Presentation Transcript

1. The Subprime Mortgage Crisis:A Canadian Success Story

   Jerry Zhao, Melina Lin, Amy Wang
2. Background Us Housing Bubble In the first half of the 2000’s, people rushed to buy houses with low mortgage rates, due to record-low interest rates Investors dropped technology stocks and instead began investing in real estate Many bought homes beyond their means, expecting higher prices in the future Eventually supply far outstripped demand, and prices peaked in 2005 Adjustable-rate mortgages (ARMs) Mortgages where rates change or “reset” at fixed intervals Sometimes offers an introductory rate lower than the market rates Many acquired ARMs in the hope that higher housing prices would allow them to refinance if rates reset to a higher level Subprime mortgages Mainly made for riskier buyers These often featured incentives such as interest-only payments In 1996, subprime mortgages made up 9% of the US home market This figure nearly tripled to 25% by 2008
3. Background MORTGAGE-BACKED SECURITIES (MBS) Securities with housing mortgages as collateral Transfers claims on principal and interest owed to investors who buy the securities As mortgages are paid off, investors receive their share Often split into several risk groups, known as “tranches” Mortgages of similar risk would usually be grouped together Riskier tranches would receive a high interest rate as compensation Because there were so many mortgages per security, it was safe to assume that the majority of mortgages would be paid off Companies which own these mortgages would sell the MBS to investors In order to boost the ratings, the companies would set up “Special Purpose Vehicles”: Puppet companies whose sole purpose is to process the securities They then give all the money to the original company Because the SPV company has no risky assets other than the securities, the securities will get a higher rating These securities routinely received A to AAA ratings This move also kept the security off the parent company’s balance sheets, reducing the perception of risk for the parent company
4. The Crisis In the 2005-2006 period, the US housing bubble collapsed Mortgage defaults, especially in subprime loans, began to soar at this time For the first time, many homeowners failed to pay their first mortgage payment The lenders receive less mortgage payments, and the value of mortgage-backed securities falls As MBS values fell, banks, who had held large amounts, incurred large losses Banks then tightened up lending conditions, slowing down the economy As more people lost their jobs, mortgage and loan defaults occurred in larger numbers, resulting in a larger supply of homes in the market, causing prices to depress even further In Canada, some of the Big 6 banks took losses as the trading of Asset-Backed Commercial Papers due to exposure to the MBS market Banks like CIBC, National Bank, and Scotiabank were hit with massive fines totalling $140 million As the crisis expanded from the US, the forming recession caused a fall in exports to the US The fall of exports eventually impacts all sectors of the economy in every part of the world—even those with no relationship whatsoever to the US real estate market
5. US Home Prices
6. Canada’s performance Canadian banks were relatively unscathed by the subprime mortgage crisis Banks in Canada were not in any real danger of failing like in the US In 2008, during the height of the crisis, the World Economic Forum ranked Canada’s banking system “soundest in the world” Canada scored 6.8 out of 7, followed by 3 countries, with 6.7 There were several instances of foreign banks receiving financial aid from their Canadian subsidiaries Ironically, Canadian banks needed stimulus from the federal government to help them compete with other foreign banks which had received large cash injections and were thus more competitive Canada is not immune though: GDP fell 2% in the first two quarters of the crisis and ensuing recession Canada’s economic well-being contributed to a higher Canadian dollar, which caused major problems for exporters already facing a tightening world market, especially in the US Especially hard-hit was the manufacturing sector (auto in particular), which relies heavily on exports to the US
7. In Perspective
8. Bay Street’s performance
9. Thesis The Canadian banking system suffered less than its American counterpart during the subprime mortgage crisis due to three factors: US government regulations regarding mortgages were less stringent than they were in Canada American subprime and adjustable-rate mortgages were much riskier than their Canadian equivalents, both for the lender and the borrower Other miscellaneous factors: Condition of the banks before the crisis began Brokers lending out money that isn’t theirs to begin with Canadian housing prices didn’t rise as much as in the US
