Bank Lending Policy Initiative by MOF

Loosen your purse strings, Canada tells banks

OTTAWA (Reuters) - Canadian Finance Minister Jim Flaherty delivered a blunt message on Wednesday to the country's banks, telling them to loosen their purse strings and summoning them to a meeting to press the point.

"There is evidence now of a constriction in credit in Canada, not only for smaller businesses and for families, but for larger businesses. So this is something that we are going to continue to address with our financial institutions. In fact a meeting is being set up now," he told CTV television.

"We expect our banks to make lending available, to have credit available and affordable in Canada. We're acquiring a lot of their mortgages ... up to C$75 billion worth. We've given a guarantee with respect to some of their obligations. So this is a two-way street. We expect credit to be available through our financial institutions."

I have had many borrowers ask me why it seems so difficult now to obtain mortgage financing, despite the fact that the official policies regarding loans haven't really changed very much over the past few months - yet loans seem virtually unavailable no matter what the applicant presents in terms of qualifications.

Anecdotally I have been told by a loan manager for a local community credit union that the credit union hasn't made a new mortgage loan since May of 2008, six months in total. The real estate market in that community is completely dead,and last month there were only two sales in the entire community.

So do you think that these items are related? You bet they are. Banks and Credit Unions claim that their lending policies haven't changed... but they aren't lending money.

What the Minister of Finance isn't saying, is that the banks are actually directly creating the current economic crisis in Canada, even though there was no crisis until they made one! The real crisis in confidence is NOT the consumer but rather tha corporate elite at the banks, who no longer trust each other or their institutions. Bank Paper is not considered worth the paper it is written on, or the electrons used to count it. The feds have done their share all around the world. It is time for the banks, worldwide, to get over it... and do what they need to do to begin lending money again.

If they don't this recession will go from a serious recesssion to a full blown world wide depression, the end of which will be uncertain at best.

And it will have been created almost entirely by bankers, because they don't trust each other. At some point these people need to be held accountable for their completely irresponsible behavior. It may be bad banking to make loans in an environment of uncertainty, but it is bad citizenship to withhold credit from the entire world because of corporate cowardice.

Mixed Messages

It's been a whole month since my last blog entry on mortgage investing. The reasons for this are many but the biggest reason is that the fall is traditionally one of my biggest seasons of the year for private mortgage investments. As a result I find myself extremely busy dealing with new investments in mortgages and MICs by investors, and have found it difficult to find the time to contribute to this column.

In addition, of course, I also had to serve Jury duty in a trial in BC Supreme Court, which was interesting, if you consider "interesting" to be a pejorative. Twelve ordinary people come together to decide the fate of one of our fellow citizens, whether or not he is guilty of the crime of which he is accused. Human nature being what it is, I was amazed that we all managed to agree on a verdict, despite much discussion about the merits of the case during deliberations. I hate the jury system, but I still think it is better than allowing the experts to decide our fate as citizens.

Now, back to mortgage investing.

2009 will go down as the year of the great world-wide financial crisis, the likes of which few of us have experienced in our lives. According to all the economists there really has been nothing like it since the great depression.

This crisis was triggered by the US sub-prime mortgage collapse, and, quite frankly, incredibly incompetant lending practices south of the border. Unfortunately it didn't end there, as the underpinings of whole international financial system have ended up coming under assault as a direct result of a profound lack of trust in the system itself by the very people in the heart of the system.

When banks won't or can't lend money to other banks, financial liquidity dries up in a hurry. Much of the efforts of the various national governments and central banks around the world are doing everything they can to restore faith in the system, not so much in the minds of ordinary investors but rather in the hearts and minds of the major players in the industry.

There has been a lot made lately of the failure of the US regulatory agencies to control the conduct of US Banks, and there is probably a significant amount of truth to the criticism. However, the challenge is not merely about regulation and control, but rather more fundamentally - if nobody understands the investment products they are buying or selling, how can faith and trust ultimately be earned and maintained. A significant part of the failure of the international financial system has been the undermining of sophisticated financial products like derivatives.

