Wednesday, January 19, 2011

High Risk Mortgages

If you’re out for a walk in the Canadian bush and you encounter a bear, what should you do? Some say you should make loud noises and make sure the bear knows you are there. Others say you should quietly retreat.

Finance minister Jim Flaherty is quietly retreating.

The Canada Mortgage and Housing Corporation (CMHC) went for a walk in the high risk forest of financial leverage. Only a few years ago, qualified borrowers could buy a home with 0 down payment and pay their mortgage off over 40 years. Our American cousins did much the same thing.

In 2007 and 2008 the Americans came across a bear in their woods: and they got mauled! American house prices were slashed and the banking system almost collapsed. Jim Flaherty is aware that the same bear could show up in Canadian forests. And he is beating a slow intentional retreat.

Last week he announced further retrenchment of CMHC policy. Borrowers would now have only 30 years to repay their mortgages. And home buyers would need a 15% down payment. And CHMC will insure high ratio mortgages for buyers of homes now – they will no longer insure borrowers who are re-financing their homes.

It appears that Canada has learned from the USA’s experience. Financial leverage means financial risk. And now the federal government is attempting to gently de-leverage the real estate market in Canada by quietly retreating from the forest of financial maxi-leverage.

But I’m wondering about those unfortunate Canadians who got in at the point of maximum leverage. We know what happened to the Americans. What about our Canadian neighbours who borrowed the maximum on their homes and bought into the old mutual funds leverage game.

Double Bears
2006 and 2007 were the days when you could refinance up to 100% of the value of your home and repay the mortgage over 40 years. And in 2006 and 2007 the stock market seemed like a good investment. Hundreds of Canadian Financial Planners (FPs) used high pressure sales tactics to persuade thousands of Canadian home owners to borrow millions of dollars against their homes and buy equity mutual funds. The sales pitch was: over the 40 years it will take you to pay off your new mortgage, the stock market will go up about 10% a year on average. At the end, you will own your home free and clear AND you will have a multimillion dollar portfolio of mutual funds. Average Canadians could retire wealthy, like that legendary barber we all read about.

Then the equities markets dropped in half from May 2008 to March 2009. “Not to worry!” said the FPs: “You still have 37 years left!” Now (January 2011), 2 1/2 years later, some of those high leverage mutual funds speculators are almost breaking even. And they still have 34 1/2 years left! Well, they are almost breaking even on the value of their mutual funds – but they’ve been making mortgage payments for 5 or 6 years: I’m not sure how long it will take them to break even on that part of the equation. And I hope their house values continue to hold up.

I am pleased that our government is returning Canada to mortgage normalcy. And I am pleased that the opposition agrees. It gives over-leveraged Canadians a chance to hold off the bear for a while. Restrictions on CMHC mortgage insurance are welcome.

But, what’s really required is some restriction on the high pressure high risk sales tactics that many mutual funds salesmen / financial planners use to persuade people to “max-out” on their capacity to borrow money to buy mutual funds. Investment dealers are regulated in this area, but mutual funds salesmen are not. Ordinary homeowners are being told that high risk leverage is low risk investing. It’s not. Our American cousins have taught us that high leverage means high risk.

When you walk in the woods, you need to keep your eyes open for bears. Mr. Flaherty has a good eye on the forest of high leverage borrowing. Now, I hope he’ll shift his focus to the bears in the stock market/mutual funds jungle too. It’s time to stop the leverage game there too.

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