In the debate about how best to address soaring housing prices in some Canadian cities, the most obvious answer is being ignored. Why? Because it doesn't serve the interests of those with the loudest voices.
Real estate agents and developers, who benefit from increased activity, claim the solution is to increase supply by easing zoning regulations and expanding the available stock of housing.
Provincial and municipal governments, which tend to bear the brunt of the blame when things get out of control, go for crowd-pleasing solutions aimed at slowing demand. The Vancouver foreign buyers' tax and the proposal by the Ontario government to increase capital gains taxes on sales of non-principal homes are examples.
The federal government, for its part, is most concerned about its exposure to a correction. As such, it is considering yet another round of changes to the mortgage insurance regime that seeks to unload some of the risk from the public balance sheet.
Yet despite all the noise about a possible solution, few seem interested in what is always and everywhere the underlying cause of economic bubbles: speculative behaviour fed by inexpensive credit.
No, I am not asking that the Bank of Canada raise rates prematurely to address the housing issue. In the Canadian housing finance ecosystem, there is actually a much better, targeted tool for dealing with speculative behaviour: cracking down on nonconforming mortgages.
Where the speculators go
The nonconforming mortgage market is where many real estate speculators go when seeking financing. They are loans given to borrowers who do not qualify under a lender's standard metrics; loans where the lender takes more comfort in its collateral than the ability of the borrower to service the debt through income.
The salaried homeowner who cannot afford a second mortgage, but wants to doubly participate in Toronto's soaring real estate market by buying another house, will invariably end up borrowing in the nonconforming market. Similarly, a foreign buyer is most likely to borrow under this type of arrangement, given the lack of Canadian income or credit.
Also, because these loans appeal to borrowers who do not qualify by their income levels, they are much more prevalent in markets like Toronto and Vancouver where housing is not just expensive at an absolute level, but also in proportion to incomes. Nonconforming mortgages generally require a 35 per cent down payment and charge roughly 2 per cent over standard rates for prime mortgages — conditions that allow lenders to bypass normal mortgage qualification requirements.
Most nonconforming mortgages are issued by banks and trust companies regulated by the Office of the Superintendent of Financial Institutions (OSFI). That means that cracking down on them or making them more expensive would not require an entirely new regulatory scheme. It would simply require action.
There are a myriad of options available to OSFI that would make nonconforming mortgages less attractive to both borrowers and lenders, therefore making financing more expensive for speculators. They include further increasing the minimum down payment, increasing regulatory capital requirements for holding nonconforming loans and requiring more stringent income tests relative to prime loans.
It's not that OSFI has been asleep at the wheel this whole time. In a statement last year, it noted that it has "observed that underwriting practices for [nonconforming mortgages] … are often not as strong as those for conforming mortgages, especially in regard to income verification." This is as obvious an observation as a biologist noting that snakes bite or that monkeys like bananas.
A brokered market
Much of the nonconforming loan market is brokered and there is often no direct contact between the borrower and the lender, but there is significant economic incentive for the broker to complete the transaction.
Unsurprisingly, this part of the market has always been most susceptible to outright fraud, as well as other unscrupulous "a wink and a nod" behaviour. The OSFI has indeed noted that it is "aware of incidents where financial institutions have encountered misrepresentation of income and/or employment."
If we want to address the underlying causes of irrational price increases in housing, we should stop looking for convenient bogeymen like "foreign buyers" and "house flippers." Instead, we need to tighten credit conditions for speculative transactions in a targeted manner that does not negatively impact other parts of the economy. The best way to do that: make nonconforming mortgages more expensive.