This should not be taken to suggest that more sophisticated products shouldn't be bought or sold, but rather there needs to be more transparency and a better job done of disclosure of these complicated financial products. The banks who rely on these instruments to provide fundamental security for their loans need to be able to rely on the ratings assigned and on the disclosure filings as to the nature of the risks being undertaken when they invest in those instruments.

High risk investments are not necessarily bad investments, they are simply investments that require a risk premium appropriate to the amount of risk and type of risk. They should also represent only a portion of a balanced portfolio rather than a primary portion.

I've never criticised my relative who goes to the horse races ever Thursday and "invests" fifty bucks in his favorites of the day. Some days he wins, although mostly he doesn't. So this investment is extremely high risk, but once in a while he wins enough to make the whole exercise worth every dime. Those nights are great.... we all go out to dinner to celebrate his success as a gambler. However, if he started to gamble his nest egg, set aside for his retirement, I would be most concerned.

Of course, I found it equally perterbing when I realized that his investments in blue chip mutual funds were almost as risky as the race track.

Years ago I began to move out of stock market based investments into secured investments or real property. Yes, real property does go up and down. Just like stocks in the public markets. But there is a fundamental difference - real estate will always retain real value over the long run, as opposed to the stock of any given company, which has at least as good a likelihood of disappearing completely in 15 to 25 years as it does of thriving.

You want proof? Check out the names and positions of the top 1000 US listed companies in 1990 and see how many of them have completely disappeared in 2009. There are no properties that have fallen into the sea since 1990, and most have increased in value at a pace at least equal to the rate of inflation in the intervening period.

Real property and security based on real property, if managed with a degree of caution, will protect an investor for the long run. In the short run you can easily lose your shirt if you make a bad investment, or leverage your capital at the wrong time and in the wrong market. However, in the real estate world, time is generally your friend.

Just remember this - subprime mortgages in Canada have a default rate of less than one half of one percent. A portfolio made up of Canadian mortgages, even subprime mortgages, will have made money during the past twelve months during this market meltdown. There is few other investments that can make the same claim.

There are few guarantees in the world, especially in the investment world. But there are reasonable ways to mitigate risk, including lending in strong real estate markets in a stable country with good prospects.

And being persistent and patient enough to see the investment through.

Final Mortgage Insurance Guarantee Parameters

Those of you who are following this blog may remember my tirade a few weeks ago about the changes to CMHC insurance rules, particularly in regards to fixing a minimum credit score at 620 and removing all discretion from lending institutions in working with people on the "bubble" as it were.

The following is extracted from an email delivered to me by the Canadian Association of Mortgage Professionals in regards to this issue which answers a number of these issues.

On Friday, September 19, 2008 the Department of Finance issued its final
mortgage insurance guarantee parameters and accompanying explanatory notes.

The final guidelines follow the initial announcement on the
financial
guarantee for mortgage insurance providers issued July 9, 2008 by
the Department
of Finance.

There are two noteworthy changes from the draft parameters:

1. Elimination of reference to a Total Debt Servicing (TDS) number, replaced
by a
principles based approach;

2. Reduction in minimum credit score to 600 from 620. Three percent "basket"
for flexibility remains;

These modifications follow discussions with stakeholders, including CAAMP.
CAAMP through its submission focused its comments on the minimum credit score
and welcomes the decision by the Department of Finance to adjust the credit
score. For more information on the mortgage insurance guarantee parameters click
here for Schedule A and click
here for Schedule B. All of these changes come into effect October 15,
2008.

If you have any questions please contact jmurphy@caamp.org; 416-385-2333 ext. 31Jim Murphy, AMPPresident & CEOCAAMP/ACCHA

This is an example of how concerted effort on behalf of an industry can help to protect the public from a poor legislative or regulatory change.

More importantly, it leaves the job of evaluating credit risk in the hands of the industry as a whole, justifiably in my opinion, given the record of the Canadian credit granting industry in maintaining stability while the rest of North America goes to hell.

