Why The Subprime Crisis Has Not Affected Canada (Yet)

by Mike Holman

This post is part of a group writing project with the M-Network bloggers and friends. See the list of other posts in this project at the bottom of the post.

There has been a lot publicity around the subprime mortgage situation in the US. There are quite a few homeowners who have been or are about to be evicted from their houses because of a number of different factors. ARMs, NINJA loan, liar loans, fraudulent lending practices and worst of all…easy credit and low interest rates led to a situation where real estate prices went up and up. People who took the plunge five years ago with flipping houses made so much money that everyone wanted to get in on it. Now that the real estate prices are not going up anymore, the gravy train has stopped cold.

In Canada, we haven’t seen this situation (yet) and I think there are several reasons for this:

  1. Real estate prices haven’t gone up as much as in the US.
  2. Lending practices in Canada were stricter than in the US.
  3. Interest rates are stable.
  4. The economy is still going strong.

Real estate prices

Real estate prices did not rise as much in Canada as they have in the US over the last several years which might have helped prevent mass speculation. It’s easier to get excited about property investing/flipping when you see 30% annual returns compared to 10% returns which is roughly what we saw here in Toronto. I believe that people who are flipping properties are more likely to use excessive leverage in order to make more money. This works really well as long as the house goes up in value but if the house goes down (which is happening in the US) then the flipper might be in big trouble.

Stricter Lending Practices

The use of the word “stricter” is this case is a relative one. The last few years have seen changes in the mortgage market in Canada where you can buy a house with zero down, get a no interest mortgage and for those who are inclined to pay a smattering of interest there are 40 year amortization terms available. All of these features allow the Canadian home owner to increase the amount they borrow which will increase the odds of problems if any of the above factors come into play.

In the US it appears that anyone with a pulse and no paperwork or job or money could get a mortgage which obviously increases the odds that some of those borrowers won’t be able to make their payments. The availability of ARMs (Adjustable Rate Mortgages) is another product which can be very useful for some home owners but for some borrowers they were a way to get a house (for a few years at least) that they couldn’t afford. It was just recently that the US government passed legislation that makes lenders consider the payment after the mortgage reset (and not during the teaser rate period) when they look at the repayment ability of the borrower. Hard to believe that sort of common sense rule has to be legislated.

Interest Rates

This is another factor that applies to both Canada and the United States. While interest rates are higher than a couple of years ago, they are still fairly reasonable. If rates were to go up say 2% then I think that this will expose some sub-prime borrowers because they might not have any room to cut back in their budget to pay for a few more hundred dollars of interest each month. A borrower with a better credit rating would also feel the pinch with higher interest rates but they would likely have more flexibility in their budget.

Economy

The economy and job situation is still quite good in Canada which is not really different than the US but if we see a recession in either country and unemployment goes up, then that will certainly put more pressure on highly-leveraged home owners and foreclosure rates will go up.

Summary

Loose lending standards and rapidly increasing real estate values were the main reasons that led to some American borrowers taking out speculative mortgages that they couldn’t afford. Because these factors were not as prevalent in Canada I think that there are a lot less borrowers in Canada who are on the edge as far as being able to afford their mortgages. That said, lenders in Canada will still give borrowers a lot of mortgage which some people have taken advantage of, so if unemployment goes up and/or interest rates go up, we could still see a smaller version of the sub-prime mortgage crisis here in Canada.

The Globe and Mail recently had an excellent article ( free login required ) on subprime lending and some of the fraudulent sales methods used.

Finally I will leave you with link to a sub-prime mortgage discussion written by a senior employee at Pimco – it’s very informative and the format (the economist is talking with his pet rabbit) is very entertaining while at the same time, somewhat disturbing. 🙂

Other posts in this series

My Two Dollars posted My Thoughts On This Whole Mortgage Crisis And Why I Don’t Feel That Bad. This excellent post explains why David is a bit annoyed that people who overbought are getting helped by the government while fiscally responsible people (like him) don’t get anything.

