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The soaring price of homes in Vancouver, Toronto and Calgary is pushing mortgage lenders to devise ways to cut the initial cost of a first house or condo. Lenders, recognizing that we are in the middle of what could be a price bubble, have also been inventing ways to reduce the risk that a decline in house prices may leave an owner with a debt far in excess of the value of the property.
The two concepts got started in Britain. Advantage, the U.K. mortgage finance unit of the American investment bank Morgan Stanley, recently introduced what it calls Flexishare. The principle is simple: the buyer gets a reduction in interest rate on a part of the loan and, in exchange, a part of the loan goes up or down with changing house prices. If the house price falls, the owner owes less. If the price rises, he owes more. He can afford the added debt. After all, he is wealthier, at least on paper.
Morgan Stanley’s concept is right for the times. British house prices have risen 184% since 1996. The company figures that the long-term trend of property prices should help it make more money. Yet house prices do fall. Since 1996, Hong Kong house prices are down 44% and Japanese house prices are down 31%. But don’t worry about Morgan Stanley. It can use a variety of hedging techniques to ensure that even if house prices do fall, it will come out loss-free.
Mortgage lenders say that some versions of these lending innovations are bound to come to Canada. Property loans that are charged both to income as straight interest and to a company’s balance sheet are commonplace. In residential lending, the concept is familiar: the more you amortize and carry on your balance sheet, the less interest you pay per month.
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What is driving the lending market now is the incredible rise in house prices. Jim Murphy, senior director of Government Relations and Communications for the Canadian Institute of Mortgage Brokers and Lenders, says, “Yes, some of these innovations will come here. We already have amortizations as long as 35 years. Canada Mortgage and Housing Corporation also introduced interest only mortgages this summer.”
Every innovation in mortgage lending speaks to the problem of affordability, Murphy says. The average house price in Vancouver is now $500,000. In Toronto, it is $375,000. There have to be new ways of financing houses if first-time buyers are to be able to get into the market.
The mortgage industry has a history of doing the improbable, Murphy says. “Ten years ago, high-ratio mortgages where you put down only 10% or 5% of a mortgage value were novelties. Today, 5% is common.” In the sub-prime market, where people with good jobs but perhaps not much credit history can get mortgages, lenders charge a couple of per cent more. By historical terms, 2% on today’s 5½% closed mortgage, 7½% total, is still low.” The latest innovation is Scotiabank’s 100% mortgage, backed with private sector insurance. Introduced Oct. 5, 2006, it opens the first-time home market to anyone with a good job.
There is pressure for mortgage products that can relieve nightmares for owners who fear they are buying at the top of the market. Tying the amount of a loan to house prices makes use of the wealth effect. That’s the phenomenon that makes people feel richer and eager to spend when the value of their assets rises and poorer and disinclined to spend when they see their total assets falling.
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In many markets, homebuyers leverage their fate on their homes. In Vancouver, it takes 68% of gross income to buy an average house. In Toronto, it’s about 44%. In Manitoba, it’s a much more affordable 34%. Even in Winnipeg there is a risk that price rises can exceed income growth - leading to an inevitable market-price collapse.
The new mortgage products and the variants that may come to Canada could change the way people finance their houses. For example, in today’s market, many borrowers prefer to take five-year closed terms to get not necessarily the best deal, but the most certain monthly cost for their mortgages. If market interest rate changes cease to apply in full to a mortgage, there is less need to borrow for long terms. Instead, one can float with the market and rely on the insurance devices in the loan to take care of the risks that rates may go higher.
And that, says Brad Bondy, director of research for Genus Capital Management Inc. in Vancouver, reduces the borrower’s risk. Insurance schemes become an incentive to borrow even more money. Indeed, if speculators know that the mortgages that carry their buildings forgive some interest costs if prices fall, they will tend to hold rather than sell if prices seem ready to fall. “It lays the groundwork for a bubble,” Bondy explains.
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