In
our joint quest to figure out how home prices became completely detached from
underlying fundamentals, we must go deeper into the rabbit hole. As we learned in the last post that there is
real evidence of fraud in the mortgage finance system.
Fraud
is never a positive sign. It suggests
that average people are unable to afford average homes and need to resort to
deception to obtain financing. If the fraud is widespread, which in my belief
it is, then the argument can be made that the industry players have resorted to
cheating to continue making money as the system itself has run out of
legitimate players. In other words,
there are only so many first-time home buyers who make $200k+/year and have
$300k in their bank account for a down payment – once that pool of buyers dry
up, if there was even that many to begin with, the industry needs creative ways
to artificially create new ones. If they don’t, the real-estate party will stop
abruptly.
Belt
tightening and unintended consequences
Late
in 2016, the CMHC tightened its criteria for obtaining mortgage insurance. This
was a long overdue step, but better late than never (I give credit where credit
is due). The most significant change was that if you obtain mortgage insurance
you are subjected to a stress test which assesses your ability to pay your
mortgage in the chance that mortgage rates were to increase about 2%. The rationale for this change was that in the
event mortgage rates increase, you would be able to handle the increase in
payments and not default. Prudent move.
In
one non-scientific survey, “79% of first-time home buyers in Ontario say that
the federal government's new, more stringent mortgage rules will throw a wrench
into their home buying plans.” No surprise there. A 2% stress test is quite significant since
home prices are already astronomical.
Let’s
take a look at a graph to see how many mortgages would not have been approved under the new rules.
Evidently,
a large proportion of buyers in the year leading up to the change would not
have qualified under the new rules. In
Toronto, 49% would not have been approved. If you lost on one of those
bidding wars last year, the odds are somewhat favourable that many of those
bidders would not have been at the bidding table if these rules were in place.
You may have even won one of those bidding wars as well for far less money that
what it went for.
To
bypass the new rules, you need to put down 20% and the regulated lender must
not insure this mortgage. Keep in mind that none of these rules apply to
unregulated lenders – they operate in the wild west of lending devoid of any rules
and regulations.
Take
a guess what people started doing.
Just
weeks after the changes, on January 11, 2017, the CBC ran a sparsely read news
story about “bundled loans” which combines a first mortgage and a second
mortgage from an unregulated lender known as a Mortgage Investment
Corporation. This allows the buyer to
bypass the new rules as she can obtain the 20% minimum even though it’s all or
mostly based on borrowed money. Just to
be clear, bundling has been around for awhile now as many homebuyers simply
could not raise the down payment needed to buy a home, it’s just now being
publicized.
Are
people resorting to such lending? According to the CBC article, "it's
becoming prevalent with everybody. This is how they sidestep the loan-to-value
issue," Guy Lew, a mortgage broker at CENTUM Metrocap Wealth Solutions
said in an interview. He added that he arranged such loans for his clients.
Which
lenders facilitate this arrangement? The big banks, thankfully, have declined
to step in this pile of manure. However, our good friends at Home Capital and
Equitable Group have jumped in head first. Many other smaller lenders with
names you never heard of followed suit. There are so many lenders now it’s
almost impossible to keep track of them all.
You’re
probably thinking this is illegal or violates the spirit of the new mortgage
rules. Spirit violations aside, it is 100% legal and 100% being pushed onto first
time home buyers who don’t have $300k sitting around. The new rules have
effectively pushed home buyers to the shadow banking system. Think of it as the dark web of the internet
or an underground casino operator.
What
is a Mortgage Investment Corporation (MIC) and a syndicated mortgage?
A
MIC is way for people to pool their money together and lend it out to borrowers
who want to buy property in a similar fashion as banks. This set up is sometimes referred to as a
“syndicated mortgage”. To avoid confusion, we’ll consider them functionally the
same thing and I’ll use them interchangeably throughout this blog post.
As
I’m sure you are aware, many savings accounts pay little to no interest these
days thanks to our ultra-low interest rate environment. GIC’s pay very little
as well. Therefore, people invest in a MIC to obtain a better return on their
money (more yield). MIC’s cater mainly to borrowers who have impaired credit
ratings or other issues with their income just like subprime lenders. Interest
rates can range anywhere from 3-15% depending on the risk. When the bank says
no, one might consider turning to a MIC.
Let’s
look at a couple of graphs that exemplify the fact MIC’s attract higher risk
loans:
As
the graphs show, MICs attract high risk borrowers for the simple fact that
traditional banks have declined them. If
the bank says you’re not credit worthy, odds are high they are right. Since
most people don’t take “no” for an answer and owning property is their god
given right, shadow lenders they must go.
Some
MICs are publicly traded companies on the stock exchange meaning they are
subject to certain disclosure obligations on their respective financials. Many
MICs are privately held corporations meaning zero or haphazard disclosure
requirements. However, there are many
legitimate MICs who do operate with transparency and provide adequate
disclosure to their investors. Strangely,
before I even started this blog, there were a few ads on my Facebook account
from a MIC offering 7-9% yield for investors. To make 7-9% yield when a GIC is
paying 2% or less is quite enticing.
To
make a long story short, MICs and syndicated mortgage companies operate with
very little oversight. That does not mean they are bad per se, but it raises
the possibility that something could go wrong.
For example, the CBC reported a couple weeks ago that 120 investors just
lost $9 million in a syndicated mortgage investment scheme. Toronto real estate lawyer David Franklin,
who specializes in syndicated mortgage cases, believes that more than $1
billion dollars of investors’ money in Ontario has been lost in syndicated
mortgages.
How
can $1 billion dollars have been lost in a continually rising real-estate market?
Well, when regulations are light and reporting requirements minimal or non-existent,
there are scam artists out there who will take advantage of investors at every
available opportunity.
Desperate
homebuyers who have been shut out of traditional banks are now going
underground to subprime lenders and syndicated mortgage companies to get the
financing they need. Is this a good idea?
***
If
you read the post "Déjà Vu" earlier in this series, “mortgage bundling” is no different
than the shenanigans that was happening back in the late 1980’s in Toronto
during the last real-estate boom. Back then, people would borrow the down
payment from the seller by means of a “vendor take back mortgage”. The seller
would effectively have a second mortgage on the property. Today, borrowers are now resorting to
arranging for two mortgages at the same time. The legal mumble jumble and lingo
used to describe both arrangements may be different, but the result is the same
– buyers are borrowing the down payment by any means possible just to get the
deal done. Is this the sign of a healthy
market or one that is running on borrowed time?
In
the words of David Madani, an economist with Capital Economics, "this is
what happens at the late stage of a housing bubble — the quality of lending
goes down." I don’t about you, but
the quality went down long time ago once ads started appearing on TV
glamourizing no income check, no credit check mortgages. His point emphasizes the thesis of this blog
post - the industry has resorted to
creating artificial buyers to keep the charade going. They are artificial
because without the creative financing tricks they could not buy at today’s
obscene prices or even yesterday’s prices.
Who
doesn’t love a game of charades?!
