"Only when the tide goes out do you discover
who’s been swimming naked” - Warren Buffet
As the credit market tightens and the real story begins to emerge, we’re starting to see who’s been exposing themselves to unhealthy levels of risk and who, by playing the game conservatively, will end up happy and fully clothed as the tide rolls out.
Many are calling this the “Sub-Prime Crisis,” which is quite misleading. This is a more a crisis of greed, and every investor, large and small, has had a part to play in the development of the wall we find ourselves up against. Hedge Funds, M.I.C.’s, corporations, banks, mutual funds and private equity groups have been stretching their risk profiles looking to eek out a couple of extra percentage points on their return, to make their quarterly report look better all in the name of satisfying their shareholders who’s short-term investment horizons drive short term business decisions. This has occurred in both Canada and the U.S. The good news is, Canada may just come out of this situation relatively unscathed.
They’re Called Sub-Prime For a Reason
As a point of clarity, sub prime does not mean the interest rate is below the Bank’s prime rate, as many believe. In this case it means that the borrower is below being a prime candidate for a mortgage, hence the term sub-prime. This small confusion alone has caused many Canadians to panic unnecessarily because their mortgage is a floating rate below the bank’s prime lending rate, thinking that means they have a sub-prime mortgage.
In the United States, borrowers with little or no income, little or no equity and a history of not paying their bills have been handed variable rate mortgages they can’t afford. By any standard these loans are high risk. So now is it a surprise to anyone that in early 2007 one in every eight U.S. sub-prime loans was in default with projections of this number doubling between now and June 2008? I don’t think so.
Why would sub-prime lenders put themselves in this precarious position, simply they thought they had a system designed to mitigate their risk while still making a profit. After they got the borrower to sign on the dotted line, the lending institutions packaged up the loans as Collateralized Debt Obligations (CDOs) and sold them to those looking for a high return on their investments. These CDO buyers included Hedge Funds, Mutual Funds and private equity groups looking to feed shareholders’ incessant short-term greed.
To make matters worse, many of these CDO buyers used borrowed funds, in some cases upwards of 90%, thus adding another layer of debt on top of an already shaky foundation. The shares of these companies were then bought by pension funds and insurance companies looking for high returns but these same funds would never have bought the risky mortgages outright. You can see how this has rippled out into all areas of the financial markets.
This whole sell-on strategy takes the high-risk loans off the lender’s books while providing them profit through the fees. The CDO buyers expect higher returns because of the higher interest rates and they expect some security as the loans are backed by a real asset.
The mad dash to create large short-term returns has led many of these investment teams to the brink. Some will topple over the edge and shut their doors while others will put the brakes on just in time, hopefully learning a major lesson on short term thinking in the process. This layer upon layer of risky debt was created to fuel one thing, North Americans’ focus on short-term results. Shareholders complain when the return isn’t high enough and in reverse are now complaining that they didn’t think that the investment company should have taken such high risks on these sub-prime mortgages.
It’s You and Me Driving this Bus
These large institutional investors are not the only ones driving this bus towards the cliff, there are many others who are standing with their greed glands exposed now that the tide has rolled out.
Over the last 5 years there have literally been thousands of new mortgage brokers entering the market in Canada and the US and they must have thought they’d hit the lottery jackpot. With financial institutions’ willingness to lend to just about anyone who could breath and, at the same time, lining up to pay almost double the commissions on sub-prime mortgages, these new Mortgage Brokers had the time of their life. It was so easy in Canada at one point that an investor or home-buyer could get a mortgage just by ‘declaring’ their income, no proof required. Anyone watching from the outside could see where this was leading.
You could also see why many individual real estate investors got caught up in the sub-prime market game. “Little or zero down, what could be better than that?” they thought. Many, who have only been investing during the last 5 years of good times, have felt very comfortable in exposing themselves to undue risks by taking advantage of the sub-prime mortgages that were being handed out like candy.
And now that lending criteria are being tightened, with many Canadian and U.S. institutions ceasing sub-prime lending all together, we’ll quickly begin to see who the real mortgage brokering and investing pros are and who have mistakenly focused on the easy ‘sub-prime’ dollars. The shifting tide will expose the truth.
The Good News For Canadians
In Canada, our Bank Act has forced our lenders to be more conservative than down south. In fact, all loans in excessive of 80% of the property’s value must be insured, protecting the lender from loss. It is true that some Canadian lenders dramatically dropped their lending criteria, and almost doubled the commissions paid to mortgage brokers if they put their borrowers into sub-prime mortgages, but still the percentage of sub-prime lending is substantially less in Canada. In mid 2007, over 21% of mortgages in the U.S. were sub-prime compared to only 5% in Canada. Of this 5%, all are insured against loss.
While Canada is approaching a record low number of mortgages in arrears, only 0.24% according to Canadian Bankers Association, we will see an increasing number of U.S. loans go into default, as $850 Billion of their sub-prime loans become re-set with much higher interest rates and higher payments between now and June 2008. So watch for an increased tightening of credit availability across North America as Canadian lenders respond to U.S. results.
Unlike the U.S., the Canadian housing market has not been artificially driven by bad lending practices. In most regions it has been driven by economic and demographic demand. This will provide home owners and investors continued long term resiliency. There will be economic bumps in the road that will shake out the short-term investors, but the long term economic fundamentals that drive our real estate market are solid. We have the fastest growing population in the G7, our energy production and commodities are in increasing demand around the world, our average personal incomes are increasing, job creation is strong, creative Eastern based manufacturers are hiring to supply goods and expertise to the booming Western provinces, our consumer confidence is high, the issuance of building permits continues to be strong, and we are attracting more international investment capital into Canada’s real estate market than we have ever witnessed before. These are just a few of the many positives supporting our real estate market, none of which are artificially stimulated.
The seed of this so-called Subprime Crisis is a lack of accurate information, a lack of transparency and a focus on the next quarter’s financial results. Without a fundamental change in our investment expectations, a few years from now we will witness another ‘so-called crisis’ hit our financial markets as the next scheme tumbles. But investors are a resilient bunch and the market eventually takes over and rights itself, just as it will after this storm is over.
Accurate Knowledge and Long Term Focus = Investment
Guessing and Chasing Returns = Speculation
What’s the lesson in all of this? Simply, chasing short-term returns can and will lead to an inevitable correction in any market. Investors can justify just about anything once the greed glands kick in. Just look at the well respected institutions who bought the sub-prime mortgages expecting high returns. We can say we’re following new and more accurate algorithms and computer models for risk management, but the bottom line is that the market will always expose those who insist on swimming naked of knowledge and foresight.
One year from now, we’ll look back to today and thank the market for being such an efficient self-cleaning system. Removing the naked swimmers and leaving the rest for long-term focused investors.