Sub-prime credit crunch in U.S.

Based on the Canadian Real Estate Association’s  third-quarter MLS® results, sales across Canada are still very impressive and reflect an economy that is performing extremely well. Seasonally-adjusted transactions posted the highest quarterly level in London-St. Thomas, Ottawa and St. John’s. Centres with the second highest sales on record included Regina, Winnipeg, Toronto, Kitchener-Waterloo and Montreal.

On the other hand,  there is bad news coming out of the U.S. where the housing market is declining and home prices are falling.

The following was prepared by CREA to answer questions about the credit crunch south of the 49th parallel. According to CREA,  what is happening in the U.S. cannot happen in Canada because of a different set of market factors coming into play.

Question: What is a sub-prime mortgage?

Answer: It’s a mortgage given to a home buyer with less than perfect credit, or a home buyer who lacks the paperwork to prove an income that can support the mortgage payments. While these mortgages may not seem like a good idea to begin with, lenders in the United States with liquid assets, or investment money were making loans to almost anyone who asked, and charging a little more interest for these “riskier” loans. 

The assumption was that constantly rising house prices in the U.S. would compensate for any lending mistakes. The companies doing this included specialty finance firms such as American Home Mortgage, which filed for bankruptcy in August 2007, as well as big well-known banks such as HSBC PLC.

By June 2007, more than 21 per cent of U.S.mortgages were sub-prime compared with only five per cent in Canada (all Canadian mortgages are insured).

According to the Canadian Bankers Association, a record low number (0.24 per cent) of Canadian mortgages were in arrears by July 31 this year.

Question: How did this U.S. lending crisis start?

Answer: When U.S. housing prices started to slide and U.S. interest rates began to rise, many mortgage borrowers ended up in trouble and defaulted. In turn, mortgage lenders started to run into troubled waters as far as their profit statements were concerned, and a number have gone bankrupt or have closed.

Many of the companies making the sub-prime loans were selling the loans to other companies, such as hedge funds and pension funds which sought still higher profits. Often, the loans were packaged together (a lá mutual funds holding thousands of individual loans) and sold to investors.

As more and more consumers defaulted and the mortgage loans started going bad, suddenly many people across the financial world were affected.

Concerned about losses, investors and lenders started demanding higher interest rates to make loans, or stopped making loans entirely. That initiated the credit crunch.

Question: What is the commercial lending paper referred to by the media as part of the crisis ?

Answer: Commercial paper is short-term debt issued by companies, usually coming due in under a year and often in as little as a month. The buyers of these “papers” tend to be institutional investors, including money-market mutual funds or low-returning funds where investors invest in the belief that the money is safe. As a result, only highly rated companies with strong balance sheets can generally issue commercial paper, limiting the size of the market.

But because of the demand of the growing fund industry for more commercial paper, financial companies, such as American Home Mortgage and National Bank of Canada, set up trusts that issue commercial paper backed by assets such as car loans, mortgages and credit-card receivables. This asset-backed commercial paper alone is estimated to be worth $120 billion. About two-thirds of that paper is sold by trusts run by banks and that segment of the market is holding up. Approximately one-third, or $40-billion, is issued by trusts created by non-bank financial companies, such as American Home Mortgage, which could not find investors.

Suddenly money-market mutual funds called into question the validity of investing in commercial paper, backed by assets such as mortgages, when the housing market was slowing and prices dropping. As a result, the trusts can’t find buyers for their paper, leaving them short of cash. They are turning to banks that had agreed to provide loans in a situation where the market flounders, but some of the banks are now balking. 

So far, it’s only a segment of the market that is in trouble and not every money market fund holds paper issued by the troubled trusts.

The confusion over what the sub-prime market is has caused many Canadians to panic unnecessarily. They think the so-called sub-prime crisis in the United States will spread to them because their mortgage is at a floating rate below the bank’s prime lending rate (hence sub-prime)

In March 2007, one of every eight U.S. sub-prime loans was in default. It is projected that this number will double by June 2008.

Question: How is all this affecting the U.S. housing market now?

Answer: Consumers in the United States are finding mortgages have become more expensive and tougher to get, and that has had an impact on housing sales. Sub-prime mortgage lending has all but disappeared, eliminating a level, or layer, of higher-risk consumers who had been active in the real estate market. 

In essence, tougher credit terms are slowing purchases and that is slowing the economy and hurting the stocks of companies involved in lending or in housing. That includes home renovation, builders and furniture retailers — the impact reaches into various aspects of the economy.

Unlike the U.S., the Canadian housing market has not been artificially driven by bad lending practices. Our long-term fundamentals are solid. Canada has a growing population. Our energy and commodities are in high demand and job creation is strong. Consumer confidence remains high. 

However, there may be an impact on the overall Canadian economy, which may affect the Canadian housing market. For example, the drop in housing starts in the U.S. will mean lower demand for Canadian softwood lumber products.

The MLS® sales forecast, published quarterly by the Canadian Real Estate Association, indicates that when these economic factors are taken into consideration, 2007 will represent a record or near-record year for the sale of resale housing in Canada, although the pace of sales is projected to slow in 2008. 

The detailed MLS® forecast is available at the website