Canada’s central bank is warning about a rapidly deteriorating mortgage environment. Yesterday we unpacked Bank of Canada (BoC) data on highly indebted borrowers representing a larger share of mortgage originations. Today we’re looking at an issue that builds on that — these borrowers have little equity. Highly indebted households with little equity are the perfect recipe for disaster. They also happen to represent a larger and larger share of mortgage originations by the day.
Highly Indebted Is Different Than Having Little Equity
Highly indebted households have a debt load significantly greater than their income. A household is highly indebted when its loan to income ratio is above 450 percent. For example, a household with a $100k/year income and a $500k mortgage has a loan to income ratio of 500 percent. They would be highly indebted, according to Canada’s bank regulator.
Having little equity means your loan to value ratio (LTV) on the home is high. Let’s say you still make $100k, and have a $500k mortgage, but the house is worth $2.5 million. The LTV ratio is 20 percent and requires an 80 percent drop to wipe out the owner. This borrower is highly leveraged, but not necessarily high risk due to the fact they can draw on equity. This allows them to “smooth” missed payments.
Less equity would make it a different situation. If you earned the same, with the same mortgage, but your house is worth $555,000 — your LTV is 90 percent. Home prices only need to drop 10 percent for this borrower to be wiped out. Not only are they highly leveraged, but they also have no equity to ride out any issues.
People with little skin in the game can be quick to abandon it. That makes them more dangerous. Risk compounds when that person is both highly indebted and has little equity in their home. The most dangerous person is often the one with the least to lose.
Don’t take my word for it though, the BoC has crunched the numbers on the data. Households with a loan to value ratio of less than 65 percent have a 7.5% chance of missing payments. As the LTV rises, so does the risk. LTVs of 66 to 80 percent (+9.4%), further at 81 to 94 percent (+13.5%), and highest at over 95 percent (+16.4%). Missed payments are obviously the biggest sign of financial distress. This can mean foreclosure, but often means forced selling. That is the homeowner is distressed and needs to list, but it may not be obvious they need to sell.
Canadian Households Missing Mortgage Payments: Probability
The rate of probability for Canadian households missing a mortgage payment, by the loan to value (LTV) of the mortgage.
Source: Bank of Canada; Bank Filings; Better Dwelling.
Canada Sees Highly Leveraged Mortgage Borrowers With Little Equity Surge
Highly leveraged borrowers are stealing a larger share of originations these days. Borrowers with a loan to income ratio of 450 to 550 percent captured 3.66 points more of market share in 2020. When broken down by LTV, we see the increase is significantly higher in homes with less equity. LTVs 65 percent or less (+0.31 points), 66 to 80 percent (+1.86 points), and 80 percent or higher (+1.49 points) all show big gains in 2020.
Even more highly indebted people captured a similar rate of mortgage originations. Households with a loan to income ratio of 550 to 800 percent gained 2.88 points of mortgage originations. If broken down, we see LTVs 65 percent or lower (+0.64 points), and 66 to 80 percent (+2.24 points) represent the whole increase. The share of loans to households with an LTV of 80 percent or higher remains unchanged
Canadian Home Buyers With More Sane Amounts of Leverage Are Dropping Out
Households with lower amounts of leverage are dropping out of the market. Households with a loan to income ratio of 350 to 450 percent made a 1.13 point decline in the share of originations. All ranges of LTV made a relatively sharp decline — 65 percent or less (-0.27 points), 66 to 80 percent (-0.49 points), and over 80 percent (-0.37). Households with lower loan-to-income ratios typically have higher incomes.
Canadian New Mortgage Composition Change
The change in the share of new mortgage debt issued between 2019 and 2020. Data is grouped by loan to income ratio, and broken down by loan to value (LTV).
Source: Bank of Canada; Bank Filings; Better Dwelling.
Those with the lowest amount of leverage are disappearing fastest from this market. The share of originations with a loan to income ratio below 350 percent dropped 5.45 points in 2020. The LTV breakdown: 65 percent or less (-1.81 points), 66 to 80 percent (-1.97 points), and 80 percent (-1.67 points). These are typically households with the highest income.
