Subprime Meltdown
Predicting market cycles is a tantalizing but
unproven tactic
This article was written
Jonathan Sowerby and reproduced with permission from the October, 2007 Forum
Magazine
The surprisingly sudden credit crunch
that has emerged in the global markets is, in reality, tied to a longer legacy of
high-risk mortgages in the U.S. Real estate expert Jonathan Sowerby
examines how it happened and what the impact will likely be on Canadian investors
— and advisors.
We've all heard it before: if something
is too good to be true, it probably is. In this instance, that something is
called an Option ARM or Adjustable Rate Mortgage. This is the real culprit
behind the subprime meltdown in the U.S. and one of the main reasons for the “liquidity crisis” that has hit the financial markets.
The hook was a low introductory interest
rate and, for many, the deal was simply too good to pass up, or so they
thought. Now, hundreds of thousands of U.S. homeowners are relearning this
most painful of lessons and the consequences for many have been nothing short
of disastrous.
How did it happen? Launched in 1981 as a
niche product option, ARMs were actually initially targeted at wealthy
homeowners with good cash flow. The low introductory rate, usually lasting a
couple of years, allowed sizeable payments to be made toward the principal
while interest was slow to accumulate. As the introductory period ended, the
borrower could then make sizeable lump-sum payments to clear up their debt. Its
primary benefit was flexibility.
So how did Option ARMs end up as the
financing method of choice for many average residential homeowners in the
U.S.? In two words: cheap credit.
In 2003, the U.S. real estate market
started to heat up. Prices were on the rise and the home of many peoples’ dreams seemed out of reach. Some,
however, spied an ad for mortgages at only 2.2 per cent. Prevailing rates at
the time were in the five per cent range. Two months later, the average family
moved into that lovely three-bedroom number in an up and coming part of town.
The total mortgage amount was $400,000 and, thanks to that great rate, monthly
payment was only $1,732. Sounded pretty good.
Except that isn't the end of the story.
More people were picking up on cheap credit. Some were refinancing their
existing fixed rate mortgages. Pretty soon, the availability of credit was
making this seem like a great option for everyone. As more people started to
buy or refinance, the cash infusion really got home prices going.
Now the other shoe drops. This is when
the A, or “adjustable,” part of the ARM mortgage comes in. This
portion of an Option ARM moves with prevailing market rates. It is split into
two parts: one is tied to something like interest rates and known as an index.
The other is a premium charged by the lender based on the risk profile of the borrower,
called the margin. If rates were going down, holders would benefit from a
decrease in their loan payment (you can bet that was a large part of any sales
pitch home buyers received). However, the opposite would also hold true — borrowers were responsible for rising
rates. That’s
where the trouble really started.
By 2005, many of the introductory
periods for ARM mortgages were over. With all these people buying houses,
inflation had become a concern and the U.S. Federal Reserve had been steadily
increasing its discount rate over the last two years. All of the sudden, that
2.2 per cent introductory rate was going to be higher, more like six or even
seven per cent.
The borrower still had the option to
stick to his $1,732 payment. But how does that work if the rate increased by
four per cent? It’s
called negative amortization and it means holders are now eating into the
principal of their homes. So now they are funding mortgage payments with the
equity in the home —
and it isn't long before they've used up their equity.
Now to put the final nail in the cheap
credit coffin. Because home buyers now have no equity, the lender places them
in a new risk category (no equity equals no value in the event of a
foreclosure). All of a sudden, buyers are paying a double-digit interest rate,
with no equity in their homes and their payments going into the stratosphere.
Forget refinancing thanks to prohibitive fees on breaking their mortgages.
Plus, with rates going up, housing prices have started to soften, so they
wouldn't get the value needed in the event of a refinance anyway.
That’s why with approximately 80 per cent of
all Option ARM borrowers making only their minimum monthly payments, some 1.5
million Americans are expected to lose their homes over the next 12 to 24
months. A sobering statistic.
But could this happen in Canada and what
might the impact be to the Canadian real estate market and the economy in
general? Well, first of all the good news. The Canadian subprime market looks
to be in considerably better shape than its U.S. counterpart.
