Are You a Sub-Prime Lender?

We have been seeing the turmoil in the US housing market takes its toll on stock markets around the world as banks around the world keep writing down more and more of their mortgage backed securities that dont seem to have buyers regardless of the offering price.

I decided to look at the Canadian market and the Alberta real estate market in particular although the first part of the discussion is national in scope. The federal government recently made changes to CMHC insured mortgages whereby individuals would have to come up with at least a 5% downpayment to purchase a home.

This is significant as this is primarily what got prices out of hand in Canada and drove prices up in the US. Individuals could get into the housing market with no investment and no risk. If housing prices went up, that was great. Individuals now had equity positions that they didnt have before. As we are seeing in the US, when prices go down, people walk away from their houses as the debt exceeds the collateral and their is no incentive to make monthly payments.

If they declare bankruptcy, so what? They didnt have any equity to begin with. In the US, some of these mortgages were backed by Freddie Mac and Fannie Mae and they have taken hits accordingly. In Canada, we have the Canada Mortgage and Housing Corporation (CMHC). The difference is that CMHC does not trade in the public markets and is fully backed by the Government of Canada so the losses that they rack up due to this Sub-Prime equivalent policy are not readily known and will be fully covered by you and I, the taxpayers. Fallout due to this policy will continue for awhile and can be considered a major contributor to weaker housing prives right now.

This brings me to the second part of the blog relating to whether you are a Sub-Prime lender. Many of the deals being marketed in the newspaper and radio whether they are Real Estate or Land are being funded up to 150% of current market values. Possibly even more. This is how it works. Company A buys a property for $10 million. They raise $14 – $15 million, however. They promise you 15% per year for a two year period. That’s approx. $4 million in interest. The balance pays commissions and salaries for their sales staff and advertising on radio and newspaper.

In essence, they can give you the promise of the interest as you are just paying yourself the money you originally invested. The problem is when the two years is up and the $15 million has to be paid back. The property needs to go up buy 50% for you to get your original investment back. Anything less and you will have a loss on your hands.

These deals took off because the Alberta market did generate those increases. Real estate prices are coming down. Inventories continue to go up. The promoters won’t be able to pay back the principal on time as they try and sell their deal at high prices. The good times are coming to an end and alot of these deals are going to go south.

What do you think? Do you agree with this assessment?

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One Response

  1. […] Last August, I wrote a post titled “Are you a Sub-Prime Lender?” which you can revisit by clicking on the link here. […]

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