A recent report in the Globe & Mail highlights the lending practices with respect to foreign buyers of Canadian real estate. Reading this article is very disturbing. It claims that there is an unwritten bias towards high net worth foreigners who can qualify for mortgages that Canadians would not qualify for. The underwriting guidelines are structured around the ability of these buyers to provide significant cash down payments in order to qualify for a mortgage.
I find that the allegations made in the article are not terribly surprising. I would express the view that there is little in the way of a solid regulatory framework in place to monitor the activities of the Canadian banks with respect to mortgage lending to foreigners. I am not entirely sure why. But no doubt these jumbo mortgages for large amounts are attractive assets for the banks. Otherwise, why would they bother?
The exemptions appear to be designed to attract citizens of foreign countries and newcomers to Canada as clients by making it less onerous for them to obtain and build credit here. Canadian applicants must still prove their sources of income. Critics say that puts locals at an unfair disadvantage and inadvertently encourages real estate speculation by foreigners who have easier access to credit.
Scotiabank said in a statement that it employs heightened due diligence “in other areas” to compensate, such as full appraisals for all properties. It confirmed that this is an exception from its standard policy for income verification.
The Scotiabank fallback on full appraisals is simply an example of “papering the file”. Appraisals are simply an estimate of the fair market value of the asset being financed. It has nothing to do with the borrower’s ability to fund the mortgage payments. That would require a full review of the borrower’s sources of income, which is a step that the bank actually skips.
This plays into the narrative of the Canadian banks on mortgage lending. You’ll see many comments on how the banks are fully secured on their loans. These statistics are frequently rolled out to support the contention that the Canadian banks are prudent in their lending policies in that they can withstand a dramatic drop in real estate prices without fear of loss. The problem is that when real estate prices drop, they will drop materially. It is not a given that the banks will be able to unload these assets in an orderly market at that time at predictable prices.
This is a serious valuation problem when you look at the balance sheets of the Canadian banks. If and when real estate markets drop, there is no certainty as to what the values will be at that time. The 35% cushion may or may not be adequate in a scenario where the market takes a dive.
The Canadian banks are not in the business of managing and liquidating real estate assets. They should be in the business of lending on a prudent basis to fulfill their fiduciary responsibility to depositors. Cash flow is king and asset values should represent a secondary level of protection, not a primary level. In the event that the mortgage holder cannot fund the payments, there is no way of knowing whether the lender will be left whole even at the level of 65% loan to value.
It’s very lenient,” a loans officer from one of the major banks told The Globe. “The foreigners can just get a wire transfer to cover the year’s payments [to qualify] or even borrow money from a friend or a relative to put money in the account temporarily.
Needless to say, these kinds of lending practices will fuel the fires of speculation. If you have little real equity in the deal, you are not seriously at risk. For many, one year’s mortgage payments is a pretty efficient way to play the market when there is an 18% gain in real estate values year over year. The return on equity is enormous.
The federal regulator overseeing Canada’s banks sent The Globe a statement, stressing that banks must attempt to confirm income sources – for all mortgages.
“Whether the borrower is foreign or domestic, OSFI expects that institutions will take reasonable steps to verify income,” said a statement from the Office of the Superintendent of Financial Institutions.
In a strongly worded letter in July, OSFI told banks that rapid rises in the prices of houses in Vancouver and Toronto call for increased diligence because of the risk of defaults if and when “economic conditions deteriorate.”
The regulator made it clear it knows income verification is lacking for non-Canadian clients and it urged lenders to be more thorough.
“Inadequate income verification can adversely affect the assessment of credit risk, anti-money laundering and counter terrorist-financing (AML/CTF) compliance,” it said. “Borrowers relying on income from sources outside of Canada pose a particular challenge … Income that cannot be verified by reliable well-documented sources should be treated cautiously.”
As to why this policy is not vigorously enforced remains an open question. If this is the policy, why do these lending practices continue?
There are many unanswered questions here. But this is starting to bear a remarkable resemblance to what went on in the United States prior to 2008. Hopefully, I am wrong about this. Time will tell. But it seems that more and more information is coming out that would lead a reasonable person to conclude that all is not well.