Friday, August 10, 2007

Local Sub-Prime?

In case you were wondering why the markets have declined by almost 5% this week to build to a 3-week loss of over 10%, we give you this local example of the wide-spread problems that are expanding into non-sub-prime territory in the US:

Reflections is having trouble pre-selling its units. Until it gets 65% of the building sold, bankers won't lend them the construction seed money to finish the project. It sat for the better part of a year with little to no work being done while salespeople worked in overdrive. It quickly became apparent that something creative needed to be done.

Enter Canada's version of the Alternative Rate Mortgage. The developers at Reflections are offering you a teaser rate. Now they don't have any control over the actual interest rates you'll be charged by your bank. But they do have control over how much you will have to pay in total. The monthly payment on a $340K condo is roughly $1800/month (40-year amortization, 6% interest, 0% down). Developer drops the price by $10K, and your monthly payment is still unattractive. So what are they going to do?

How about tease you with cheap mortgage payments for a year? Which is exactly what they have done. You pay them full price ($344K or $334, depending if you read or heard the add) and they give you a cash-back option equal to half your mortgage payments for one year (12 x $900 or so). At last count, they had 10 units for sale under this scheme and 3 units sold leaving another 7 to go.

Now I know some of you are going to claim this isn't sub-prime. And your right. The lender will still need to qualify the buyers and the buyers will still be required to purchase mortgage insurance. But what this has done is artificially inflate the purchase price of the condo. How can I say this? Because they'd have no trouble selling the units if they dropped the price down to what consumers are willing to spend.

Just how big is this problem? In the Victoria market it's--as far as I know--contained to Reflections. But think how wide-spread this credit issue is throughout our economy. Bought a car recently? Did you get 0% or 7% financing? My guess is you got much lower than 7% if you financed through the dealer's creditors. Bought furniture? Did you "buy now and do not pay for one full year?" How about electronics?

You may have noticed that prices in these categories aren't really inflated, but the demand has been. This is why I argue vehemently that true inflation numbers are much higher than the CPI suggests. Demand has been inflated too. And when people borrow to spend now it creates long-term economic consequences in much the same way that increased prices do.

It's these types of new-fangled credit schemes, targeting those that don't qualify for traditional credit products, that have created the largest credit bubble in world history. In the US it seeped into over 20% of the housing market. Up here in Canada, experts are claiming it's only 5% of our housing market. But the problem is so much bigger than the so-called sub-prime debtors because many so-called "prime" candidates--you know, people with good credit--have taken advantage of loose lending so that they can over extend themselves too.

When assets start to decline and the real interest rates start to kick in, those "prime" buyers look twice at their debts and usually stop spending. They want to consolidate into the cheapest interest bearing vehicle (the HELOC) but their home's value has dropped and they can't get one. They either walk away or get forced out of their assets (homes) because lenders need to get something for the debts they are owed. And good creditors become "victims" of their own desires to have everything now and lenders/retailers desires to provide everything now for a price that won't drive you out of your home. Oh, the irony.

If I had a nickel for every teaser interest rate pre-approved credit card I've been offered by mail or over the phone I wouldn't need to work. Guess what? I haven't worked much over the past 4 years while I've been in university. Don't you think I shouldn't be offered pre-approved 0%-for-the-first-year credit cards with limits totaling 25% of my yearly gross income? I do. So I say no. I bet I'm in the minority on that one though.

Painful economic times are coming. And they are deserved.


Anonymous said...

I work for a local financial institution, and I can tell you that at least my financial institution (and I would bet money most others in Canada do the same thing), we take the mortgages consumers sign with us and re-sell them on the market in a very similar way to how it was done in the US with subprime market. Basically, the mortgage is combined with a bunch of other mortgages and then the total sum of these is broken down into various levels of risk AAA, AA, A, B, BB etc... and sold off to other institutions as investments of various risk levels & the appearance of long term performance guarantees. So far this is all pretty similar.

What's different is that the lending practices of at least my institution isn't as loose as it was in the USA. For instance, we need proof of income (not just verbally stated income), and credit scores are most certainly taken into consideration.

Now that being said, about a year ago our senior executives announced that we would (strangely) be focusing our efforts more on selling to high risk clients than to average good credit clients, because the rewards were bigger.

Is this the same as the US sub-prime? Nope, but there's enough factors in there, combined with 40 year mortgages & 0% downpayments being allowed to initiate a minor catastrophe of our own.

I guess the future wil tell.

Anonymous said...

I carry $20k in consumer credit debt. A 0% credit card offer would be handy right now. =)

oh please said...

a-mous 9:29 - thanks for that info. I've long wondered whether our banks were doing just that. At this point the only difference I can see between mortgages up here and down there is we don't seem to have the liar loans. That's a pretty important difference, of course, but I've also heard from more than one banking source that there are a whole lot of folks in our country who are way over extended, and who are going to feel some serious pain if rates go up significantly.

The real question, I think, is will the easy money dry up this side of the border, and if so, when?

vg said...

anon 9:29, thanks for that info, appreciate. I was always convinced this had to be happening as sales would naturally decline as the boom is nearing its peak and upper management can see that coming and raising the risk threshold is the only way to keep the machine in motion. The bottom line is as you say, it could well create our own catastrophe with a different name for it.