Mortgages aren’t just deteriorating in quality due to the size of leverage. The market is also seeing highly leveraged borrowers making smaller down payments. This not only increases the probability of them not being able to pay but helps to push prices higher. If you’re willing to have a smaller share of equity, prices can expand even further than they have.
Can you blame them? Canada just paused mortgage payments for anyone that asked. There was no income qualification, just an offer to take a break from paying for your shelter. Households most likely think this is the new normal, regardless of what happens. Risk is dead. Long live risk.
Like this post? Like us on Facebook for the next one in your feed.
I believe it was RBC that said they’re no longer going by LTV, since it’s inflated and will be a poor predictor of how much equity borrowers have.
Reading between the lines, they’re safeguarding against a drop in LTV to make sure they’re protected. If they’re watching out for an LTV drop when their book is mostly 65% or less, buyers should be careful.
I’m not saying don’t buy to be clear, but if you do make sure you have sufficient room to ride out any downturns. You may not default, but being forced to sell is the fastest ticket to screwsville.
Forced to sell aka stealth defaults. In Canada you don’t default, you just lose a bunch of money and someone else buys it. It’s not as illiquid as parts of the US. LA and NYC also had low foreclosure rates during the market bust. That doesn’t mean people didn’t lose money.
Why do we let CMHC continue to make record profits and not lower the CMHC fees for the first time home buyers .
… greed from all the banks.
CMHC raise the qulfactions during the pandameic. Not one objection from our provincial or federal representatives.
Property usually goes up, but when it doesn’t it’s a nightmare. I remember the stress my parents faced getting in over their heads. Dad thought we were going to be millionaires (more like $100 millionaires in today’s dollars. Then 1990 came, and then no one wanted to talk about property.
it went from, “nice weather, the house down the street just listed!” to “don’t talk about home prices”
Live your life, and buy a home, but make sure you’re not speculating. Even if you think you’re not, evaluate how you REALLY feel about it. It won’t make much of a difference in 20 years. It will make a big difference if you were planning on selling in a few years to “ride the property ladder”
Bank doesn’t care. Over 80% LTV it’s the taxpayers issue. Line up kids. You’re all getting a loan for less than inflation.
Ever wonder why insured rates are almost 50% cheaper than putting 20% down? It’s cheaper to borrow 500k when you put 5% down than 20%. Now ponder how screwed up that is.
Can you expand on this?
I’d love to see some data around this actually happening…
Yes, it is very screwed-up. Think about it. People who are broke and have no money are driving prices higher. While people who have a decent down-payment can’t afford high prices and get nailed with a higher interest rate.
Is this because banks prefer buyers to have insured mortgages incase of default?
As I understand it, the bank becomes responsible for a mortgage if the buyer puts down more that 20% to avoid paying the insurance.
The government needs to get out of insured mortgages. If the private industry wants to take on the risk of LTVs above 80%, go crazy. Right now they get all of the profit, and taxpayers are only looped into the risk.
Just be glad you don’t have negative gearing to place a reward on bad business speculation for housing.
I agree with David on this.
Some of us wonder what the heck the gov is doing insuring mortgages in the first place…..
I really enjoy your articles.
I believe in a nutshell credit for housing is too easy and I believe this is the main cause of our current situation.
This mess is 35 years in the making.
We should go back to qualifying mortgages with only one income and 15 percent of that income should be used to service the mortgage.
But if these rules are enacted we’d have a disaster literally overnight
It’s always been the credit. Even if it’s the money launderers, it shouldn’t have been so easy for regular people to compete with them. Even if it’s foreign capital, locals were still being lent more and more to chase the prices. Every solution with this government has been, “that’s not a problem I won’t let you pay for with i come you’ll make 20 years from today.”
I would like to see more discussion from a cash flow perspective. Say, the broke person/family with minimum
income and low downpayment is paying rent approx 1600 – 1800 $ for an apartment. If he can afford a mortgage with insurance and gets a low rate of interest where he is rent payment equivalent changes to a mortgage payment, the idea of buying becomes attractive vs renting. There’s also the prospect of home values heading higher because the bubble was never allowed to actually break in the past. That combined with easy exit options like right of sale make the whole process a more rational decision for buyers, even the broke ones. Would love to hear your take on this.