Because of the confusion around terminology and the lack of comprehensive data, it will take a bit of explaining before we can come to a conclusion on whether sub-prime lending is a problem.
In our previous article, we determined that shadow banking and sub prime mortgage lending are very different. Shadow banking cover a large area of financing outside of banking that most people find acceptable such as credit unions, pension funds, trust companies and mutual fund companies. Sub-prime mortgage lending is only a very small part of it.
So, what is “sub prime lending”? Some say it is lending to people who may have problems maintaining the repayment schedule.
Then sub-prime mortgage must be lending to people who may not be able to pay their mortgage. And if it is unregulated then it just seems like a bad idea.
The problem is that the term is loosely defined and is applied to describe mortgages that are relatively safe as well as mortgages that are guaranteed to fail. During the time of the US financial crisis, sub-prime mortgage lending was lending money to a minimum wage earner a 100% of the value of the home. And because they have no way of paying for the mortgage, the lender also lends them the monthly payments for the next two years. In Canada, we are talking about 20% – 25% down payment with non-traditional proof of income because the client fixes cars on the side. It is like comparing apples to oranges.
Mortgage lending is so misunderstood by the media, that I often see articles referring to First national, Street Capital and CMLS as shadow lenders and implying that they are not regulated which is so far from the truth it is ridiculous. If shadow banking is defined as non-bank lending, then it is true these are shadow lenders. But these lenders follow all the rules the banks do because their mortgages need to be insured by CMHC. Also, they sell their mortgages to the banks which requires the mortgages to conform to government guidelines. Including their volume numbers into the “sub-prime” category just confuses the issue because their mortgages are as safe as the bank’s if not safer. They often ask for more paperwork. And they don’t finance mortgages for multi-million dollar homes to students or house wives with no income.
Now Home Trust and Equitable Bank are sub prime lenders. They mainly deal with two types of clients. One is people with credit issues and the other is people who have problem proving their income in the traditional manner. But self-employed people, recent immigrants and those with thin or no credit history often have trouble securing financing from traditional banks even though they have the ability to support the mortgage payments. So while we know how much mortgage loans are generated by these sub-prime lenders, we really don’t know how many of them are true sub prime; that is, at a higher risk of default then bank loans. Also getting mortgages at these types of institutions often mean a down payment of 20% to 25%. Hardly a dangerous risk unless, the value of the home drops by 20% to 25%. And if you have been following what has been going on with Home Trust (parent company is the Home Capital Group), you’ll know that these entities are far from unregulated.
And finally, we get to the true “remote corners of shadow banking” – private lenders. But even here the classification is not clear. In fact, there are two distinct groups. First is the mortgage investment corporation (MIC). Basically, these entities were designed by the government to increase the flow of capital into the mortgage market and to allow small investors access to mortgage investments. Legislations were brought in in 1973 to allow for their existence. When the government refers to these MICs as unregulated, they mean MICs do not follow any lending guidelines put out by the provincial or federal government, but it doesn’t mean they are not governed by rules. Yes, they can lend to who ever they want, but because these loans are not insured by the government, they are not securitized. Instead of selling them off, which was a large part of the problem during the US financial crisis, all the MIC’s mortgages are kept on their books. If they make a bad loan, they eat the loss, not some poor shmuck who bought the investments from Goldman Sachs because they were made to believe the toxic mortgages were triple AAA rated investments. I would argue that if all the mortgage loans must be kept on the books of the lending institutions, the US financial crisis could not have happened.
Now comes the truly unregulated shadow bankers: the individual private lenders. People with extra money to invest, who decides to invest their money by lending it to people who cannot get the loan from a bank. They may be lending fifty to sixty thousand from their RRSP accounts or it could be a high net worth individual with several millions to invest. They may feel it is safer than putting it into the stock market. And many would argue that they are right.
Now the big question. Should we be concerned about unregulated sub-prime lending? If we are just talking about the individual private lenders, then obviously not because the amount is so small, but even if we include all the MICs, we are still only talking about 1% of the outstanding residential mortgage credit according to a recent CMHC report on private lending. It is too small to cause any great harm to the economy. Focusing on this is only a distraction to solving the real problem of ever raising real estate prices. Increased sub-prime lending is a response to this problem. While reckless borrowing may cause personal tragedies, sub-prime lending is not going to be the cause of some sort of economic disaster in Canada in my humble opinion.
