The US Subprime Crisis: Why History will Not Repeat Itself in Canada

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Carlgary by Brian
Calgary by Brian

According to the Economist, Canada’s homes are 21 per cent overvalued, while TD Bank warned that overvaluation ranges from 10 to 15 per cent. Despite the different numbers, economists agree that the real estate market is vulnerable and that Canada’s housing bubble has become a topic of hot debate. Canada’s debt-to-income ratio has reached 151 per cent (higher than in the U.S., which peaked at over 160 per cent in 2007 and since that time has declined). Income is growing slowly and interest rates are low, so there is no chance of improvement. Should we really be afraid of the crisis that burst in the U.S. four years ago? The answer is clearly not.

Canada is Stricter

Canada’s banking system was considered the soundest in the world by the World Economic Forum for the past three years. The title can find a new owner this year, but Canada’s banking standards remain transparent and much stricter than in the U.S. before the crisis. Minimum downpayment is 5 per cent, while in the U.S. there were no downpayment requirements. Unlike the U.S. banks, Canada’s lenders didn’t get involved in the sort of risky products that in fact drove the U.S. housing boom and led to its collapse.

House in Calgary by Bill Longstaff
House in Calgary by Bill Longstaff

It is extremely rare to obtain a Canadian interest-only loan, while in the U.S. they were considered a great financial decision as many homeowners could see the values of their homes increase by as much as four times in the early 2000s. They earned more appreciation during this period. When the prices started falling, borrowers carried a mortgage larger than the value of their houses and they weren’t able to refinance the house into a fixed-rate mortgage. Interest-only loans became a poor financial decision.

U.S. lenders attracted potential clients by even more risky means, including teaser rates. Teaser rates are generally temporary and are far below the common realistic rate for the service.

Securitization Not So Risky

About 45 per cent of U.S. subprime mortgages were income stated, while in Canada less than 5 per cent. Securitization in the U.S. represented more than 60 per cent of all mortgages, and the securities were issued by investment banks. The banks weren’t regulated, and when the crisis started, Bear Stearns and Lehman Brothers, over 100 years old, collapsed. Others stayed in trouble, and in 2008 Goldman Sachs and Morgan Stanley decided to abandon their status as investment banks and convert into “traditional bank holding companies.” The Dow Jones closed down just over 500 points on September 15, 2008, after Lehman Brothers declared bankruptcy, which was at the time the largest drop in a single day since the days after the attacks on September 11, 2001. The fall of Lehman Brothers also had a strong effect on small private investors and it contributed to the fast and devastating spread of the crisis.

In Canada, about 70 per cent of mortgages stay in the hands of lenders and the rest of them are issued as mortgage-backed securities by Canada’s housing trust CMHC, so they are backed by a government body. Only higher-quality mortgages are securitized, while in the U.S. subprime mortgages were sold as well.

Don’t Panic; Don‘t Underestimate

If the housing market buckles, the big banks are strong enough “that they could absorb that hit,” said Ed Clark, chief executive of TD Bank. However, that doesn’t mean that Canadians are safe and have no reason to be afraid. Economic slowdown or, in the worst case, recession will affect everyone. High indebtedness will lead to a higher number of foreclosures. Speculators will have to leave the market and will probably find themselves in financial trouble. Just don’t panic. Canada’s housing market will cool with no doubt, but it isn’t likely to crash in U.S. style.

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2 Responses to The US Subprime Crisis: Why History will Not Repeat Itself in Canada

  1. Pingback: The US Subprime Crisis: Why History will Not Repeat Itself in … | Krispy Hut

  2. Joe Q. says:

    Yes, you do have to have 5% here, but we did have 0%-down, government-insured mortgages for several years (2006-2008), and even now there are several banks that will refund your down-payment money (and more!) on closing.

    There are also important differences between the mortgage systems in the USA and Canada. Americans can commonly lock in a mortgage rate for 30 years, while in Canada it’s rare to lock in a rate for longer than five. Many Americans thus consider our real-estate market to have a baked-in system of “teaser rates”, even though the rate resets we have are not predatory (like the sub-prime mortgages issued in the USA). Just the same, the idea that most Canadian home-owners mortgage rates reset based on the prevailing rates every five years (or less) is very troubling to the Americans I’ve talked to — because of the similarities to the worst of their own mortgage system pre-2008.

    There are a lot of people who are stretching the very limits of affordability with 5% down-payments and VRMs with long amortizations. A drop of 10% in the value of their homes, coupled with (maybe caused by) an interest rate increase, would put them in serious hot water. It is these people that we have to be concerned about — their choices will set the “comps” that determine home values in general.

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