HHV, not sure if it is time to go shopping yet,my investments held up fine today but the opening hour was a little scary,we shall see next week wether this massive $36 billion injection by the Fed will calm things down. Thats alot of cash and signs some big boys must be having some difficulties.

On a positive note my brokers office has no edge of panic and are taking this as the projected correction they have been warning of since earlier this year.

The ultimate bottom line here is this has to have some serious effect on any would be house buyers in Victoria and the west,slowing sales in August will be step one,by September the price cuts show up as no one wants to go into another rainy Victoria winter with endless open houses,showings etc if you HAVE to sell. The shift in tides is now here in my opinion.

olives said...

I admit I know nothing at all about banking, but if big Canadian banks are requiring the bank of Canada to suddenly provide them with billions of dollars of cash, it would seem odd that lending for mortgages will continue as before. The credit crunch is obviously affecting Canadian banks. is this not right?

vg said...

olives, you have to think it is effecting us as well,we are no different in risk exposure but we may not have as high a risk exposure as the US but we will suffer the same. This is one of the several psychological changing events that we needed to see to wake people here up,if they don't get it now then theres no excuse.

Talk about the BOC holding off on the September rate hike,some interesting hedge fund talk too:

olives said...

Well our lending standards should change pretty drastically then, right? It will be much more difficult to get a mortgage? Just like in the U.S., people who have been pre-approved may find that they are now out-of-luck? Rates for certain types of mortgages will suddenly be much higher?

Do you think this will happen immediately in Canada VG?

vg said...

olives, hard to say but it would not suprise me to see it tighten up here in the next month or so once the 5% pre-approvals expire,will be interesting to watch this next while.

Lucky Luke said...

Hi Olives,

The BoC, like the other Bank reserves of other countries, are not injecting these billions of dollars for free. The money is actually lent to the financial institutions of each country at either standard rates or if severe enough, below standard rates.

Eventually this money has to be paid back into the country's reserves. So lending billions, even though some countries are quoting we'll offer "inifinite" amounts, banks can not realistically pay back infinite amounts. So this is only sustainable for so long.

The idea behind lending the banks money is to keep the economy going. In order for the banks themselves to lend money to their customers (Lines of Credits, Mortgages, Car loans etc), they need to have the money to lend in the first place. If they get the money at prime from BoC for example they can still carry on (barely) by lending the money to customers like you and me at prime + 3% or whatever.

If the masses ignore the injection of these billions (as they more or less have been lately) and continue to panic, the governments will be forced to implement lower interest rates.

This is the other alternative to injecting billions into banks as a backup measure to calm the masses from massive sell offs. Unfortunately, lower interest rates have the direct affect of stimulating the economy and gives citizens a somewhat false sense of relief.

This is because our economies are already quite stimulated. Stimulated/booming economies tend to result in inflation upon the citizens which must then be cooled down by increased interest rates which would again remove the false sense of relief.

Given that prices for houses are already out of whack everywhere, if they lowered interest rates, this would further stimulate house purchases and inflate their prices even more, resulting in even more defaults, which then results in another crash, etc. It's a bit circular as you can see.

The term "Credit Crunch" means that financial institutions completely tighten up lending rules such that only very qualified borrowers will have access to loans, and essentially the tap of easy money gets turned off overnight. This has not happened in Canada, nor yet in the USA, but without question both are tightening lending rules such that the most risk averse clients (the ones with very bad credit scores or no credit history) may actually start to be declined loans. Imagine that!

If the markets keep dropping like they have in the past week, and more news of sub-prime defaults continue, then a global credit crunch may indeed take place. Not just in Canada or the USA, but globally.

Given that today the citizens of practically every modern nation are in debt up to their eyeballs, and most don't know how to live on just what they earn, this would have a very drastic effect on consumer confidence and purchases, which would basically lead to a Global Recession which would be a very bad thing X-( ... although good for those that managed to keep their investments safe and have money to buy things or houses, when everybody else is selling them at discounts.

Aside from that, what a credit crunch means to Canadians is that there will be much fewer buyers on the market, which will without question drive down real-estate markets (supply vs. demand).

Hope that makes more sense now,
Lucky Luke

oh please said...

It may not be no doc, but it's low doc - imagine a 100% down mortgage based on a salary letter". We may not have quite the same degree of subprime lending up here, but to say we don't have it is nonsense. American lenders have made inroads into Canada with these products.

House Frau said...

Lucky Luke,

Europeans are also in debt. That is unusual as they are actually big savers.

I grew up in the early 70s in an upper middle class neighbourhood in Winnipeg. I remember most people had 1 car (especially in the 60s), 1 TV was normal. Everyone seemed to own a cottage and it didn't break them. Mortgages did not eat up most of one's salary and most women stayed at home. (now women have a choice but most would love to take a couple of years off with young kids but they can't). We did not have computers, I pods etc., blackberries. We did not go on fancy holidays. People SAVED for "The Big Trip" to Europe or wherever. Some kids went to disney land which was huge and so appreciated and the spoke about it for years. We are spending money on Botox, Boob jobs, personal trainers, expensive yoga outfits. Life coaches - what the hell is a life coach?????

When did this all start?

olives said...

Thanks Lucky Luke.

If there is a loss of confidence and an increase in the perceived risk, will the government lowering rates make any difference to either the lenders or the borrowers?

It is interesting there is lots of talk that the credit crunch has already begun.