The U.S. subprime mortgage meltdown

Angela and Tim Sneary and a couple of their dogs stand in the driveway of their home in Thornton, Colo., on Feb. 21, 2007. Their financial problems have resulted in foreclosure on the house by their subprime mortgage lender. (AP Photo/Ed Andrieski)

Would you like a mortgage that lends you more than the value of your house?

Would you like it structured so that your first payments are extra low?

If the mortgage weren't structured that way, would you be unable to afford the payments?

Are you convinced that real estate prices will continue to rise?

Do you have a poor credit history?

Congratulations if you answered "Yes" to most or all of those questions! You're an ideal target for a subprime mortgage lender.

Of course, there is a downside amid all the fine print, as hundreds of thousands of American consumers are now finding out. Mortgage delinquencies and foreclosures are way up. Dozens of companies that lent money to anyone with a pulse have gone belly up. And suddenly, some economists are starting to worry that the whole mess could send the U.S. economy into recession.

How did this happen?

What makes a mortgage "subprime"?

The term "subprime" isn't well known in Canada because most of our mortgage lending is "prime," or conventional. In the U.S., however, rapidly rising house prices and a poorly regulated industry combined to create a mortgage monster that is now busy running amok.

"Subprime" refers to the risk associated with a borrower, not to the interest rate being charged on the mortgage. Typically subprime mortgages are offered at interest rates above prime, to customers with below-average credit ratings. Subprime mortgage lenders in the U.S. tend to target lower-income Americans, the elderly, new immigrants, people with a proven record of not paying their debts on time — just about anyone who would have trouble getting a mortgage from a conventional lender such as a major bank.

Their pitch is irresistible and it unfolds along lines like this: "You want to buy your first house? We'll make it happen! And don't worry about a down payment. In fact, we'll even lend you more than the house is worth. We'll even charge you a super low rate [the "teaser"] during the first year or two to keep your payments low. Sure, the loan will eventually reset at prevailing rates, but since housing prices are rising by 20 per cent a year, all you have to do is refinance your house to keep your payments low!"

Needless to say, the subprime bubble soon burst. After enjoying a short period at low fixed rates, people with subprime "bargains" suddenly found their loans were being reset at rates that were in the double-digits. U.S. housing prices, which had been soaring, started falling. People with subprime mortgages found they could no longer count on the increasing value of their homes to refinance their way out of the mess.

By late 2006, one subprime loan in eight was in default across the U.S. Foreclosures were soaring. More than 20 subprime lenders were bankrupt. And the National Community Reinvestment Coalition estimated that as many as 1.5 million Americans could lose their homes by the time all the damage is done.

Could it happen in Canada?

Subprime mortgages are available in Canada. But it's a different story up here. For one thing, the subprime market share is much smaller in Canada. About 20 per cent of all U.S. mortgages are of the subprime variety in 2007. That compares to just five per cent in Canada, according to industry figures.

All high-ratio mortgages in Canada — those with less than 20 per cent down — must be secured by mortgage insurance, through, for example, the Canada Mortgage and Housing Corporation. In addition, Canadian financial institutions do not finance more than 100 per cent of a home's purchase price, and that value must be verified with a separate appraisal.

Canadian mortgage lenders have been scrambling to assure the population that there are major differences between the subprime markets in the two countries. "We have not seen the aggressive lending practices common south of the border," said Paul Grewal, chair of the Canadian Association of Accredited Mortgage Professionals. The association says Canadian underwriting practices are "more prudent."

Outside analysis backs up that assertion. Benjamin Tal, an economist with CIBC World Markets, noted recently that "only 22 per cent of subprime borrowers in Canada use variable rate mortgages — half the rate seen in the U.S." Tal also says there is no evidence linking the use of subprime lending in Canada with the increase in house prices. In the U.S., there is a "very high correlation," he says.

"Our view is that the price appreciation in the U.S. housing market over the past two years was, in many ways, artificial — boosted by aggressive lending and irresponsible borrowing."

Overall mortgage arrears in Canada are at just 0.5 per cent, the industry says, near record lows.

That doesn't mean there's nothing to worry about in Canada. A drop in Canadian housing prices and increases in interest rates would pose problems for borrowers. But with Canadian real estate showing fewer of the warning signs, with fewer subprime mortgages in this country, tighter borrowing restrictions and fewer mortgages at floating interest rates, the risks do seem to be considerably lower.

But the U.S. subprime meltdown has recently shown signs of spreading to the wider U.S. economy and into Canada. General Motors cancelled a shift at a truck plant in Oshawa, throwing 1,200 out of work, because sales of pickup trucks have plunged in the U.S. Most of Oshawa's production goes south of the border.

Stock markets in Canada and the U.S. began moving lower in the summer of 2007 as investors reacted to signs that lenders were beginning to tighten credit, boosting fears of a slowdown. Many Canadian companies reported having millions in cash tied up in normally safe short-term debt products that suddenly became illiquid as no one wanted to buy investments perceived as being risky.

Central banks on both sides of the border are watching closely for further signs of subprime fallout in the months ahead, as interest rates in many more U.S. subprime mortgages reset at higher levels.