Real estate prices are falling, and a U.S.-style collapse could cost taxpayers plenty

Could it happen here?

Could it happen here?

Christopher Judge is accustomed to turning heads in Vancouver. During the decade-long run of the cult hit TV show Stargate SG-1, which was filmed in and around the city, Judge starred as the muscle-bound alien Teal’c. But when the six-foot-three actor appeared in B.C. Supreme Court in mid-November, amid raised eyebrows from the galley, it was for a role he’d desperately hoped to avoid. Judge, who owns three luxury homes in B.C., faces foreclosure. He’d flown up from Los Angeles the night before to ask the court for time to get a new appraisal done on one of his properties, a West Vancouver home with stunning views of the city that he’d bought for $2 million in 2006. At the same time, one of Judge’s former co-stars on the show, Michael Shanks, is facing foreclosure on another sprawling West Vancouver home purchased in January for $4 million. “I was always told the safest place for your money is in the real estate market because it would never drop by 50 per cent, but that’s exactly what’s happened,” a congenial Judge said outside the court. “I watched the L.A. housing market fall and now I’m having to watch the B.C. market go down, too.”

But it’s not just two actors on the hook. Canadian taxpayers, through the Canadian Mortgage and Housing Corp., may ultimately have to make good for any losses stemming from their woes. That’s because mortgages on at least two of Judge’s high-end properties were insured by the government-owned agency. If the foreclosures go through, and the houses are sold at a loss, lenders could turn to CMHC to make up the difference. “This wasn’t some mom-and-pop homebuyer,” says one Vancouver real estate observer familiar with the situation, but who asked not to be named. “CMHC was never supposed to be in the business of insuring speculators.”

Like Fannie Mae and Freddie Mac, the two failed mortgage finance giants that were seized by the U.S. government in September, CMHC’s primary job is to encourage home ownership by making it easier for people to obtain mortgages from banks. And over the decades, the Crown agency did just that, helping millions of Canadians buy a place to call their own. Yet there’s growing evidence that CMHC’s lax policies in recent years ignited a housing bubble in this country in much the same way Fannie and Freddie did in the U.S. The Canadian mortgage industry may not have gone to the same extremes as in the States, and the subprime market was not as big, but experts say lending practices here were far more liberal than first thought. The question now is, will homeowners find themselves squeezed by huge debt loads and plummeting house prices? And if so, how deep will taxpayers have to dig to cover the losses?

In Canada, anyone buying a house with a down payment of less than 20 per cent must purchase mortgage insurance, which protects lenders in the event of a default. But starting in 2006 the CMHC, along with smaller private insurers, raced to loosen their standards. CMHC, with roughly 70 per cent of the market, kicked things off by offering to back mortgages with 30-year amortizations, instead of the traditional 25 years. As rivals like Genworth Financial fought back, amortizations quickly grew to 35, then 40 years. Meanwhile, mortgages could be had with no down payment whatsoever. At the time many in the real estate industry welcomed this competitive tit-for-tat, since it helped thousands of young Canadian families who would otherwise have been shut out of the market. To others, it was a sign Canada was headed down the zany path America’s mortgage lenders had taken. In June 2006, David Dodge, then governor of the Bank of Canada, fired off a gruff letter to CMHC CEO Karen Kinsley warning the new policies were “disturbing.”

When the full extent of America’s housing crisis became apparent this past summer, Ottawa slammed the door on extreme mortgages. As of last month, mortgage amortizations were limited to 35 years, while buyers must now cough up a down payment of at least five per cent. The flip-flop, which CMHC said it supports, is aimed at preventing a real estate crisis here. But critics say the clampdown came too late. In October the average resale price of a home in Canada’s major markets fell 9.9 per cent to $281,133 from a year ago, the fifth straight month of falling prices. “Given the highly leveraged situation of many homeowners, it is quite clear to me that we are not immune to what has happened in the U.S.,” says Moshe Milevsky, a professor of finance at York University. He says a five to 10 per cent price decline over 12 to 24 months could wipe out the equity of hundreds of thousands of Canadians who rushed to buy homes in the last few years. “Bottom line is, there are many Canadians today who own homes they should have rented instead. I’m afraid CMHC was responding to politics as opposed to prudence when they loosened their standards a few years ago.”

CMHC declined an interview for this article. In an email, the Crown corporation said it made it clear at the time that 40-year mortgages “were not for everyone.” The agency says its qualification criteria ensure that “only borrowers with the ability to manage their debts can access our products.” The agency didn’t reply to specific follow up-questions. But interviews with real estate agents, mortgage professionals and economists suggest many homeowners were able to qualify for large mortgages they might have trouble managing in the event of a downturn.

Take, for example, so-called liar’s loans. The term refers to mortgages given to people who can’t document their income. In America the practice was widely abused, since many borrowers simply lied when asked how much they earned. But such loans were available here, too. Last year CMHC trumpeted its new Self-Employed Simplified program, allowing those with no documented proof of income to obtain mortgages, provided they make a down payment of five per cent and have good credit. The result was that in some cases those borrowers with proof of income were at a disadvantage to self-employed workers in the same industry who had no documents at all, since the latter could overstate their earnings. “It got to the point that we could actually get a larger mortgage for somebody who couldn’t prove their income than somebody who could,” says Ajay Soni, a senior mortgage broker with Invis in Vancouver. “On the whole, Canada’s borrowing culture is more responsible than in the U.S., but in some cases risk assessment was thrown out the window.”

