For a long time, the conservative mortgage lending standards in Canada, including a slew of new ones since 2008, have been touted as one of the reasons why Canada’s magnificent housing bubble, when it implodes, will not take down the financial system, unlike the US housing bubble, which terminated in the Financial Crisis.
Canada is different. Regulators are on top of it. There are strict down payment requirements. Mortgages are full-recourse, so strung-out borrowers couldn’t just mail in their keys and walk away, as they did in the US. And yada-yada-yada.
But Wednesday afterhours, Home Capital Group, Canada’s largest non-bank mortgage lender, threw a monkey wrench into this theory.
Through its subsidiary, Home Trust, the company focuses on “alternative” mortgages: high-profit mortgages to risky borrowers with dented credit or unreliable incomes who don’t qualify for mortgage insurance and were turned down by the banks. They include subprime borrowers.
So it disclosed, upon the urging of the Ontario Securities Commission, the results of an investigation that had been going on secretly since September: “falsification of income information.” Liar loans.
Liar loans had been the scourge of the US housing bust. Lenders were either actively involved or blissfully closed their eyes. And everyone made a ton of money.
So Home Capital revealed that it has suspended “during the period of September 2014 to March 2015, its relationship with 18 independent mortgage brokers and 2 brokerages, for a total of approximately 45 individual mortgage brokers,” who’d together originated nearly C$1 billion in single-family residential mortgages in 2014. That’s 5.3% of the company’s total outstanding loan assets, and 12.5% of its total single-family mortgage originations in 2014.
That’s a big chunk. The company, however, didn’t disclose why it took so long to disclose this.
It said an “external source” had warned it about income falsification on mortgage applications submitted by a number of brokers. Its investigation did not find any evidence of falsified credit scores or property values, it said.
It’s not hard for a lender to require income verification. Not requiring it is precisely what US lenders had done before the Financial Crisis. Add a little encouragement from a broker, and that’s how you get perfect liar loans.
Home Capital had already announced on July 10 (Friday afterhours!) that in Q2, originations of high-margin uninsured mortgages had plunged 16% and originations of lower-margin insured single-family mortgages had plummeted 55% because it had axed some brokers. Its shares plunged 20% the following Monday and another 4% the next day.
At the time, HCG was the fourth most shorted stock in Canada. By July 29, the day before the current announcement, HCG had risen to the second most shorted stock. Today, massive short-covering set in, and shares soared 13%, but remain 42% below where they’d been during the halcyon days last November.
“Everyone had their ideas about what transpired in the past six months; this corroborates some suspicions but dispels some others,” Shubha Khan, an analyst at National Bank Financial told the Financial Post, adding – with Canadian understatement – that there were “still some questions.”
Among them, whether these insured liar loans would continue to be insured; and whether this was an isolated problem, rather than an industry issue in the Canadian housing market. In other words, is it just the tip of the iceberg?
Housing bubbles are money generators. Temptations are huge. Falsifying mortgage applications is easy if no one checks them. It’s a mad scramble to extract as much money as possible for as long as possible – but with a devastating aftermath.
Now liar loans are coming out of the Canadian woodwork. The much touted down-payment requirements in Canada have already fallen apart. Don’t have the money for even 5% down? Solutions are openly promoted, for example:
It is not a problem anymore!!! Canada Mortgage & Financial Group (CMFG) has a new product that now allows you to borrow your down payment from any source…. The only amount you need to show on your own is 1.5% of the purchase price….
With regulators breathing softly down their necks, banks might have become more careful in lending to people to buy homes that are among the most overpriced in the world. What has that accomplished? The rise of alternative lenders in the shadow banking system. They’re not subject to the same regulations as banks.
“There’s a lot more that can be hidden from the public, things that are not right could not be noticed early on,” Michael Dolega, a senior economist at TD Economics, told the Huffington Post of Canada. “The quality is slipping, and it’s far more questionable for some of these smaller lenders, but at the same time I think it’s still better than it was in the U.S., when it went south pretty quickly.”
Yes, this time it’s different.
But the patterns are crystallizing: Home Capital Group with liar loans on its books, CMFG with ultra-low down-payment loans on its books…. In banking, bad deals are made in good times.
Even the Bank of Canada, in its most recent Financial System Review in June, fretted over the risks in the shadow banking system due to its “less regulated nature” and outright “opacity,” and considered it a “particularly important vulnerability” to financial stability. While the sector is still relatively small, it would impact the overall economy, it said.
But it’s not so small anymore – estimated at 10% of Canada’s mortgage market and growing rapidly: A report by CIBC (Canadian Imperial Bank of Commerce), cited by the Huffington Post, found that lending by alternative lenders had doubled since 2012, and as of the Q3 last year, was still growing 20% year-over-year.
This comes at the worst possible time for Canada. The economy likely shrank in the first half. Hence, the Conference Board of Canada just downgraded growth to 1.6% in 2015, worst since 2009. It sees some deep problems, after a 15.5% plunge in business investment in Q1:
Oil and gas firms are expected to chop their investment by almost one-third…. Outside the energy sector, firms remain hesitant to invest. Purchases of machinery and equipment suffered a substantial decline in the first quarter of the year, and a decline in building permits suggests a downturn in commercial construction in 2015. Overall, business investment will drop by close to 7% this year.
Household spending is also expected to weaken, despite savings for consumers at the gas pump and federal tax cuts. Soft employment growth, weak wage gains, high level of household debt and job losses in oil producing provinces will combine to limit growth in consumer spending to 2.1% in 2015.
That would be the optimistic scenario. It assumes that the magnificent housing bubble can be maintained; but all bets are off if it takes liar loans, among other underwriting schemes, to maintain it. And when the housing bubble deflates, all these schemes that are forgiven as long as prices rise will turn into an unappetizing mess.