Turns out middle class real estate investors caused the US real estate crash, not subprime borrowers. A new working paper titled Credit Growth and the Financial Crisis: A New Narrative was published on the US National Bureau of Economic Research (NBER). In it, the distinguished researchers pour over thousands of credit and mortgage data points, to analyze housing during the real estate boom. Subprime mortgage debt didn’t explode in growth, and these borrowers didn’t default at a higher rate. Middle class “investors” and home flippers caused the bubble, and collapse. Now that we know this, Canada’s real estate market might actually look a lot like the US before the crash.

Credit Growth In The Prime Segment

It’s a commonly held belief that mortgage debt experienced huge growth in the subprime market. Turns out that’s bulls**t. Authors of the paper argue that subprime borrowing actually stayed relatively constant. Looking at their chart, we can see that as prices climbed during the home price boom of 2002 to 2006, primary homeownership actually declines. What picks up instead? People with more than one home. People that saw their net-worth increase from homeownership, decided having extra homes would lead to even more gains. This growth is strongest in those with middle credit scores.

Credit scores are divided by quartile, with quartile 1 being the lowest credit score (a.k.a. subprime borrowers). Source: Credit Growth and the Financial Crisis: A New Narrative.

Middle class investors that built their modest wealth from their primary home, decided to start a buying frenzy. Mortgage balances held by people with more than one home grew from 20% to 35% between 2004 and 2007, for those with middle credit scores. By early 2004, 10% of borrowers with good to excellent credit scores accounted for owners of multiple homes. In 2007, that number hit 16% for those with middle credit scores. Those with the very best credit did see a jump during this period, but they only grew to 13%. Investors with the worst credit accounted for 6% of mortgage balances, and grew to 8% during the same period. In case you didn’t get that, middle class investors saw more growth than poor and rich investors combined.

The Rise In Foreclosures Were Real Estate Investors

The authors also note that when shit went sideways, the rise in delinquencies were “exclusively accounted for by real estate investors.” During the real estate boom of 2002 to 2006, foreclosures were “similar” for both investors and non-investors, in all segments of credit. During the crisis however, investors foreclosed at a substantially higher rate. Middle class investor foreclosures actually jumping by a “factor of 10.” Which makes sense, since primary homeowners actually need their homes to live in. Needing somewhere to live is a powerful motivating factor to ensure those bills get paid on time. Investors on the other hand, can better afford to lose their second, third, or fourth home.

Forclosure rates by credit score, with Quartile 1 representing the lowest. Source: Credit Growth and the Financial Crisis: A New Narrative.

Don’t get this wrong, subprime borrowers are still risky. In normal market conditions, they’re more likely to account for foreclosures. In the US, subprime mortgages accounted for 70% of all homes foreclosed during the housing boom (2002 to 2006). However, during the crisis they accounted for only 35% of all foreclosed homes.

What? How Did That Happen?

Middle class investors need more leverage, and have less incentive to keep an investment property. Unlike wealthier homeowners that have access to capital, middle class investors need to tap the money tied up in their primary home. In order to do that, they need to maximize leverage by tapping the home equity windfall they received during a housing boom. Researchers of the paper note that people with middle credit scores would maximize leverage by going to alt lenders, and switch to variable rate mortgages to buy investment properties.

When the Great Recession came, primary homeowners had more tools to protect their home. Mostly the ability to go to bankruptcy court, and have unsecured debt discharged. This allowed them to keep their home, and not have to give it up to foreclosure. Investors however, don’t get the same privileges. The system is designed to ensure that primary homeowners don’t end up in the street when things turn. Not to protect highly leveraged gamblers from losing money by playing condo roulette.

This. Changes. Everything.

Now that we can see conditions and default factors were very different from what most experts “know,” this changes everything. Canadians are actually showing many of the same factors that led to the US housing bubble, and eventual collapse. We don’t track this kind of data in Canada (shocking, I know), but we can find quite a few data points that warrant studying this further. We do know that mortgage credit growth is disproportionately concentrated to those with good credit scores, there’s significant leverage against home equity, and multi-homeownership is exploding in at least Toronto and Vancouver.

Let’s start with mortgage credit growth, which isn’t very high for those with the lowest credit score. Equifax data obtained from the Canada Mortgage and Housing Corporation (CMHC) show that 5.3% of mortgages in 2013 Q1 are to those with poor credit scores across Canada. That dropped to 4.6% by 2017 Q1. In Toronto, we went from 4.6% in 2013 Q1, down to 3.2% of mortgages in 2017 Q1. Even Vancouver, where money has little correlation with buying activity, went from 3.5% in 2013 Q1, down to 2.6% of mortgages in 2017 Q1. The quality of credit is getting better, but that’s not necessarily a good thing.

Source: CMHC, Equifax, Better Dwelling.

Canadians with good credit might be leveraging up, as home equity is used for a huge number of loans. The Bank of Canada this week, estimated that up to 40% of Canadian mortgages have a home-equity line of credit attached. Canada’s federally regulated banks now hold $248.95 billion in loans secured with residential property, a jump of 6.91% from last year. Most interesting, Toronto, Montreal, and Vancouver are seeing tens of thousands of residential homeowners withdrawing 10% or more of their equity. What they’re doing with that debt is anyone’s guess, but there’s a lot of flipping and second homes these days. Speaking of second homes…

Source: OSFI, Better Dwelling.

The number of people buying second homes is getting pretty high. The Ontario government warned that 121,000 people in Toronto and the surrounding area now have at least one other home in the same region. Earlier this year, we also determined over 7% of Toronto homes were bought and sold in less than a year.

It also looks like the same issue is hitting the West Coast. Vancouver Realtor Steve Saretsky, recently did an analysis where he concluded that over 10% of Vancouver condos were bought and flipped in less than 24 months. We also found that 10% of Vancouver homes for resale were not lived in, as identified by the listing agent. Investor driven home hoarding is alive and well in Canada, we just don’t want to accept it.

These issues definitely require a deeper look, and more data collection to confirm that we’ve hit the same environmental variables. We’ll dive deeper into each one of these segments as we collect more information, but isn’t it fascinating? The very things we thought made Canada’s real estate market different from the US, are actually the things that caused their crash. Experts were just wrong about what caused the US housing collapse in the first place.

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