Mortgage clampdown is positive

Canada’s banking regulators are putting the screws to lending practices they see as risky—particularly in the bubble condo markets that are forming in Toronto and Vancouver.

Good.

One need only look at the mess being sorted through by the newly announced Residential Mortgage-Backed Securities Working Group to get a sense of the intricate ways bad loans can infiltrate an economy and cause calamity.

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Even with the full resources of the U.S. Justice Department brought to bear, though, it’s doubtful whether the spider web of vested interests involved in mortgage fraud during the last decade will ever be unraveled. The working group effectively has between now and the November election to do its work and bring charges against any wrongdoers before the next administration shuts it down.

Don’t expect anyone from the big underwriters to do any jail time.

It’s easily argued that Canada’s real estate appreciation has not been as excessive as that experienced in the U.S during the last decade. But that sentiment ignores the realities of how long the real estate bubble in the U.S. expanded before it finally popped.

Run ups in U.S. real estate prices actually got underway in the early 1990s, when Alan Greenspan started furiously cutting interest rates to jump start the economy and save George H.W. Bush’s presidency. The strategy didn’t work, but it did set off a home buying and refinancing frenzy when 30-year mortgage rates slipped below 7% in 1993.

Bill Clinton worked with the Fed chairman to maintain the low-rate strategy. It got him re-elected. It also helped baby boomers turn their homes into ATMs and allowed them to move aggressively into the trade-up market. Low rates combined with demographic realities to drive home-buying and ownership rates to new highs.

And Fannie Mae and Freddie Mac were compelled to raise their classification for what were called “jumbo loans” on the nation’s more expenses houses: those above $280,000 in total borrowing. The numbers seem quaint today, but they signalled a sea change in buyer behaviour. Home prices had effectively doubled in less than a decade, and there was no end in sight.

Columnists reporting on these issues, myself included, expressed concerns about the growing size of home loans. In particular, we raised the alarm about rapidly rising loan to value ratios on home purchases. Buyers were starting to look less and less creditworthy and the products being built from some of these lower-quality mortgages started looking more and more like toxic waste.

In part, that stemmed from a Clinton administration initiative aimed at pushing up homeownership rates among lower income Americans. Thankfully, the program was squashed after data on foreclosure rates showed those buyers weren’t keeping up.

Problem was, the home building and selling industries had gotten used to both the subsidies and a newfound pool of buyers. When the second Bush administration entered offices, officials in charge of federal housing programs were persuaded to reinstate the low quality mortgage programs.

Shortly after, private lenders got into the game, supported by the securitization market which was eager for new product, and the liar loan was born. Regulators turned a blind eye to the activities—knowing full well that swelling home values were the only thing supporting an otherwise fragile boom.

The result was that when home buyers (many of whom really needed to be told they couldn’t afford houses) and the lending and securitizing operations that supported them needed a watchdog, there was none to be found. That rising housing tide lifted a lot of boats. But the resulting wave tossed a lot of them onto the shore.

In light of that, Canadians should be thankful when regulators put a sharp eye on borrowing practices. Overextension leads to default. And it can start small and take years to play out.

If the watchdogs don’t act early, the speculators can spin things out of control and leave them no time to react.