A Canadian regulator is sounding the alarms on private mortgages, but are they too late? The Financial Services Regulatory Authority of Ontario (FSRA), which oversees mortgage brokers, recently issued a warning on the risks of private mortgages. They have observed a boom in consumers using these high interest loans, often paired with interest only repayment.
Traditionally these products are favored by those with poor credit, resembling subprime loans in the US during the mid-2000s. Much like the US during that period, Canada’s frothy home prices have attracted investors with solid credit, looking for more leverage than traditional lenders will provide.
Canada’s Bad Credit, Interest Only Private Mortgages
Private mortgages are loans between a borrower and a private, often unregulated entity. The lender can be anyone from an individual that has a few extra bucks to lend, or a company specializing in these types of loans. They all cater to the same type of client though—one that can’t get traditional financing.
This has been seen as Canada’s substitute for the subprime market. In some ways it is. Like the US subprime market, these are high interest loans thought to be used by people with bad credit. However, prime and super prime borrowers with flawless credit scores sometimes end up here. Primarily investors that are looking for more leverage than traditional lenders will provide.
Let’s put a pin in that point, and discuss it after we look at the industry’s explosive growth.
Canadians Are Increasingly Turning To Private Mortgages
Since private lending is largely unregulated, there isn’t a reporting body with a central data repo. Information is scarce, but there is enough data to know the problem is getting out of control. Private mortgages represented no more than 5% of Ontario’s loan originations until 2016. By 2018, nearly 7% of mortgage originations in the province were private.
Greater Toronto’s mini-real estate bubble was a big contributor to this trend during that period. At the time, CIBC concluded investors used private loans for nearly 1 in 7 (16.2%) newly built condos in 2017. It was likely higher, since the conclusion was based on accounts paying 9% or more interest. The overnight rate was also substantially lower in 2017 than it is today.
Fast forward to today, and the Ontario consumer agency in charge of mortgage brokers has concerns. The FSRA looked at private mortgage originations, and found explosive growth. The dollar volume increased 72% from 2019 to $22.4 billion in 2021. They estimate over 1 in 10 (10.6%) of all Ontario mortgage originations in 2021 were private loans, doubling the share a half-decade before. Nice.
The stats for 2022 have yet to be compiled, but the FSRA is confident it experienced growth. They also see higher rates contributing to ever further growth this year. Though it’s worth noting the bulk of this growth, and recent surge in 2021, occurred with interest rates at record lows, while investors captured a larger share of the market.
Most Canadians Don’t Understand The Risks of Private Loans
One big issue that’s materialized here is that people don’t really understand these loans. A survey commissioned by the FSRA recently found that most people (54%) believe private mortgage payments cover both principal and interest. In reality, since these are temporary solutions, many of these products are interest only payments.
It’s unclear how many people that borrow from private lenders know that a private lender can turn down a renewal, at which point you’re stuck without financing if you didn’t make other plans.
Canadian Investors Are Turning To Private Loans, Just Like The US Before The Subprime Crisis
Back to investors, which haven’t just taken over the majority of new condo construction ownership. They also make up a bigger share of assignment owners, attempting to flip the units before they’re completed. By selling before completion, these owners don’t have to take out a mortgage, or even qualify for the home they’re buying. In Canada, they can just make the regulator deposit payments.
If they can’t sell before the property finishes, they have a problem on their hands. They need to either lose the deposit and hope they don’t get sued to complete the sale, or find financing. If they can’t qualify for traditional financing to finish the deal they weren’t planning on closing, they may have to opt for a private lender.
Of course, not every new home assignment buyer is an investor. The news has recently been filled with tragic stories of buyer’s that won’t be able to close without grabbing a high interest private loan.
For instance, a recent piece in the CBC on an Uber driver closing on a $2 million home he totally was going to be able to buy, likely won’t be able to close without a private loan.
Or perhaps a recent piece in the Star, highlighting buyers not fully aware of the risks of pre-sale construction. This tale of misfortune included a buyer that bought their $2.5 million dream home… twice, and is wondering if they can walk away without the developer suing them for completion. If they can’t walk away they may be forced to use a private lender.
