Blessed by the Potato

There is a great deal of systematic risk associated with allowing people to buy homes with 0 or 5% down. It’s a part of the system that I really think needs to be changed, and that I hope does get changed soon if our government ever gets back to work (especially with the deficit, I hope they’re refunding their salaries for all this time off!).

The risk comes from a number of fronts. One is that it allows young, stupid people to buy homes. People who don’t have a track record of sticking to a budget, or of weathering a bad year, or even of being able to save very much at all are allowed to take on massive amounts of debt, which is in a way kind of crazy. Especially since the ability to buy with a small downpayment means that it often ends up that the downpayment is all the homebuyers have at first: no emergency fund in case something unexpected happens, and no equity in their home to borrow against. They start off stretched to the limits. Multiply it out across all the young recent homebuyers in our population, and a slight recession (where they are caught with their shorts down and need to sell due to job loss) can turn into a massive housing bust. I have to admit that I was actually surprised that the emergency interest rates were able to overcome this last year — I had given the Canadian housing market up for dead when it ground to a halt in the fall of ’08.

Add it all up: people with no proven history of being able to stick to a budget for a long period of time, no home equity to speak of, and no safety net, and it may not surprise you to hear that having no equity in your home is almost as strong a predictor of defaulting on your mortgage as having poor credit. Now, that’s for the post-crash US market, so it’s having no equity to begin with and then being upside-down that I’m talking about, but with only 5% and closing costs of ~10%, even a flat market can leave you upside-down if you’re forced to sell. Of course, “layered” risk factors are exponentially more risky: someone with poor credit (i.e.: someone who has been late or defaulted on a payment in the past) but managed to save up a 20% down payment and has it invested in the house has let’s say a ~1% chance to default in a bad housing market, and someone with good credit but no equity has a ~0.8% chance of defaulting, but someone with poor credit and no downpayment is way more likely to default, at say ~7%. This is where a lot of the attention goes in the discussions of the shoddy US lending practices and how Canada is “different”… but we’re writing a tonne more low-downpayment mortgages (though to people with decent credit), which is really only a difference of degrees vs subprime in terms of risks to the system. It’s not throwing gas on the fire in terms of adding accelerants, but it still burns.

And speaking of acting as an accelerant, have you ever heard someone complain in the last few years that “the market goes up faster than we can save!”? And what happens when someone complains that the housing market is going up faster than they can save? They stop saving and dive in with whatever they’ve got, even if they have to borrow the downpayment from mom and dad. It’s how speculative bubbles are made: prices start to rise, and people, being afraid they won’t be able to buy higher, buy in a panic. Which drives prices higher… When you have to have skin in the game, it can slow things down. If you have to save up 20%, it can mean that no matter how fast the market goes up, you still have to keep saving. You can’t bring demand forward from younger and younger people afraid of being priced out but who don’t have savings yet. And if you do get priced out then that helps act as a natural brake, because the demand is both removed when prices over-shoot (and people trying to save harder may spend less and put a damper on the local economy which may also help slow the market), and because it limits speculative frenzy. You don’t see a whole lot of people running down to pick up a half dozen condos on the first day of pre-sales when they have to put down 20%.

Of course, the most bizzarre proof that I have that low down-payment mortgages are dangerous is the existence of the CMHC itself. Banks are not allowed by law to hold a mortgage with less than 20% down — if they could, they might write many such mortgages. But doing so would put our whole banking system at risk if there’s a housing crash because there’s a good chance that even with a minor housing crash, with many homes having several years of mortgage payments under them, that the banks could not expect to recover more than 80% of the home’s original value. And banks failing due to aggressive mortgage writing could bring down commercial lending, and lead to panic and runs for deposits, and all the doomsday scenario stuff that we just went through in the US. So our banks aren’t allowed to hold those sorts of mortgages without insurance.

However, in a strange twist, a low-downpayment mortgage insured by CMHC is less risky to the bank than a conventional mortgage would be, since CMHC doesn’t just cover the difference between the actual downpayment and the insurance-free 20%, but rather the whole cost of the mortgage. The risky mortgage is basically off the bank’s balance sheet and put into a CMHC mortgage-backed security. Ah, yes, “securitization”. You’ve heard that word in the news a lot: a way of taking the risk away from the people making the decisions about writing a mortgage. Yes, that risk factor is alive and well up here in Canada, despite the recent lessons from the south.