Finance Freelance Life explains how renting a home and buying a home are not as different as they seem in Why renting is right for us right now.

Rocket Finance has a great post about his own real estate mistakes.

My Dollar Plan (yes, the one with 181 financial accounts) tells us a very unusual story of how she has an adjustable rate mortgage (ARM) and not only is she happy with it – she doesn’t blame her mortgage broker, the government or space aliens for the fact that she has one.

Moolanomy explains Debt-To-Income Ratio and Why It Matters. This post covers why you shouldn’t spend too much of your net income on your house.

Millionaire Money Habits tries to decide between investing in stocks or real estate in Catch a Falling Knife – Buying the Housing Slump.

PaidTwice wrote an interesting post on the “Can we afford it” mentality which gets into the problem of people deciding if they can afford something (such as a house) based entirely on the monthly payments.

Debt Free Revolution talks about how maybe it’s not such a good idea to take advantage of increased equity in your house by paying off credits cards with a HELOC. (Home equity line of credit).

Remodeling This Life wrote a post about how she and her husband bought a house and totally gutted it. This post brought bad some unpleasant memories for me because of our own fixer-upper experience. She has a fair bit of advice and warnings for anyone who wants to buy a fixer upper.

Being Frugal wrote Frugal Hacks For Your Home. Still not sure exactly what a “hack” is but maybe this post will tell me….

Plonkee Money asks why anyone outside the US should care about the subprime mortgage crisis.

Cash Money Life explains how mortgage escrow accounts work. These are more common in the US although I have heard of house insurance payments being combined with mortgage payments. In a related article he discusses how his mortgage payment dropped recently because of changes in the escrow liability amounts.

Single Guy Money talks about the real cost of home ownership.

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{ 12 comments… read them below or add one }

1 Traciatim

I pulled the average sale price from the CREA website in their statistics area for average sale price for December 2007. Like I noted, I couldn’t find a median sale price. I’m not certain what areas are included for each city.

I pulled the income figures as a 2005 median income as stated by stats Canada in the March 29th 2007 edition of ‘The Daily’. I then added 2.1% per year for two years to get a rough guess of the median income for 2007.

Mike, I agree. There are many people who have owned homes for long times, or have a pile of savings. There are also people not from this country buying property. Then there are investors that are trying to get income property. Though all of these things will make price rise and make the median families that much less able to afford homes. I don’t think that having a home in an overpriced city is a right of an individual or family, they should probably just move to an area that’s more affordable. I also don’t think moving is a great solution for everyone, sometimes it just makes sense.

Things do look better if you look at the statistics on canequity.com, they list Vancouver as having an average applicant income of $61,301.00 with a co-applicant average income of $40,666.00. All this with the average loan amount is listed as $256,925.00. That puts them almost exactly at the 2.5 “Cost Ratio” that was listed above.

Canequity.com breaks out Vancouver, North Vancouver, and West Vancouver as far as I could tell, that stat I listed above from the area they call ‘Vancouver’. It’s an interesting site, I like to watch rates with it and look at mortgage stats sometimes (Yes, I’m a big dork).

2 Traciatim

I would like to point out above, the average income stat for applicant and co-applicant from canequity will include only averages from people obtaining mortgages. This makes it look like the average salary is something around 100K or so, when in reality the median income for 2007 is probably somewhere near 60K-65K. This just goes to show that home owners in Vancouver would probably need to make around 60% to 65% higher than the median income to afford a home there.

Contrast that with the same data from my city where the median income I estimated at somewhere near 59400. The canequity page lists the average applicant income at $41,766.00 with a co-applicant average income of $39,242.00 and an average loan amount of $96,814.00. This would put the Cost Ratio as calculated by this data at only 1.2 times income.

Now granted, I don’t really like comparing and using the canequity data for comparisons like this because I assume things like the co-applicant average income only includes applications with a co-applicant so you can never great a real average of family income. This is why I like to use sale price and median income from stats Canada and the CREA.

