime’ mortgages accounted for more than one in three new applications. Over half of them required little to no documentation of income at all, and little to no down payment. In the movie there is a case, likely not far from reality, of a property financed in the name of a man’s dog. Even your pet could get a mortgage.
In Canada, even in 2006, subprime loans accounted for less than 1 in 20 applications, and account for even fewer today. Even in cases of limited documentation, the Canadian system typically required 35% down payment. Equity = security.
2. In the U.S. the system had mortgage brokers packaging loans with little to no oversight or review on Friday, and selling them Monday to an investor on Wall Street who was in turn re-selling the debt to yet another investor in another country. All the while, credit rating agencies focused on maintaining their initial (heavily biased) ratings of mortgage bonds, even as the mortgages inside the bonds were sliding into default, because if they did not ‘some other ratings agency down the block would’. It was (and is) a system designed to offload risk as if all the players were in a protracted game of musical chairs.
In Canada the lender, often a credit union or chartered bank, has rigorous approval standards that leave most applicants’ heads spinning, with some wondering if a hair sample will also be required. Mortgage brokers in Canada are licensed and regulated. More important still, few Canadian mortgage applicants ever pay any kind of fees, higher-than-market rates, or simply sign documents without spending the time to understand what exactly they are signing on for.
3. The U.S. system created A.R.M.’s, an unbelievably good deal on paper… at first. Recall the subprime mortgages from point 1 above. Well, about 90% of those mortgages (for people with no income) were written under A.R.M.’s.
Mr. & Mrs. American, please sign here for your A.R.M. What's an A.R.M.? It was a question that millions seemed either not to ask, or not to think very hard about the answer.
Adjustable Rate Mortgage
The pitch in 2004: “Today and today only, we can give you a 1.00% rate with interest-only payments for the first three years (Yes it gets better still: interest-only payments). That’s right: Your payments will be just $415.80 per month. Now, in three years the interest rate will reset (keyword there: reset) to 4% over a 30-year amortization, but no need to worry about that as we will just refinance you at that time or flip out of the house since it will be worth so much more; just look how much it has risen in price since I started speaking a few minutes ago…”
“What's that? How much is the payment at 4%? Why, you’re the first one to ask me that in months. I am not even sure. Let me figure it out ”.(Leaves to find office manager, who in turn finds a guy that was in the business a few years earlier when math was still important. Returns.) – "It would be $2,377.59 per month. Wow, that is pretty high. But hey it's only $415.80 for now, and three years is an awful long ways away.”
In Canada it is rare to see a ‘teaser rate’ mortgage as we call them, as the optics are not great around them since 2007. However, when you do see a mortgage product such as this in Canada the qualifying rate used is not the artificially low teaser rate as with the U.S. system, it is the higher (inevitable) rate to ensure that the borrowers will qualify.
In Canada we have variable-rate mortgages which are significantly different products and again use a qualifying rate much higher than the effective rate. At the time of this writing a variable rate mortgage is at 2.20% net, but the qualifying rate used is 4.64%. In other words the Canadian system goes the opposite path of the U.S. system. We ensure an applicant is well overqualified for the mortgage they are applying for.
4. Many U.S. residential home builders are publicly traded companies, and as another by product of the bubbly finance system at the time, vast sums of money were thrown at them to build, build, build, and build. In 2004 it was estimated that 40% of US real estate purchases were investment or vacation homes.
In 2006 there were already vast numbers of partially constructed homes that were no longer selling, there were no buyers for them. The overbuilding was significant, and as the economy slowed it was one more layer on a rapidly rolling snowball that became an avalanche.
Meanwhile in Canada… more than 90% of real estate purchases are for owner-occupied properties, with less than 4% of mortgages being written for investment properties
. Supply in most markets remains tight. Markets like the city of Vancouver have seen the last single-family home site created. In fact, single-family homes are dwindling in many urban centres as consolidations occur to create new multifamily sites. With geographical constraints such as mountains, coastlines, borders and agricultural lands, among myriad imitations to growth, the supply side of the equation in cities like Toronto and Vancouver will not be easily remedied anytime soon.
5. Mortgages in many states are ‘non-recourse’ loans, meaning that the lender cannot go after the borrower for any monies owed over and above the final sale price of the asset pledged. In states such as California and Arizona, this led to many ‘strategic defaults’ by borrowers. Essentially these were an exit plan for home owners with otherwise good credit and stable incomes who found themselves saddled with a mortgage balance more than double the market value of the home. Looking at how long it would take to pay the debt, and whether the home would ever recover its value, many people chose to throw the keys to their homes — or at least their second, third and fourth homes — on the desk of the bank and walk away.
This played a role in foreclosures rising to as much as 14.4% of all mortgages in the USA by September 2009.
In Canada all mortgages are full recourse, and the lenders can chase the homeowner to the ends of the earth, garnisheeing wages to collect monies owed. In 2009 Canada also hit a record high foreclosure level… of 0.41%. This is just slightly above the twenty year average.
As the movie ends it is a scene of massive government bailouts, another thing that no Canadian bank required through that time (Canadian Banks were the only lenders in the G7 that did NOT require Government assistance). It is also a scene, unchanged to this day, of little fault being found with those who built a system doomed failure. There were no jail sentences for those involved in perpetrating what became a massive global economic meltdown. It is as if it were something that just happened on its own. A force of nature.
In the USA there was clear evidence of fraud at all levels in a broken system that rewarded multiple layers to look the other way and go along to get along. In Canada we are conservative by nature, as a mortgage broker myself I am on the front lines dealing daily with my fiscally prudent brethren who opt to borrow, in most cases, significantly less than they legitimately qualify for.
As much as many would like to draw comparisons to the Canadian and USA mortgage markets, there are few commonalities to be found that are any more logical than ‘Ryan Gosling starred in a film about the U.S. mortgage meltdown, Ryan Gosling is Canadian, Ryan Gosling… mortgage meltdown… Canadian’. Illuminati confirmed.