Written by Elisa Krovblit
Are you worried that the Canadian market is in for its own "Big Short"? With five Oscar nominations, The Big Short was one of the blockbusters of 2015. Not your typical hit, it was more of interest to market watchers and financial types. It was an intense movie, doing its best to explain why banks needed bailouts and homeowners found themselves in foreclosure with the U.S. market crash in 2008. And if you're worried that we're next for a 'Big Short' in Canada, you can relax.
The circumstances are different and we're not at a risk for a Canadian "Big Short." The difference is in our banking practices.
Of course, the hysterics may point to the slumping dollar, the potential of rising interest rates, the new rules on mortgages and the non-stop talk of a bubble as signs that we're headed for financial crisis, but I doubt we'll see any broad financial disaster. There's no bubble. Inflated prices? That's market value -- supply and demand at work. New mortgage rules are a safeguard.
Let me explain.
The Big Short was predicated on greed, irresponsibility and opportunity. Real estate markets were hot and banks were making massive amounts of money on mortgages. Bonuses were given based on the number of mortgages approved, so there was huge motivation for mortgage approval. The banks were stacking these mortgages together to back bonds. Between obscene bonuses, great business on the books and happy new homeowners, it seemed like a win-win-win all around.
Except a huge number of those mortgages were given to people who should never have been approved. Bonds that were backed by what should have been solid AAA mortgages were actually being backed by mortgages that were likely to default.
And that's precisely what happened.
Mortgages defaulted and, as the market plummeted, homes became worth much less than their mortgage value. Short sales were common for banks to try to recoup whatever they could, but they lost a lot of money on these mortgages that couldn't be recouped.
To make it worse, in 2005, one multi-millionaire surgeon-turned-hedge fund manager dug deep into this data and discovered the disparity, predicting the crash. He realized that these mortgages weren't strong and that the foundation of the money market was much, much weaker than anyone realized or wanted to admit.
With big banks bound by minimum down payments and very specific approval criteria, mortgages in Canada are stable.
So he did what any renegade hedge fund manager would do -- he saw an opportunity to make a lot of money and he bet against the banks. The banks took his bet -- what they perceived to be a high-stakes-no-risk bet -- because this scenario seemed incredulous, completely impossible to them. In fact, two other fringe investor groups found out what he was doing and opted to do it too.
And we know what happened next -- the "impossible" happened.
Have you ever tried to get a mortgage in Canada? You need to qualify. You need to provide tax assessments, pay slips, T4s -- you need to prove your income and verify in triplicate that you'll be able to pay the mortgage. With good income and great credit, you're not a huge credit risk. With big banks bound by minimum down payments and very specific approval criteria, mortgages in Canada are stable.
As an additional safeguard to the health of the Canadian mortgage industry, the government introduced new legislation in February of 2016, raising the minimum down payment on mortgages. The ratio of borrowing to value is lower this way, enabling the banks to sell properties for what is owed on them to recoup loss in the case of mortgage default and foreclosure. Even if the market were to downturn, the borrow-to-value ratio would compensate the banks appropriately.
While we may experience market volatility -- and we have in the past -- our market is stable. As for 'The Big Short'? Grab some popcorn, it's a really interesting movie, but I just don't think Canada will ever be starring in it.
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