Stormy Weather - Any shelter in a storm?

Those of us who grew up on the west coast know all too well that when the weather gets really nasty, when you're out on a boat on the ocean, that it's a good time to head for a safe harbour. Preferably one where you can get out of the wind and waves, behind a solid breakwater if possible.

Well, the world economy is certainly going through a major storm these days, with the storm centred in the US Financial services meltdown as a result of the mortgage crisis.

Some investors are choosing to move to cash investments, others to precious metals, like gold. Both of these strategies are a little like adding ballast to the boat, stabilizing it but not really helping you get where you want to go. Holding cash or near cash investment is a sure fired way to go backwards against inflation and shrink your capital base. Holding gold is probably as high a risk as holding stocks right now... after all stocks are at historically low values and gold is at the top of its cycle of prices...

Actually the ballast in the case of gold might actually sink your ship... to carry the metaphor further.

Anyone who follows this blog knows that I am a big believer in mortgages and Mortgage Investment Corporation investments, because of their inherant stability and underlying security. Like all investments mortgages do require diligent review and careful allocation of funds, in addition to common sense lending (something not practiced in US backed subprime mortgage market previously).

But mortgages do represent a relatively safe harbour in an economic storm, with security based on something that every investor can understand... a home where the borrower has something real to lose in the way of equity.

AIG Bailout - Will they sell AIG Canada?

AIG Canada is one of the most secure investments in the AIG universe with strong Canadian government guarantees behind it. If the US government managed its mortgage industry the way that the Canadian government has, the US wouldn't be in the total mess that it is...
Both McCain and Obama are promising to increase regulation of the financial services industry after this mess.... sounds all too familiar... the leaders promised the same after the Savings and Loan screw up... leading to this???

I think it is unlikely that the US government will make sensible changes in the rules... in an environment with such strong state rights... including the right for any state to make stupid.

Price and Volume Changes in Canada

Headlines in the local papers in Vancouver this week were screaming about a decline in prices on sale of homes in Greater Vancouver of approximately 4% since the spring, and an increase in new listings of an alarming amount.

Excuse me. One of the things that drives markets, of course, is media speculation about the current trends in the market. Sometimes it seems to me that there are those in the media determined to create a real estate crisis even in the absence of one. New statistics from the Canadian Real Estate Association indicate a decline in the volume of sales from last year to this year, along with a significant increase in new listings. But the numbers hardly indicate a crash in the market across Canada, or even in British Columbia, with an increase in average sale price to the end of July of about 8% over the past twelve months.

I caution anyone thinking of buyer or selling to be careful and think for themselves.

Anyone who thought that the real estate boom of the past few years would continue indefinitely, without pause, hasn’t been around very long. It has already been a very long positive market, and it is time for a market pause or even correction. The question at the end of a long boom is how severe the correction might be.

I leave you with this thought. Residential vacancies in Greater Vancouver are less than 1%. Unemployment is at just over 4%, and is stable, despite rapidly increasing populations. Does this sound like a bubble? So when prognosticators tell you that the market here is going to hell, take their opinions with a grain of salt.

Issues in Mortgage Underwriting for Mortgage Investors

Technical Discussion – Strata Ownership in BC

One of our brokers approached me the other day with a question about a self-managed strata corporation in Richmond –

“I have a client with a Strata Townhouse in Richmond who wants to take a mortgage. But they have one of those 'self-managed' strata committees, ran by all of the owners themselves. Is this insane? Is it legal?? There are strata minutes available, but no financial statements. There is also no contingency reserve. Dumb question - Is this safe for a private lender to lend against a building built in 1984 that has proper insurance but no contingency fund? How can they protect themselves? “

The broker obtained a legal opinion on the deal, after verbally discussing it with me, and this is what the lawyers said,

