Are sub-prime troubles headed for Canada?

A study released Wednesday by Britain’s Financial Services authority shows that the sub-prime lending problems that have plagued the U.S. economy are not isolated to America. Britain has uncovered its own set of sub-prime issues, raising questions about whether Canada may be heading down a similar path as well.

The FSA study uncovered poor risk management by both intermediaries and lenders and has resulted in enforcement action against five of the studied firms.

When it comes to economics, Canada is usually fast on the heels of the U.S., but there have been no signs of a sub-prime crisis brewing in Canada. By all accounts, the problem seems to have leapfrogged Canada on its way across the Atlantic.

Canada has seen an increase in sub-prime lending, but overall the mortgage industry in Canada is quite different from its U.S. and U.K. counterparts, according to the Office of the Superintendent of Financial Institutions (OSFI).

“A few institutions are very interested in this business, including some small institutions and unregulated institutions. OSFI would, as part of its job, be looking at what those institutions are doing,” Rod Giles, an OSFI spokesperson, says. “We don’t see the same conditions here.”

OSFI says that sub-prime lending in Canada represents about 2% of the Canadian market versus 15% south of the border.

“We’ve been looking more closely at it,” Giles says. “The U.S. market is providing us lots of examples of what to look at. We’re not, for example, seeing the exotic mortgages; we’re still seeing 25-year amortization with three- to five-year fixed terms.”

One of the root causes of the sub-prime crisis in the U.S. was the variable sub-prime rates. Lenders would aggressively pursue sub-prime clients and entice them with mortgages that start off with low interest “teaser” rates.

“Lenders are far more aggressive outside Canada in trying to recruit consumers of these sub-prime products. They have these teaser rates to get them in at low levels and then they have resets [after] one to three years. Borrowers get payment shock because the mortgage will then get readjusted to a much higher interest rate,” says Beata Caranci, head of economic forecasting for TD Financial.

Caranci says Canadian mortgage consumers and lenders tend to shy away from risk. Even in the sub-prime market, the majority of consumers opt for fixed rates.

“As a nation we tend to have a lower incidence of variable rates. It’s about half the level that they take within the U.S. when it comes to sub-prime mortgages. This is good because we are expecting a rate hike from the Bank of Canada on Tuesday, so even sub-prime mortgage holders will be insulated,” Caranci says. “Part of the problem in the U.K. is that they have a tendency to go more variable on their interest, and the Bank of England just raised rates for the second time in three months.”

Defaults among the lenders themselves are far less likely in Canada, because the market is primarily concentrated among the large banks, says Basil Kalymon, a professor of finance with the Richard Ivey School of Business at the University of Western Ontario.

“The mortgage market in Canada is really dominated by our major banks,” Kalymon says. “I think that it’s generally a more conservative set of financial institutions that are operating in Canada.”

For instance, Kalymon says the majority of banks insist on mortgage insurance if it’s a high-ratio loan, greatly reducing the likelihood of defaults.

It’s not unheard of for large Canadian financial institutions to get into trouble with real estate lending, though. He points to bad commercial real estate lending practices that led to the downfall of Royal Trust and Confederation Life.

“In the past we have had financial institutions failing because of real estate values,” he says. “When you do have a severe correction in the housing market, there tends to be problems in the mortgage lending issues.”

Kalymon says there are no signals that any sort of correction is imminent but that rising interest rates and our dependence on the U.S. housing market as a source for exports could have an impact in Canada.

“We’re not totally insulated. If you have turbulence and interest starts rising fast, it’s bound to have a knock-on effect. The stoppage in the [U.S.] housing market has already had lumber prices plummeting in Canada, basically because of the slow-up of construction across the border,” he says.

Not everyone thinks that sub-prime lending is necessarily a bad thing, though. Done responsibly, Jim Murphy, president of the Canadian Association of Accredited Mortgage Professions (CAAMP), says that alternative and sub-prime lending serves an important role in society.

“There is no doubt that there is an alternative lending market here. It’s about 5% of the market, and it is growing. It certainly meets a need — sub-prime or alternative lending deals with somebody’s creditworthiness,” he says. “A lot of these products are helpful because they allow these people to get into home ownership. At the end of the day, this industry is all about people wanting to live the dream of home ownership.”

Murphy says he’s well aware of risks with sub-prime lending, but CAAMP wants its 10,000 members to develop ethical guidelines and lending practices to recognize potentially risky situations.

“Borrowers or consumers should always be mindful and select somebody they’re going to feel comfortable with. They should be knowledgeable; they should be trained,” he says. “We have guidelines of what to do and what to look for in a completed mortgage application.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/06/07)