In the past few months, several articles have appeared in major newspapers attempting to persuade Canadians that we will not see a foreclosure wave similar to that in the United States. In every case, the author advances some pretty weak arguments along the lines of “our banks are more conservative” or “Canadians are more prudent than Americans” or “we have recourse mortgages”. These arguments hold little water. As I have long maintained, a 30% correction is in the cards. But suppose I’m wrong. Let’s suppose we get the milder 10% correction that is now being called for. Could that lead to a significant increase in foreclosures? Well, let’s examine the factors that have led to the foreclosure wave in the U.S.
1) Negative equity:
One of the great fallacies being bandied about is that foreclosures are the result of diminished affordability. While that is sometimes the case, it is certainly not the only reason people choose to default. In fact, in a report by the Troubled Asset Relief Program inspector general published in March 2010, it was noted that that federal mortgage modification programs have met with only limited success due in part to the fact that they do not reduce the principal balance of underwater mortgages (where mortgage principal is greater than current home value), and thereby fail to address strategic defaults. Strategic defaults occur when the mortgage holder chooses to default, despite the fact that they have the financial means to continue to make the payments.
Why on earth would anyone do this?
Interestingly, the report pointed out that a large number of homeowners who had their mortgage payments reduced to levels that the government deemed “affordable” still defaulted, noting that “negative equity is the most important predictor of default” (pg17). It went on to note that at least 20% of all defaults in the US are currently the result of negative equity, not affordability issues. That number is rising (pg 17). Let’s dispense with the notion that Canadians will somehow be more likely to continue to pay their mortgages even when they are significantly underwater.
Lest you think this is a new phenomenon, Martha Olney explored the connection between strategic default and the real estate bust during the Great Depression in a 1999 paper published in the Quarterly Journal of Economics. She noted that indebted households largely made the choice to default due to negative equity, rather than being forced to due to affordability.
However, you may be inclined to believe that Canadians have been more prudent with their real estate purchases, and perhaps new homeowners have more equity in their homes due to larger down payments. Let’s get some truth on that one.
2) Down payment
In 2007, the average first-time homebuyer had 7% equity in their home upon purchase (see attached graph, courtesy of Jonathan Tongue).
It’s a pretty safe assumption that this percentage has not increased, given that the savings rate has actually decreased since then to a paltry 2.7%. “But”, you may say, “CMHC got rid of 0 down mortgages in 2008. Surely that has increased the equity”. Have they really gotten rid of them? If they have, then how do you explain these:
(Read halfway down the second column on page 2)
(meaning you could borrow the down payment on a LOC or credit card and immediately pay it off)
We also have a wonderful government program that will actually GIVE you the down payment. Seriously! It’s called ‘The Canada-Ontario Affordable Housing Program’. There is obviously nothing better to be spending taxpayer money on. Geesh!
Anecdotally, I know of several couples who have recently purchased properties with no money down, except the 1.5% needed for closing costs. That leaves them with exactly 0% equity. So I don’t buy for a second that equity for first time buyers has gone up. I would be shocked if it’s above 5% currently. This means that a mere 10% drop in house prices (we should see that by early 2011) will wipe out the equity of thousands of new homeowners. Remember that you only need to squeeze the margins to start a self-correcting mechanism of beggar-thy-neighbour defaults a la U.S.
“But we have recourse mortgages” you may say. Very true. But a commonly unknown fact is that many US states are recourse states. So let’s look at their experiences over the past few years.
3) Foreclosure rate in recourse states
In a working paper by the Richmond Federal Reserve, the authors classified states based on whether they were recourse or non-recourse states.
The authors go on to state that the threat of recourse decreases default by approximately 20%. This number makes sense to me. I’m not so naive to believe that our recourse system has no bearing on people’s decision to walk away, but I do think that it will have less of an impact than people believe.
Let’s look at a few examples of some recourse states and see what their foreclosure rates are. According to the Fed, both Florida and Nevada are considered recourse states. Now, admittedly, no state will have laws identical to those in Canada. Nevertheless, there is still an element of recourse available to the lenders, so it is worth examining how these states have held up relative to others. Funny I mention Nevada and Florida, as they are the states with the highest percentage of mortgages in foreclosure, despite being recourse states.
Yes, you read that right!
Two other recourse states also have double digit foreclosure rates: Illinois (11.27%) and Michigan (10.72%).
So, according to the working paper by the Fed, all of these numbers would be 20% higher had they been in non-recourse states. I bet those homeowners are thanking their lucky stars for that! Does that make the financial pain and real estate carnage any less devastating? No, it does not.
Remember that lender recourse only serves as a deterrent if the homeowner has other assets to recourse on. If not, it’s a moot point. See points 2 and 5.
Perhaps recourse loans prevent rapid declines in real estate values, as suggested in the articles. Nope.
4) Percent Decline in recourse states
Current information on the percent decline in real estate by state is sparse. However, there is certainly enough to dispense with the notion that recourse mortgages protect from large, rapid decreases in real estate valuations. Consider the following chart, which shows home prices by State between October 2007 and October 2008.
Let’s consider the one-year declines in the four states mentioned above:
Florida: Over 10% decline
Nevada: 0-5% decline
Illinois: 5-10% decline
Michigan: 5-10% decline
Those are the percent declines in one year at the start of the current bust. Currently, Florida and Nevada are over 40% below peak values. Clearly recourse mortgages do not fully prevent significant, rapid declines in real estate values. That notion is bunk.
Finally, here in Canada we have a special investment vehicle that may serve to remove some of the incentive to not default.
5. Segregated funds
Any sparse financial assets that new homeowners may own can be protected from creditors in the event of bankruptcy. As mentioned above, it’s clear that the average first time homebuyer in the past few years has little in the way of savings, so that should not prove to be a significant foreclosure deterrent. However, should a homeowner consider defaulting, their financial assets can be protected by investing them in segregated funds, which are issued by a number of insurance companies. This is a little-known fact, but I can’t help but think that people will figure this out as the correction intensifies.
It should be obvious to anyone willing to look beyond the headlines that we are in fact at risk of a default wave here in Canada. Remember that it is negative equity that is the real risk, not affordability. If I’m right and a 20-30% decline is an absolute given, we definitely will see default rates soar. Perhaps not to the heights seen in many U.S. states, but I would be shocked if we don’t see at least a 5% default rate within the next 3 to 5 years. This correction is just beginning and will be a long, drawn out affair. Don’t listen to the gullible media. Their arguments hold little water. Weigh out the data I’ve provided you against the anecdotes in the above articles and come to your own conclusions.
Cheers and blessings,