According to a statement released by the
Canadian Association of Accredited Mortgage Professionals (CAAMP) in March of
2007, Canada is helped by a few factors:
·
the
subprime market as measured by outstanding loans is significantly smaller in
Canada. Although stats vary by provider, general numbers suggest between
three and five per cent of all outstanding mortgages in Canada are subprime;
in the U.S., that number is between 14 and 20 per cent of outstanding mortgage
dollars;
·
the overall
arrears rate on mortgages in Canada remains at or near record lows of less
than 0.5 per cent;
·
the
Canadian mortgage market has not been using Option ARMs (Adjustable Rate Mortgages)
for subprime borrowers; also, when Canadian borrowers are qualified for
mortgages, consideration for payment variation is included in any qualifying
calculations. This has not been the practice in the U.S.;
·
Canadian
underwriting practices are more conservative than in the U.S. and most would
characterize the Canadian subprime market as under-developed when compared to
a fiercely competitive U.S. subprime market;
·
with a few
regional exceptions, Canada has not generally seen the same rapid home price appreciation
nor the same level of speculative investments as compared to the U.S.;
·
finally,
Canada is experiencing strong employment with relatively low interest rates
along with high consumer confidence.
The U.S. and Canadian subprime markets
are worlds apart. Most with knowledge of the subprime sector in Canada would
likely suggest it still has considerable opportunity available. One of the
primary reasons for this is that, for better or for worse, Canadians and their
lending institutions are simply more conservative in their approach to credit.
What has this meant for the Canadian
housing market? In real terms, so far not much. The Canadian housing market isn't perfect. For example, parts of Alberta
have seen average price increases of 45 per cent since January of 2006, but
that’s a function of $70
barrels of oil, not aggressive lending practices. The fact of the matter is
Canada has a healthy market where lending practices are generally more
conservative.
Will it remain so forever? Perhaps that is
a little less cut and dried. Certainly, there has been a significant influx of
products into the Canadian mortgage scene over the last 12 months. This product
development has been driven by new entrants, so, clearly, that means there is a
chance competition will heat up. However, with the U.S. subprime market likely
to serve as a very visible reminder, the likelihood of such an occurrence in
Canada seems more remote.
What does this mean for Canadian
investors and homeowners? Just like a market investment, a home is generally
best able to pay off if held over the long term. However, here’s the rub. Homeowners,
like investors, don’t always act rationally. A family losing their home
generally evokes a powerful emotional response. Multiply that by 1.5 million
families and one of two things will happen: Canadians will become so deadened
to it that it will fail to resonate at all and they will move on fairly
quickly. The alternative is it will hit them so hard, it will hamper them in
just about every conceivable way — from buying that new car to putting their money in the
market.
It is the latter response that will have
the greatest impact on the advisor community. When clients are worried about
losing their homes, things like RRSPs and leverage loans become far less
appealing. People start to examine their situation more carefully and they
look to mitigate risks. Why buy a stock or a mutual fund when you can buy a
nice safe T-bill? It is the actions that accompany this kind of thinking that
can do real damage, like pulling their money out of the market and deciding to “wait out the storm” in a GIC.
So what can be done to help your clients
avoid doing this? Knowledge is the key. Be informed or stay in touch with
someone who is. You don’t
have to be a mortgage expert but it would probably help if you knew someone
who was. Some might say that such an expectation is unfair to a financial
advisor as they already have a long list of things to watch out for.
True, but here is a final fact to
consider: the median net worth of a Canadian renter is approximately $8,000;
for the homeowner with a mortgage, the number is $112,000; and for the
homeowner who is mortgage-free, the number is $259,000. The median home price
that accompanied this was $125,000 (Kerstetter 2003).
What that means is a home to the average
Canadian will become their single most significant asset over time. Building a
sound financial plan should take that reality into account. For most, a
mortgage plays a part in some aspect of their lives. Yet, most people do more
research financing a car than financing a home. They put their decision down
to the best rate, just like people who buy a fund based on last year’s return.
I would like to think that at least a few
people avoided this fate thanks to the help of their financial advisor who took
an interest in their complete picture. Accordingly, selecting the proper mortgage
to help your clients achieve their goals is also an important aspect of
ensuring financial health. The consequences of not doing so will be in the news
for some time to come.
Credit Crunch Redux
Consider
the collapse of Long-Term Capital Management in 1998 —
a cheery topic to be sure but one that does bear a certain similarity to the
current market situation.
The
predominant issues involved a liquidity crisis brought about as the result of
a series of defaults, although in this instance it was Russian bonds not U.S.
mortgages. A significant liquidity hit at the time, the market quickly overcame
the crunch. Within a year, the S&P/TSX Total Return index was showing a
return in excess of 25 per cent and, as we just hit the 10-year mark, looking
back that same index on a $10,000 investment would have grown to $28,000.
Considering that time frame included the bursting of the tech bubble, that’s not bad.
So one conclusion is that like other
credit crunches, this too shall pass and it will likely provide a good chance
to make a pretty penny over the short term. The tough spot is picking the
bottom.
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