The Great Unwind – Mortgage

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The Great Unwind

In recent years thousands of Toronto real estate “investors” purchased negative cash flow properties betting on further price appreciation.  For many ordinary Canadians real estate seemed like a sure bet.  House prices continued to rise as employment incomes flatlined and the stock market under performed global peers.

Housing became not only the safe bet in Canada, for many it became the only bet.

Strong and stable economic conditions, in addition to low and stable interest rates supported increasing home prices in Canada for over 25 years.  As home prices increased, net worth and income levels increased.  Confidence supported additional borrowing and spending.  The housing boom encouraged everyone to get into the market, and to borrow money.

In Canada, to understand the housing market it is important to understand that a traditional mortgage is a loan against your income, not a loan against the value of your house.

Many low income, house rich Canadian have already discovered it isn’t easy to access the equity in your home without employment income.  Mortgage regulation, including the stress test, require regulated lenders to lend based on your income and not the value of your house.

The shocking, and sudden, increase in unemployment and layoffs caused by a virus has reduced incomes for the country at large.  Oil companies, airlines, dental offices, restaurants, retailers and just about anyone in the private sector has seen or will see income impacted, negatively.

In Canada, the affected will also include the banks.  As banks themselves find it more difficult to access capital and increasingly worried about loan losses, mortgage borrowers are already facing higher interest rates and less available credit, despite falling bond yields and rate cuts from the Bank of Canada.

On Friday March 13th, the Office of the Superintendent of Financial Institutions (OSFI) lowered the domestic stability buffer requirement for Canada’s key banks so the banks to be able to continue to lend during this crisis.  Realistically, as the domestic economy reels from both the coronavirus and plunging oil prices, banks needed reduced capital requirements to manage probable future loan losses.

Credit and debt are opposite sides of the same coin.  Most of what we view as money is really credit.  Because credit creates both spending power and debt, whether more credit is good depends on whether the borrowed money is used to generate enough income to service the debt, and this is the reason Canada’s real estate market is particularly vulnerable.

Many mom and pop landlords are losing money each month (as rent doesn’t cover mortgage payments, condo fees, taxes, maintenance) based on the expectation they can sell for more money at a future date. As prices start to decline holding a negative cash flow “investment” no longer makes sense.  Especially if you just lost your job.

Prices are set at the margins.  In up markets, the most aggressive buying wins the bidding war.  In down markets, the most aggressive seller sets the price.

In Toronto, February data showed that rents were already flat year over year, prior to the economic impact of the virus.  After some construction delays, many new properties will be coming online.  Developer and politicians may understand that we didn’t really have a supply issue after all, as housing supply hits the market at a time few are looking to start renting, and many renters are now already unable to pay.

For a period, Airbnb helped some landlords extract higher rents by offering short term rentals options.  A combination of social distancing, health concerns, and potentially newly enforced Airbnb regulation seems likely to end the semi-pro Airbnb game faster than the music stopping in a round of musical chairs.

Construction and real estate are a greater percentage of employment and economic output in Canada, than at any point in history.  Many people employed in this sector believe that real estate prices can’t go down and have become landlords on the side.  The high correlation between income and assets for this economic segment is the exact opposite of diversification preached by those personal finance types.

From my experience as an active mortgage broker, I know that fraud is a major player in the mortgage market.  Borrowers have been able to overextend themselves, often with the help of their bank’s mobile mortgage reps creating fake income documentation.

Based on what I see from my mortgage business, I believe that more than 10% of mortgages obtained in Canada have been obtained fraudulently and it has been my experience that both banks and regulators willfully turned a blind eye to this activity.

The results is that many borrowers are overextended, and many have already been resorting to private second mortgages to pay the first mortgage.  Taking a second mortgage at 10%+ to pay your first mortgage at 3% is probably a bad strategy to begin with, but it is also a strategy that borrowers can only  use in an environment where prices are rising.

As regulators started tightening mortgage rules in Canada, an unregulated mortgage market consisting of companies, individuals, and mortgage investment corporations (MIC) operating in the shadows flourished.  Borrower who increasingly could not qualify for tradition lending turned to these lenders which are less concerned with an applicant’s credit or income, but much more concerned with the value of the property.

Private lenders offer mortgages at rates much higher than traditional lenders and for shorter terms.  The lender wants a cushion between what they are owed and what the property can be sold for in the event the borrower stops paying the mortgage.

Private lender must now contend with risks that were almost unimaginable only a month ago, including a closed court enforcement system if borrowers stop paying, reducing their willingness to lend.  At the same time many MIC’s have less available credit from banks and investors looking for redemptions, reducing their ability to lend.  At the risk of putting readers to sleep, I wont even get into the asset liability mismatch unregulated lending has created.

In speaking to realtors, many investors are suddenly more motivated to sell.

Strong and stable economic conditions, in addition to the housing market support from record immigrant levels into Canada seems unlikely to return in the short term.  As home prices decrease, net worth and income levels decrease, causing lenders to pull back further…

The good news is that, if policy makers manage the great unwind correctly, the market could eventually clear at prices that makes housing affordable again for families.

Kevin Bell


In addition to helping clients navigate financial upheavals, in my day job I help my clients reduce mortgage interest costs, lower investment management fees, and save taxes.  Learn how.