Coverage on the collapse of the sub-prime mortgage in the United States has been extensive in recent months.
Headlines, such as From Wobble to Crunch and Washington Primed to Halt Credit Crunch, have certainly grabbed readers’ attention.
As one columnist recently wrote, “summer is over,” concluding that it is time to get back to work and do whatever is possible to stem the tide of easy money that led to a serious credit crunch.
Canada’s mortgage market is far different than the American experience. For example, Canada has legislation and a bank system that is more restrictive and does not allow the exotic financing and lending practices that created the American mortgage meltdown.
The big concern for Canada, where provincial economies like Manitoba’s rely heavily on exports to the United States, is a broader economic downturn that reaches across the border.
As a result of what has been happening in the U.S., the Bank of Canada decided to keep its overnight benchmark rate unchanged at 4.5 per cent on September 5. The trendsetting bank rate remains at 4.75 per cent.
Until the mortgage crisis occurred every indication was that the Bank of Canada would likely continue to raise interest rates to rein in inflation.
The bank is indicating concern for some spillover from the U.S. sub-prime mortgage market collapse into broader financial markets which will have implications for Canadian borrowers. This could in turn temper domestic demand. It may also imply that we will not see a rate increase for October 16.
A column by Randy Reynolds,published in the Winnipeg Free Press on Sunday, August 26, is a wake-up call to Canadians on the benefits of using a REALTOR® to learn about the market situation and receive proper advice on what they can reasonably afford to pay for a property.
A Primer on the U.S. Subprime Mortgage Crisis, by Randy Reynolds (On Mutual Funds)
“With all the hysteria surrounding the subprime mortgage crisis and the collateral damage being inflicted upon stock markets around the world, now may be a good time to take a step back and look at what the whole issue is really about.
“First of all it’s important to understand what a subprime mortgage actually is. Simply put, it is essentially a mortgage issued to a homebuyer with questionable credit.
“This is not common practice in Canada, but surprisingly, lenders in the U.S. eager to make a few extra points of interest were making these loans like there was no tomorrow. What did they have to lose? Rising U.S. housing prices would compensate them for the additional risk. If they had to repossess a house it would probably be worth substantially more than the remaining mortgage balance.
“But as U.S. interest rates rose and housing prices fell, a lot of the high-risk borrowers realized that their mortgages were higher than the value of their property and simply walked away — leaving finance companies on the hook and ultimately headed for insolvency with some big banks facing a big hit to their bottom lines.
“Further amplifying the issue, a lot of the companies that were making the subprime loans sold them off to hedge funds and pension funds looking for higher returns. The trouble started when the loans started unwinding. Unwilling to take on more risk, lenders started to demand higher interest rates on loans or simply refused to lend any more money and no one could unload the iffy loans that were already on the books.
“Hence the current credit crunch. Tougher credit terms for consumers and for large mergers and acquisitions are slowing the economy and driving stock prices downward.
“Short-term commercial paper has also been negatively affected and some money market mutual funds (a category previously believed to be of the absolute lowest risk) have experienced losses. In fact, almost all income-oriented mutual funds have been stung to some extent.
“According to Eric Bushell, manager of CI Investments Signature group of funds — and one of the few managers who profited during the last major market correction — recent demand for securities to put into income products for yield-hungry investors has put a high demand on corporate and high-yield bonds, which has consequently caused their valuations to be excessive.
“He says that now there is a lot of forced selling driving prices down and creating opportunities for smart money managers.
“For example, Bushell says that where spreads on corporate bonds over U.S. Treasury bills used to be 2.5 per cent, they are now closer to 4.5 per cent. Taking advantage of these new spreads — which will eventually narrow again — is what he intends to do with the cash he currently holds in his funds.
“Another area affected is leveraged buyout activity, which has hinged upon easy access to credit. That’s now drying up, Bushell says, and so companies that were expected to be leveraged buyout targets have seen their valuations normalized and the cost of borrowing money to finance the takeover has made them much less attractive.
“Typically, bear markets for stocks are precipitated by overvaluations of stocks. Back in 2000, the average price-to-earnings ratio of an S&P 500 company was around 30 to one. Today it’s less than 16 to one. Stocks are cheap.
“Bushell says, ‘Now is the time, with the backdrop of a healthy global economy, for financial markets to back off these exotic structures and rein in the bad lending practices. If that happens, I think we will be able to look back on this time as helping to extend the growth cycle for the global economy.’”
(Randy Reynolds is a mutual funds representative at Griffiths Reynolds Stalker Financial and Worldsource Financial Management. Contact him at 982-4743 or e-mail firstname.lastname@example.org)