3 telly

Great comments Traciatim.

Another interesting thing is that, while home prices have increased by ~10% on average in Canada over the last several years, rents are barely keeping up with inflation and rental vacancy rates are climbing.

Mike, I see your point about large downpayments but I’ve never been a fan of determining affordability based on monthly income (that’s how people justify 40 yr amortization). Apparently 85-90% of 1st time buyers are taking 40 yr amortization loans!!

If someone’s house is worth 5 to 6 times their salary, it’s entirely possible that most of their net worth is tied up in their home, although huge gains in home value may have a lot to do with it for some. Not necessarily the predicament I’d like to be in personally, but it does change the affordability issue.

New mortgage options are pushing prices up and when you don’t have anything new to offer, prices start to come down, which is precisely what’s happened in the US. We’ve already got 40 yr amort. (actually, a 55-yr exists with at least a few lenders), 0% down, interest only, ARMs,…not much wiggle room I’d say but who knows, prices may continue to climb for some time but that shouldn’t be a reason to overstretch your finances to own a home like I think many people are doing today.

4 Four Pillars

Very true Telly – people who use exotic financial products to stretch for a house are taking on a huge risk and for what? If rents are a lot lower then I’d say renting is a much better deal. This is definitely true in Vancouver and I’m wondering if it might not be true in Toronto as well?

Mike

5 Traciatim

I don’t know if I really think the 40 year AM is a bad thing. Even myself, I used a 35 year AM because my spouse at the time was in school, and we weren’t sure what was happening after. Now she’s decided to go sole proprietor and not just get a job; which I think in the long run will be a great thing. If we were on a 25 year AM, our payments with her trying to start a business would be very restrictive. As it stands now we’re even running a pretty tight ship.

I think the key is people buying things that they can’t afford. People (in general) confuse a monthly payment with the ability to afford, and they are two completely separate things. There is also a huge difference between affording something, and having the ability to pay for something. For instance, say you make 30,000 after taxes for a year. In theory you could probably pay 15,000 toward mortgage payments to get a home worth 200,000 over 25 years, or 237,000 over 40 years. Can you actually afford that? Probably not, the sacrifice elsewhere is too great.

However, if you take the same income (about 37,500 before tax) and figure out that you should be able to spend 32% of this on housing that’s 12,000. Now the problem is, that this will include about $150/mo for heat and another $150/mo for taxes, that leaves 8400 for your mortgage payments each year. That’s only 700 bucks a month. That puts you at 112K max for a 25 year, or 132K for a 40 year.

Now, there is a huge difference between a 112K home and a 200K home. In my area you can get a home just fine for a family of 4 for 112K (102K in my case). Some areas this person could barely even survive. Many people will just sacrifice now thinking that in a few years as their salary goes up things will get easier, and in a perfect world they would.

Also, keep in mind that a mortgage is probably the cheapest form of money you can possibly borrow. So some people will choose the 40 year AM just so that they can save and invest more money. I doubt it’s a huge percentage, but it’s probably not insignificant.

Even more, you have to think that setting the AM on your mortgage is like picking your minimum payment. It’s kind of like built in insurance for those tough times when life throws you a curve. With lump payment options, and monthly payment flexibility most people won’t know their true AM period until their last payment is made. I would be willing to bet there is a good percentage that could afford a 25 year AM, and are making extra payments but chose a 35 or 40 year AM anyway. Again, probably not a majority, but certainly not an insignificant amount either.

6 Four Pillars

Good point – we have a 25 year amortization but will only take half that long to pay it off.

Mike

7 telly

More good points Traciatim and I totally agree with you about affordability.

The thing is, instead of taking a 40 yr AM, a lot of people never even consider renting until their salaries reach a level that’s affordable. This used to be a perfectly normal alternative when you couldn’t afford to buy but now seems to not be an option. I think the pressure to own has made this the case (and we fell for it as well).

