Canada's Subprime Problem

The Globe and Mail broke this story. Canada's subprime problem appears to be a West coast thing, B.C. and Alberta in particular. But when I first saw the headline on the front page of Saturday's Globe and Mail, I panicked. I'll tell you why.

The term "Subprime" is being thrown around a lot, so I want to take some time and elaborate on this topic. Subprime refers to loans made to people who have bad credit. The term comes from the lender’s perspective. A “prime” borrower is a person you give your most competitive interest rate to. Everyone else is sub-prime, so they receive a relatively unfavourable rate. As a result of profiling as higher risk clients (bad credit history, or unemployed, etc), these borrowers must go to subprime lenders in order to finance their houses or cars. In exchange for receiving these loans, the lender needs to be compensated for higher risk, which results in sometimes outrageous interest charges.

One of the additional quirks to subprime lending is that they don’t verify income or assets as strictly as normal banks do. A normal bank in Canada has to verify and record how much money you make, and what assets you own, in addition to checking your credit rating. Subprime lenders got themselves, and everyone else, in trouble by ignoring the standard procedures.

On a loan-by-loan basis, the subprime lending business comes with it's fair share of foreclosures and defaults. But believe it or not, the business model is sound. If they set their interest rates correctly, they stand to make money on the loans overall. The basic idea is that the extremely high interest paid by 90% of their clients will offset the 10% that default.

In the Globe article, they briefly discuss the business model. They discuss how if the price of a house keeps going up, even when people default, the banks can flip the house for a profit. Subprime lenders were leaning heavily on this. Having a profitable backup plan meant they could be more aggressive in issuing loans. They did this by easing up on the standard procedures even more. In turn, the rate of default was increasing. But there was little consequence, since the housing market was so hot. This aggressive style of lending was employed in booming cities. Places where real estate agents would preach, "Housing prices haven't gone down in 40 years!"

Around the same time, Wall Street was devouring mortgages from all sorts of lenders in the US. They were purchasing mortgage loans, aggregating them, packing them up and selling them as Mortgage-backed securities. At first, Wall Street purchased the safer ones, but by the end of it, they realized nobody was really looking at the quality of the loans, so they started to sprinkle in some of the subprime stuff on top of the good ones. At the root of it all, no matter how complicated the transaction became, there was an underlying assumption that housing prices would continue to rise.

The entire investment community was acting on it as if it were a fact. With access to Wall Street, subprime lenders no longer carried the traditional risk of lending. In fact, with Wall Street taking the mortgages off their hands, they really didn’t have to do any sort of analysis anymore. It allowed them to indiscriminately issue mortgages - no background checks necessary.

Subprime lenders, who were inherently in a risky business, woke up one morning to find the risk was all gone. It was no longer their problem if people went into default. No more math exercises for the accountants of trying to balance interest rates with foreclosure rates. They went from banks to salesmen overnight.

Which brings us back to the article. The Globe gets on Harper for failing to acknowledge the subprime problem we have. But honestly, Canada got off easy. The subprime problem is so far spread in the US that they’ve literally killed their banks. You might come across the term "Zombie Banks," which are banks that are financially dead, but being kept alive by government bailout injections.

We can rest assured that our financial institutions won't come crumbling down because of these loans. You'll notice it was American subprime lenders coming into Canada. That means one half of the problem is theirs. As the article notes, we've got a lot of regulations in Canada that don't let you transfer the risk that way. Actually, we have housing insurance, which means an independent third party is now financially vested in home owners paying their loans back.

Yes, we must fix Canada's half of the problem – we must find solutions so people can keep their homes in B.C. and Alberta. And yes, we shouldn't be ignoring this, we should investigate immediately the extent of troubled home owners because of American subprime lending. But given what’s just happened to our neighbours to the south, and the fact that we didn’t actually have any true protection from American subprime lenders infiltrating our mortgage markets, I was actually relieved when I finished reading the piece. This is a nice problem to have.