10. US Gov’t Policy—Deregulation In 2004, the SEC made changes to its net capital rule, which allowed some banks to self-regulate The change allowed five large US investment banks to become “Consolidated Supervised Entities,” and shifted the duty of supervising the parent companies from the Fed to the SEC Under the new rules, these CSEs were allowed to utilize money previously held in reserves to fund projects in other departments of the firm The SEC also agreed to use the companies’ own risk-assessment models to calculate risk Because they were being “supervised” by the SEC, the companies were thus exempt from mandatory EU regulation in Europe Role of Freddie Mac and Fannie Mae: In 2004, two government-sponsored companies, Freddie Mac and Fannie Mae were ordered to spend at least 56% of mortgage financing on low-income borrowers and affordable loans The two companies were forbidden in 2000 to count purchases of most subprime loans towards this goal, but a failure to meet the goal meant the restriction was lifted in 2004 In order to meet these goals, Fannie Mae and Freddie Mac increasingly turned to mortgage-backed securities and purchased $175 billion in subprime securities (44% of the market) Fannie and Freddie require private insurance from mortgagees if down payment was below 20%, and they also have relatively high standards for lending Because Fannie & Freddie were not directly buying mortgages, but rather mortgage-backed securities, they could not apply their lending standards to these mortgages Foreclosure: Under US law, lenders can usually foreclose the property and take the settlement The alternative is to spend more time and money suing in court to get their money back
11. Government Policies in Canada Mortgages with less than 20% down payment must be insured Mortgage lenders pay the premium, which is usually passed onto borrower Riskier mortgages sometimes also have to be insured Canadian homeowners cannot freely default The lender will be reimbursed in full by the government and/or other co-owners Defaulter must still pay back debts Canadian banks cannot freely trade mortgage-backed securities Prohibited under Canada’s Bank Act, 1992 Banks cannot trade securities dealing in “ownership interests” Exception is if the security is guaranteed by: A government at the provincial/federal level A Crown Corporation A foreign government or international agency, such as the World Bank Only 24% of mortgages in Canada are traded in securities Those 24% were mainly securitized by the Canadian Mortgage and Housing Corporation (CMHC) with the blessing of the government Canadian mortgages were mostly securitized for liquidity purposes, not to prop up company balance sheets Canadian experimentation with subprime mortgages ended in 2008 when the CMHC stopped insuring these mortgages
12. Mortgage Quality in the USA Homeowners were required to show proof of employment, income, etc. in order to get a mortgage Eventually “Ninja mortgages” became quite popular NINJA stood for No Income, No Job, or Asset Credit score was the only thing required for obtaining one of these mortgages Some prospective buyers were simply told to give their signatures and the date Sub-prime mortgages and other risky mortgages Low interest rates and an inflated housing market caused an increase in these mortgages 25% of the US mortgage market consisted of subprime mortgages, about 80% of these which were Adjustable-Rate Mortgages (ARMs) ARMs “reset” at fixed periods, therefore they often reset to a much higher rate Sometimes this even caused payments to double, as some mortgages had introductory offers of interest-only payments This often made paying the mortgages impossible for homeowners who relied on the introductory offers to get by This was especially the case when rates reset after the initial discount period Foreclosures and defaults Defaults almost doubled for these subprime mortgages Because of legal restrictions against lenders, homeowners could sometimes just default and walk away, leaving lenders with the house—and the unpaid mortgage
13. Mortgage Quality in Canada Variable-rate mortgages Unlike in the US, variable-rate mortgages change whenever the indicator rate changes This meant homeowners were not subjected to sudden price shocks when rates change Subprime mortgages In 2008, Canadian subprime mortgages made up only about 5% to 6% of all mortgages Canadian subprime mortgages are actually closer in risk to American near-prime mortgages Home equity lines-of-credit have remained at a relatively low level in Canada In 2008, the rate of homeowners 90 days (or more) in arrears is 0.27%, down from 0.65% in the 1990s Appraisers in Canada usually give a more conservative value than would be the case in the United States This would in turn lower the quantity of mortgages or reduce the size of those mortgages Canadian banks and lenders continue to check the applicants’ financial background (e.g. Income) Despite the popularity of Ninja mortgages in the United States, Canadian banks still check income and employment, among other information