Some suggest that’s because Canadian mortgage lenders had nothing to lose. One problem that led to America’s housing crisis was that millions of mortgages were securitized and resold to investors. This meant the companies that originally issued the mortgages to consumers with poor credit histories had nothing at stake if the loans went bad. CMHC may have played a similar role here. “The banks could write as many mortgages as they wanted, subject to being able to get them insured by CMHC,” says one prominent economic analyst on Bay Street who spoke off the record. (Several of the people Maclean’s spoke to for this article expressed concern about reprisal from CMHC, which has come down hard on critics in the past.) “The banks knew they wouldn’t be on the hook.”

Now there are concerns the sudden drop in Canadian house prices, along with rising unemployment, are proving too much for some borrowers to handle. For instance, the number of foreclosure filings in B.C.’s Supreme Court between January and the start of November stood at 928, up 50 per cent from the same period last year. Foreclosure lawyers in B.C. and Alberta have had to hire extra staff to keep up with the workload. Gloria Vinci, a Calgary real estate lawyer, says she’s been astonished to find a large number of cases where homeowners have taken out as many as four mortgages on a property in the span of three years as housing values soared. “I don’t know if this is just the beginning or we’ve reached the peak [of foreclosures],” she says. “But with the massive increase in equity over the last two to three years, people have maxed themselves out.”

Some who borrowed heavily to pre-buy during the Great Canadian Condo Boom are also struggling. Scott Hannah, CEO of the Credit Counselling Society in Vancouver, has seen cases where buyers obtained mortgages to buy condos with no down payment. As the equity in their unfinished properties rose, they took out secondary loans to buy furniture. Now those buyers are underwater, and they still haven’t moved in.

Even in Toronto, where the market run-up wasn’t as big as in the west, some owners face problems. The number of homes listed under power of sale, which refers to repossessed properties, has climbed from 300 to 500 since the spring, says Jim Common, a real estate agent whose monthly newsletter tracks the sector. It’s a small fraction of the total active listings, but he expects the number to rise.

It can take months for the full extent of a collapsing housing market to be felt. For instance, some in the real estate industry point to the relatively low default rate on residential mortgages as a sign the market remains strong. According to the Canadian Bankers Association, the percentage of residential mortgages in arrears stands at just 0.28 per cent of the total market. But when the 1990 housing bubble burst, the national default rate was also 0.28 per cent, and it took two years before defaults peaked at 0.65 per cent.

If defaults rise, claims against CMHC could climb, too. The good news is that because the buck ultimately stops with Ottawa, the country should avoid a mortgage-fuelled banking crisis like the one that has claimed so many victims in the U.S. In fact, through CMHC the federal government plans to buy up to $75 billion worth of mortgages from the banks as a way to inject liquidity into Canada’s financial system.

But could taxpayers be left holding a massive bill? There’s almost no way to know. CMHC doesn’t divulge key information about its lending portfolio, which it considers to be competitive information. Even so, Nick Rowe, an economics professor at Carleton University, recently posted online a “back of the envelope” calculation of CMHC’s potential losses. Based on what is known about the agency’s $334-billion insurance portfolio and $7 billion in reserves, he argued CMHC could lose $9 billion if prices in Canada fall as much as they have in America. (U.S. prices have dropped 20 per cent from their 2006 peak, with some cities down 35 per cent.) By contrast, CMHC posted profits of more than $1 billion for three straight years, thanks largely to insurance premiums it charges homebuyers. Rowe admits his analysis is crude. But he worries CMHC officials may not have accounted for serious price declines when constructing their financial models, believing, as Fannie and Freddie did, a catastrophic economic event would never happen.

For what it’s worth, CMHC remains more optimistic about the Canadian market than some of the real estate industry’s most bullish proponents. On Oct. 30, CMHC predicted the average MLS selling price for this year will come in higher than last, and continue to rise in 2009 to $306,700. A week and a half later, the Canadian Real Estate Association predicted the average price of a Canadian home will end the year down 0.6 per cent to $303,900 from 2007, and continue to fall in 2009 to $297,600. “Somebody needs to work out what the losses for CMHC would be if house prices fell 20 per cent across Canada,” says Rowe. “We’ve got a rough idea of the national debt, and what the deficits are going to be, but there’s an item here that hasn’t been taken into account. There’s no question of anything going bust, but this is something we should know. It’s very clear who is on the hook here, and that’s the taxpayer.”

No one is saying this is all CMHC’s fault. Genworth, Canada’s second-largest mortgage insurer, moved in lockstep with its government-backed rival. Meanwhile, smaller U.S. mortgage insurers rushed into the Canadian market at its peak. (Almost all have since fled Canada.) And CMHC didn’t exactly hold a gun to the head of lenders, who were the ones actually doling out questionable loans at the outer limits of CMHC’s insurance policies.

Still, at the end of the day, CMHC isn’t a private company, which means taxpayers may have to write a sizable cheque if the housing market worsens. It’s happened before. Back in the early 1980s Ottawa had to bail out CMHC when thousands of homeowners defaulted on their mortgages and insurance claims skyrocketed. Much has changed since then, but it’s becoming clear that CMHC’s policies encouraged many homebuyers to jump into the market before they were ready. And the consequences of that could be far-reaching. “[The easy credit] dragged buyers kicking and screaming from the future to today and they were lent money whether they could afford it or not,” says Ozzie Jurock, a Vancouver real estate promoter. “The only test was whether they could breathe.”

With Rachel Mendleson

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