I have to think that the number of people that choose a 40 yr AM so they can save and invest more money would be fairly insignificant. Considering you have to pay an extra 0.5% (or 0.2%) for every 5 years AM beyond the standard 25 makes it pretty tough to beat considering rates are around 5-6% currently (after tax of course) before even adding in the extra fees of mortgage insurance. Our interest rate is 4.39% and still we choose to make extra mortgage payments rather than invest the savings.

But Traciatim, I think you’re likley in the minority. Most people that I know that went long AM did so to get a nicer / bigger house. The brokers are “reminding” younger couples that their salaries will increase so they should be able to afford to renew in 5 years with a 20 yr AM.

I find it a bit strange that these brokers have no problem selling people homes based on “expected” salary but neglect to mention that inflation will eat up a portion (or all!) of that raise and so might interest rates. And they neglect to mention that maybe adding kids to the mix, a stay-at-home parent, child care, etc. could really swing things into unaffordable territory.

If they’re going to take potential future earnings into consideration, they should add potential future expenses and inflation into the equation as well.

8 Traciatim

Wow, I found a great point over on All Financial Matters:
http://allfinancialmatters.com/2008/02/09/some-insight-from-jeremy-grantham/

“The other near certainty is that house prices will go back to a normal multiple of family income. In the end, we, the people, have to be able to afford the houses and they are affordable at something around 2.8 times family income. When they peak in Boston at 6 times and nationally at 3.9 times, you know you are in for tough times.”

I thought it might be relevant to look at that quote a little more. It’s interesting that according to the average sales price on the CREA website the average home selling price in Canada is $317800. According to the median income on the May 29th 2007 issue of the daily by stats Canada we make around 60,600 (64300 if you add 3% for 2 years to get 2007). That puts our ‘cost ratio’ at 4.9 . . . (317800 / 64300 = 4.9). Then you look at our peak, which is in Vancouver as far as the data I have goes at 9.2 times income. It looks to me like our price run up is far worse than in the USA. Possibly we are looking at some even tougher times than in the USA right now.

I don’t have any stats that would support my theory that any amount of 40 year AM’s are taken by people why are either investing or simply taking the 40 year to keep minimum payments lower. I’ll have to take your word for it, I would think there would be something like 5-10% of the people in each case so around 10-20% of the total. Like I said above, with lump payments and payment flexibility I don’t see any great reason to not choose the 40 year AM if it’s available; other than the insurance cost I mean. Even that is fairly negligible in the grand scheme, if it’s only 0.2% per 5 years and you are putting 5% down you end up with instead, of 2.9% for insurance at, 3.5%. So on a 100000 house you would put 5000 down and instead of your mortgage being 95000, it would either be 97755, or 98325. This would translate to 619.64 at 5.9% over 25 years or 529.31 at 5.9% over 40.

Granted, it doesn’t save much, but during a job loss the 90 bucks a month might end up meaning you keeping your house, or losing it. Plus, over 25 or 40 years there is probably going to be some point where your income is less and some where it’s more. Even if you make lump sume payments strictly to have some breathing room later if you need to reduce your monthly payment in the slow times it’s still not that bad.

I guess it all comes back to ability to afford; if you are making 40K you can’t afford a 400K house, no matter what your banker, broker, or agent say.

9 Four Pillars

Very true – in general you wouldn’t think the ratio of income to house price would vary over the years.

Mike

10 Toronto houses

I think that you’ve done a very good job on the analysis, articulating examples of the issues. You’ve gone very deep with the report of why these issues are related to Canada. When you look up houses for sale in Toronto and compare their prices to their value from 5 years ago, you can see the difference. But fortunately the increase of prices of real estates has not yet had as big effect in Canada as in e.g. United States.

11 Four Pillars

TH – thanks for the comment.

12 Mark

Curious what you think now given that prices in TO and Vancouver have grown crazy, interest rates on mortgages should go up with the US Fed announcing increases, and it seems like people are borrowing beyond their means.

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