We’re not talking about those folks, but actual investors using private lenders to complete their purchase. Like the 1 in 7 we discussed using them to close on their investment condo. They don’t typically have poor credit quality, but insufficient leverage.
The narrative during the US subprime crisis was that people with poor credit defaulted. In reality, the biggest rise in delinquencies was observed with investors with multiple properties, and credit scores that were prime or better. They just happened to be using subprime lenders since they needed more leverage, and traditional lenders wouldn’t provide it. Actual subprime borrowers that had been end users, only saw a mild uptick from normal levels. Which makes a lot of sense, since living paycheck to paycheck and job insecurity isn’t just something that happens during a recession for the working class. It’s just another Tuesday.
Why would investors take on such obscene amounts of risk? The perceived risk of not being exposed to real estate gains far outweighed the risks of interest-only, high cost mortgages, obtained with few qualifications.
Until they didn’t.
This situation misses the features of US’s subprime fiasco. Regular mortgage brokers were making loans to unqualified buyers by lying about the borrowers’ creditworthiness. Often the borrower did not know about the lies. Other times, the lender said not to worry about the jump in payments in year 3 of 5 as they would be able to re-fi before the payments increased.
The mortgage broker than sold the subprime loans to Wall Street which bundled them with other subprime loans and then paid to have the bundled mortgages rates triple AAA++. Then, the executives is attach credit defaults swaps for a few extra dollars which would guarantee the buyer a certain return on the investment even if the home buyers should default. Then the executives would also by CDSs on the same property, knowing that the bundled mortgages would fail to perform and they executives would cash in their CDSs even though they had no insurable interest in the bundle. With 10 to 100 CDSs on each defective bundle, the investment house which put together the bundles and which sold the CDSs would have to pay off not only the entity, like Iceland, which had bought the bundle, but all the executives who had bought the CDSs knowing that the bundle would fail. Of course, the investment firms failed — they could not pay off all the CDS which their executives held. That’s why the federal government bailed out the investment houses — so they could pay off the executives who had concocted the scheme.
That does not seem to be what is happening in Canada, but from the few facts in the article, it looks like a lot of lenders are going to be in trouble — but not the major investment houses which will buy foreclosures.
It should be fairly obvious that investors are at the highest risk of default. This is because they are over leveraged and when your payment increases substantially on multiple properties that they likely hadn’t planned for they will only be able to come up with the new payment amount over 3,4 or 5 properties for so long. The attrition will take time but if they don’t have an exit strategy majority of these investor types will face at least some losses.
when the financial crisis hit the US in 08/09 canadians were pretty smug saying this can’t happen here. do you think that only the banks and financial institutions in the US are parasites. well i think we are going to find out. my money is that we are completely screwed. those who have been the most greedy are going to get crucified and you will get no sympathy from me.
I wish I could give you Thumbs up 👍 👌 👏
“those who have been the most greedy are going to get crucified and you will get no sympathy from me.”
Are you talking banks?
I like richards energy!
And all these whining cry-babies, would they agree to pay the builder a higher price if the prices had gone up instead of down?
If you look at every detail of Canada’s real estate bubble every metric is way, way worse than the US prior to its housing collapse in 2008/2009. With every bubble in history everybody says it is different this time. Guess what it isn’t.
Private mortgages are timebombs. I gave one to a purchaser of my house 30 yrs ago and within 1 yr sold it on to a large financial institution, that was happy to buy it.
I never found out what renewal rate the purchaser had to pay, but I am sure it was way above what I offered for the original 1 yr mortgage. Private mortgages often do not promise a renewal or a renewal rate. It can be any rate the private vendor feels like or not at all..
Sean Fraser is bringing in too many immigrants to Canada.
Greed works both ways. Does the Uber driver mentioned in this article really need a 2 million dollar house??? Holly Shit talk about Greed. I am sure he could have made due with 700k home. These developers and subprime lenders are too big of a cat to be scratched by a kitten.