…Self-managed stratas are more common than I would like… As for the Contingency
fund (CRF), the Strata Property Act requires them to keep one, and for good reason. Insurance covers some catastrophic situations, but a myriad of others would leave the owners (and more importantly, the lenders) high and dry - from the basic replacement of pipes, to the building envelope issues we see so much of. Add to that that some lender, or owner might get antsy that there is no CRF and petition to court to appoint an administrator to run the strata, effectively putting control in the hand of a bureaucrat.I would strongly recommend against such a loan.[i]

This got me thinking more generally about issues related to strata corporations, and the implications for lenders, investors and underwriters. A recent report by the Vancouver Island Strata Owners Association (“VISOA”) raises a number of issues arising out of current legislative deficiencies, and proposes remedies in a new Act or Acts governing various aspects of the issues.

There are a large number of issues addressed by the VISAO report, and I’m not going to attempt to address all of them, especially since a number of the issues are primarily related to deficiencies in the Acts that relate to the owners of the strata units or bare lots, not all of which directly impinge on a mortgage interest. Unfortunately most of them do, as the legal interests of a lender are derivative, that is, they are derived from the rights of an owner established under the various acts.

Strata or condominium ownership has grown to 25% of taxable properties across British Columbia, with there now being 460,000 individual strata units. In several large urban areas, strata homes now account for 50% of all taxable properties. Growth in strata homeownership is expected to continue as land prices increase and efforts are made to reduce the “environmental footprint” of new housing.[ii]

In many urban areas such as the Lower Mainland and southern Vancouver Island strata ownership is becoming the de facto standard form of housing for most new homebuyers, indeed the vast majority of home ownership in the next twenty-five years will likely be strata titled property. Increasingly, for lenders, there will be little choice but to invest mortgage dollars into strata properties, as there will be few opportunities otherwise, especially for private mortgage lenders who tend to lend in situations where banks are unwilling to do so.

The Strata Property Act (SPA), the Real Estate Development Marketing Act (REDMA) and the Real Estate Services Act (RESA) affect strata homeownership. Although the RESA and the REDMA are relatively recent (2004) creations in response to concerns of the real estate industry, no public review of strata legislation to address homeowner concerns has occurred since 1998. In the meantime, other provinces have moved ahead with legislation to address emerging concerns in strata (or condo) homeownership. In 2003 the BC government recognized there were significant issues with the SPA and committed itself to a review. This review has not occurred.

VISOA has identified many deficiencies in transparency and accountability under current legislation and has categorized them under the topics of:

A. Strata Governance,
B. Strata Management Licensees,
C. Disclosure,
D. Strata Development Approvals,
E. Property Taxation,
and
F. Strata Fee Equity.

The areas which primarily are of immediate concern to lenders are: Strata Governance, Strata Management Licensees, and Disclosure. Although there are serious issues related to Property Taxation and Strata Fee Equity are also of some concern to ownership, they are of less relevance to the vast majority of mortgage lenders as they do not directly affect the quality of the security on a mortgage loan placed on a strata title.

Strata Governance

The complexities of shared ownership and mutual obligations among individual owners and their corporate body require relevant knowledge of the Strata Property Act and simple, direct and affordable access to due process for enforcing the Act and resolving disputes. Current legislation provides for only cumbersome, intimidating and expensive judicial, arbitration or mediation processes to administer the Act. It effectively indulges irresponsible actions and leaves disputes unresolved.

The main concern for a lender here is the derivative consequence of unresolved or irresolvable conflicts related to the maintenance and/or repair of common property held by a Strata Corp. Because there are requirements that a Strata Corporation must obtain 75% approval for any significant expenditure, including substantial maintenance or repairs, a council with reluctant participant with over 25% of the votes at an annual meeting may find itself unable to make corrective investments or even to repair serious damage to a building. The owners may have a remedy, by suing the corporation, to force necessary repairs, but there is no efficient mechanism by which an owner can enforce responsible conduct by a strata council, especially one where irresponsible members form a substantial minority of the votes (ie: over 25%).