14. Bank Conditions United States Canada The net capital rule stated that banks had to limit debt-to-capital ratio to 12:1 2004 change cancelled ratio for five investment banks—Bear Stearns, Merrill Lynch, Lehman Brothers, Morgan Stanley, Goldman Sachs None of these five companies still exist in their original form Bear Stearns, Merrill Lynch, and Lehman Brothers collapsed and were bought up Morgan Stanley and Goldman Sachs became bank holding companies, which are more closely regulated American banks are very concentrated geographically, and usually specialize in a certain area (e.g. investments, deposits) As a result of this specialization, many banks, especially investment banks, found it difficult to stay afloat during the crisis Capital Adequacy Requirement: Canadian banks must have asset-to-capital ratio of 20:1 A separate requirement states that total capital must amount to 10%+ of risk-weighted assets All of the top five Canadian banks offer all-round financial services in all 10 provinces The larger banks also have numerous branches in other countries TD bank has as many branches in Canada as in the US Scotiabank owns 2000+ branches in more than 50 countries Royal Bank: 46 branches in the Caribbean, 430+ in Eastern USA, and investment branches across the world This ensures that the banks have a large base (geographical and industrial)
15. Bank assets
16. Whose money is it? United States Canada Many mortgages are handled by an independent broker, who are usually paid on a commissions basis Because they are paid up front, some may try to set up as many mortgages as possible, or set up some large mortgages Since banks often passed these mortgages onto other investors, they did not try to stem the surge of subprime lending Thus the end-holders (i.e. buyers of the mortgage-backed securities) were left with massive losses when many owners defaulted Most mortgage brokers are the lenders themselves Because they are lending their own money, the brokers tend to be more cautious Only 24% of Canadian mortgages are securitized, and even those 24% have all been insured Canadian banks did not “originate to securitize” (Create mortgages solely for the purpose of selling them) Virtually all of the 24% of securitized mortgages were securitized in order to raise short-term cash
17. Housing bubble United States Canada Interest rates: In 2001, the US Federal Reserve dropped interest rates down to 1.75% from 6.5% The Fed then cut rates to 1% by 2003 However, even as the economy began to boom in ‘04, the Fed kept rates low These extremely low rates were one of the biggest factors in the housing bubble Mortgage interest is tax-deductible Many investors fled from the ruins of the dot-com bubble to real estate markets, believing it to be a safer market Lax lending conditions and poor oversight led to an inflated housing market In 2005, home prices peaked at 260% of 1989 levels, then crashed back to 180% Canada was not as affected by the dot-com crisis, and so did not cut interest rates as much Rates fell from 5.75% (January 2001) to 2% by January 2002 Interest is not tax-deductible, therefore removing an incentive to purchase houses Canadian banks continued to check for income, etc. therefore cutting down the potential housing market Since 1989, Canadian home prices have gone up by about 190% then fell back to roughly 180%
18. Conclusion The Canadian bank system took little of the damage inflicted on the American banking system during the subprime mortgage crisis, mainly due to several reasons: Differences in government policies across the border, with Canadian banks held under tighter restrictions The quality of the mortgages was quite different, as American banks took on high-risk mortgages while Canada stayed mostly on the sidelines Canadian banks had more net capital than Americans to begin with, and were better-adapted to survive losses in any one sector American brokers and lenders setting up mortgages and walking away with usually no regard for the consequences Lack of a Canadian housing boom whose magnitude matched that of America’s housing bubble As jobs are lost, the banks and the overall economy will still take some hits Canadian banks were several steps ahead of the competition when the crisis began They can stay ahead of the pack in the future (good times and bad) if they and the rest of the country’s decision-makers follow the example they set