On the Edge

A Canadian mortgage broker who watched the Big Short

If you are Canadian, you know that we hear a lot about the US, whatever the subject. As the little brother of the US through trade and proximity, we usually are in their tail lights on the same road, but with little impact on the direction ahead. An example of that is the financial melt down of 2007–2008 that was caused by the careless mortgage policies in the US that started in the 70’s and finally came to a head.

After watching it, I felt that there were some important issues in the movie that were worthy of clarifying the difference between the two systems.

To me the first layer that is worthy of discussion is comparing the support systems behind the scenes. In Canada we have the Canadian Mortgage and Housing Corporation (CMHC) and Genworth that provide the bulk of the back end insurance for mortgages. One is a Canadian government entity, the other mimics many of their policies. This is how the government normally makes the changes to mortgage lending rules; it is efficient to control lending as soon as a new policy is introduced because everyone follows suit. Generally, borrowers who make a down payment less than 20% are required to make a one time, included in the mortgage, premium payment. There are exceptions, but when dealing with “Prime” lenders (in a nutshell, banks and credit unions, but they may have a “Sub-Prime” arm) it will be the minimum requirement. Some banks insure every mortgage they write, but only pass on the premiums to those who don’t put down 20% or more. This is a very important distinction, because it creates a scenario where every mortgage that is insured is now rated AAA because in the event of default the insurer becomes responsible.

In the US, the equivalent organization was begun earlier, normally referred to as Fannie Mae, the Federal National Mortgage Association (FNMA), has morphed numerous times since 1938 (part of the New Deal) and like many other US government entities, privatized. Then in the early 2000’s, the investment banks started moving away from this model and selling the mortgages as mortgage backed securities. Fannie Mae loses the ability to control the market as more mortgage brokers stop having to use them. Now the banks are selling the mortgages to these originators and then are in control of securing them by ‘selling the paper’ to their investors. What was Fannie Mae (and Freddie Mac, similar idea) to do? Why compete of course, and thereby loosening their underwriting standards to stay competitive.

The difference between the two countries? Canada has approximately 3% of mortgages not securitized by an insurer or bank deposits. The US at it’s peak was 40% was privately secured through mortgage backed securities. Canada could be compared to a pre-1970s banking system in the US.

They have thousands and thousands of mortgages worth billions of dollars that they need to sell. How do they do it? They create these huge bundles and cut slices. It used to be no problem, they’d create these huge pools, the rating agencies would say they were great, they’d cut slices (commonly referred to in the movie as a ‘tranche’) and sell the interest in them as bonds. They would sell them over and over again until there were 20x more money floating around secured to that mortgage than the actual mortgage itself. Then they started ‘insuring’ sub-prime mortgages as part of the bundle, but as the sub-prime market expanded, so did their mix into these products, creating instability.

“In finance, subprime lending (also referred to as near-prime, non-prime, and second-chance lending) means making loans to people who may have difficulty maintaining the repayment schedule, sometimes reflecting setbacks, such as unemployment, divorce, medical emergencies, etc.”

Now they have these big chunks of mortgages that aren’t as stable as expected. Hence the Big Short, selling money to people with the expectation that it can handle some of the mortgages going into default.

Default generally refers to a mortgage that is no longer being paid, which will result in foreclosure. Foreclosure is expensive for the lender and requires that someone will buy the house. The banks risk is based on what they believe they would be able to resell that property for, so imagine of there are suddenly A LOT of foreclosures all at once.

Usually a lender is going to rather lend to people that are more likely to repay and the rules establish that level for everyone. In Canada, the loosest became was that we allowed people to buy a house that was 100% financed with a 40 year amortization, making the payment (but also the principle repayment) smaller. Now if you are putting down less than 20% you are generally required to have 5% of your own money (exceptions are possible) and a 25 year amortization. In Canada we have a default rate that sits just north of 1% of mortgages that are originated. Before the collapse of 2008 we were at .45%. Both numbers are low compared to the US.

The bond offerings that were being mentioned in the movie said the entire bond would fail if the defaults reached 8%. Subprime mortgages hit a 20% default rate. Now imagine a financial investment instrument that has a ‘AAA’ rating from large ratings agencies (whose job it is to understand and report on risk so that investors can determine what level of risk they are willing to take on. Greater risk should equal greater reward. ‘AAA’ is very little risk and thereby there is the expectation of smaller returns) but are actually full of doomed American mortgages.

Then it gets interesting…for some…but why?

In Canada, we have two kinds of mortgages generally; fixed and variable. The length of time can vary from 6 months to 20+ years for a term. For the US, they’re system is set up to have the same rate over the 30 years you are going to take to repay the mortgage. Now because they offer a singular product, they have to get creative. That leads to some of the details I find the most interesting. There were a number of people who under the sub-prime market, were offered mortgages when they had; no money for a down payment or no job or bad credit. The banks were falling over each other trying to get these people mortgages because the market was skyrocketing and everyone wanted in. There would be no end of the cash spit out. Of course, as we know, wages are stagnant in the US (their minimum wage is still $7.25 an hour in New York City!?), so many of the loans were destined to fail. Now imagine this, you are given a mortgage today, which you are required to pay monthly at $X, but after 3 years, your payment increases to $3X and the last 3 years hasn’t shrunk your principle a penny. And there are thousands of people in the same boat who are all thinking the same thing…sell!

At the end of the movie they talk about how the US is headed in the same direction all over again. Just ask Bernie Saunders (Feel the Bern!), Wall Street is still dictating US fiscal policy for their own benefit. The US just raised their interest rates because things are going so well for them, but I can’t help but consider they are building another house of cards.

To summarize, Canadian rules are getting tighter again to start the year, we will hold off raising our overnight lending rate until the economy improves (re: oil prices rise in our resource dependant economy) and our national banking system means that Moncton has the same rules as Vancouver. Two very different markets. Buying a house here has always been less risky.