The mortgage interest in a property can be seriously damaged if the quality of a building declines through deferred maintenance or damage that is not repaired. The lender has little or no leverage on the owner to force the strata to take action. To whatever degree the owner is handicapped in enforcing responsible behavior by a strata corporation, the lender is even more vulnerable in that the lender has even less in the way of access to due process than does the owner.

And while the law requires the strata corporation to maintain a contingency fund to pay for repairs and other liabilities of the strata corporation, in the event that a strata council doesn’t set fees high enough to ensure an adequate fund, there is little that an individual owner can do to force the council to do so.

This is one of the reasons that a lawyer would be doubly concerned about a self-managed strata corporation. In the absence of a professional management company there is very little way for an owner (or the lender) to even know that there is a problem regarding the strata council and its conduct in maintaining and protecting the ownership interest.

There is no requirement for audited annual financial statements from the strata corporation so there is no way to know how adequately they have been reported. The preparation of Form 9 disclosure statements by self managed strata corporation is necessarily a function of the elected executive of the strata council. There are no consequences of misreporting or under reporting of potential liabilities against a strata property. The law provides a form of disclosure that requires certain behavior but does little to enforce it.

Lenders (and their lawyers) are understandably nervous about disclosures from self managed strata corporations. Even when there is a professional management company responsible for the strata management, there can be no guarantee of fair, plain, and true disclosure necessary for the registration of a proper security interest. Strata corporations rank with governments in obtain position on title for any obligations of a unit holder to the corporation. Failure to fully disclose potential liabilities to a lender may open a manager to legal consequences for failure to disclose, but practical remedies that do not include suing third parties for negligence do not exist.

Lenders also have no way of knowing when a strata corporation is getting into trouble, either as a result of deficient property management practices and deferred maintenance, or as a result of structure problems, i.e.: leaky condo syndrome.

These problems, and others, which arise out of a fundamentally flawed set of legislative Acts, can ultimately only be resolved by legislation designed to address them. Lenders, on the other, can’t wait for a pie in the sky solution but rather have to take measures to protect themselves.
Which is one of the reasons why many lenders, including private lenders, are seeking independent inspections on all strata mortgages where the strata is self managed, as well as on any strata mortgage where there are any alarm bells at all arising out of an appraisal or an investor interview done at the time of loan approval prior to loan advance.

While issues related to deferred maintenance, structure deficiencies, environmental hazards are potentially present in all real estate transactions and therefore all mortgages, where title is more complicated and processes for resolutions of disputes more difficult, the risk is exacerbated.
Therefore it would be prudent to obtain a higher level of disclosure on Strata Titled properties during underwriting.

Conclusions and closing thoughts

In regards to private investors making direct or indirect investments in strata mortgages, it is important during the review of an investment opportunity to comfort yourself as to whether or not a strata is managed by a professional management team, or self managed; and, either way, that there is an adequate contingency fund as well as a well planned and self-evident maintenance program for the whole strata building. Look closely at the appraisal for any evidence of deferred maintenance or potential deficiencies arising out of the design or execution of the design of the building in the first place. Have your broker talk to the borrower, and see if they have any concerns about the property.

At the end of the day, if investors are going to invest in mortgages, which are still one of the safest and most secure investments available in the marketplace, it is important that investors be aware of any potential risks, and the scale of those risks.

In the case example given at the beginning of this blog, clearly the lawyer is correct. Not only is the property self managed (an alarm bell all by itself, not necessarily fatal, but still of concern) but in the minutes of the strata meeting the disclosure of no contingency fund and some deferred maintenance, combined with an unwillingness to increase strata fees to cover necessary repairs would disqualify this strata unit owner from obtaining a second mortgage. It may also prevent the unit owner from refinancing if these deficits are not remedied within a reasonable period.


[i] This initial quotation is a quotation from an email exchange between a broker and our office.
[ii] All other references in this blog are to a report - Ensuring Transparency and Accountability in BC Strata Developments May 2, 2008, Vancouver Island Strata Owners Association - http://www.visoa.bc.ca/static/VISOA%20Report%20on%20Strata%20Legislation%20Issues%20-%20May%202,.pdf