Canada's conservative side.

The rising floodwaters from the subprime mortgage and credit crunch in the United States are trickling into Canada, where lending practices are so hedged with legislation and regulation that it is bound to stay a trickle. More important, residential mortgages are nearly fully insured against loss by the Canadian government, and demand and prices in key housing markets keep going up.

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The people, culture, customs and institutions in Canada and the United States are more alike than they are different--except for their financial systems. The scale and very nature of nontraditional and subprime mortgage lending in the United States, for example, would never be countenanced in Canada. Neither is there much pressing need for them, because the five chartered banks handle an estimated 80 percent of conventional mortgage loans. Another estimated 20 percent are in the subprime mortgage market, and about 5 percent are in the alternative lending category--for people who don't qualify for a first or second residential mortgage loan from a bank or credit union and who turn to the Yellow Pages to find mortgage brokers and lenders that are ready to step into the financial breach. [??] Subprime mortgages surfaced on the fringes of the mainstream mortgage loan industry, but only since 2002. The mortgage section of the Yellow Pages telephone directory says it all: "no documentation programs, poor credit or no credit, no qualifying, 100 percent financing, self-employed, bank refusals, past bankrupts." [??] Why, then, are subprime and nontraditional lending growing in the United States and remaining on the margins of the residential mortgage market in Canada? [??] "There is more due diligence [in Canada], and we don't have adjustable-rate mortgages [ARMs], although some of our lenders issue what are known as alternative lending products. What is happening in Canada [the subprime spillover] has more to do with the credit market," explained Jim Murphy, president of the 10,000-member, Toronto-based Canadian Institute of Mortgage Brokers and Lenders (CIMBL), in an interview with Mortgage Banking.

CIMBL represents mortgage lenders, brokers, insurers and other industry stakeholders--and is the largest organization of its kind in Canada.

Mortgages are regulated by the federal Bank Act. Mortgage brokers and real estate agents in eight of the 10 provinces, who account for about 30 percent of the mortgage market, are registered and regulated. Credit unions are regulated. Disclosure requirements are more demanding. All of that is aimed "not as much at banks and savings-and-loans, but at mortgage bankers and the securitization of mortgages," Murphy says.

Another big difference, at least for now, Murphy adds, is that average home prices in the United States are softening--while in western Canada they are up by double digits, and by 5 percent to 7 percent in central Canada (notably the Greater Toronto area). "We have a strong economy and population growth, unemployment is low, and disposable income is rising," he says, "all of which is positive for our industry." (In Canada, 23,300 new jobs were created in August, according to Statistics Canada, Canada's national statistics agency, while U.S. employers for the first time in four years saw a loss of 4,000 jobs that month.)

The strength in Canada's economy is driven to a great extent by the oil and gas industry. On Sept. 12, for example, the Canadian dollar finished higher--nearly a 30-year high--against the U.S. dollar, closing at $1.0361, or US$96.52, after the price of oil nudged past US$80 a barrel.

Murphy also notes that Canadians, generally speaking, are "much more conservative [than Americans] with their mortgages, most of them fixed and for five-year terms. Personal debt levels are increasing, but aren't as high as they are in the U.S.," Murphy says. Moreover delinquency rates in Canadian mortgage markets are at historic lows (see Figure 1), and demand for mortgages continues to grow by an average of 10 percent a year.

All that adds up to a residential mortgage market of $200 billion in Canada and overall outstanding mortgage credit that will top $800 billion for the first time this year, he says. (All dollar figures are in Canadian funds.)

Sounds reassuring, but Canada is nonetheless not immune to global financial upheaval, and some fallout from the credit crunch has drifted up from the United States. The impact, so far, has landed most heavily on investors shopping for asset-backed commercial paper (ABCP)--i.e., very short-term securities backed by such assets as credit-card loans and mortgages--which dried up in mid-August because of widespread apprehension that the paper was backed by assets quite liable to be devalued due to the turmoil on world markets.

When that commercial paper didn't "roll over" almost every day as usual, its sponsors hunted for new investors every day, and that proved unsuccessful. The ABCP market then shriveled, and many sellers went to "liquidity providers" or sponsors such as Coventree Inc., Toronto, a niche investment bank specializing in structured finance using securitization-based funding technology, to find new investors every day.

When buyers fled, the market froze and many investors were stuck with paper that couldn't be rolled--reportedly as much as $35 billion of it. That's when some of the highest-profile investors and commercial paper sellers in Canada drafted an emergency "Montreal Protocol" to support the ABCP Canadian market's liquidity. More than 80 percent of Canada's ABCP market participants support the protocol, which provides for a 60-day standstill agreement while a way is found to convert the paper into longer-term notes related to the underlying assets. The signatories of the protocol are trying to figure out a way around the impasse and head off significant paper losses for holders, ideally at 100 cents on the dollar. Below 100 cents, and securities would have to be revalued at a lower level.

The Montreal Protocol national investors' committee was spearheaded by the Caisse de depot et placement du Quebec (the country's largest pension manager, with $237.3 billion in assets under management), and includes other pension funds, the National Bank of Canada, Alberta's ATB Financial and federal Public Sector Pension Plan Investment Board, and other Canadian and international institutions.

At press time, the credit markets had not yet found a solution, and investors were still staying away in droves. In the meantime, Canadian financial institutions issued a flurry of reassuring statements in late August, summarized as follows:

Banks

Canada's largest chartered banks announced their commitment to ensure that markets for bank-sponsored commercial paper or short-term corporate loans "continue to perform satisfactorily." It was a commitment from the chief executive officers of the Bank of Montreal, Canadian Imperial Bank of Commerce, National Bank, Royal Bank, Scotiabank and TD Bank. National Bank of Canada also said it will buy about $2 billion in ABCP paper from its mutual funds and corporate clients.

But the news wasn't all upbeat. Canadian Imperial Bank of Commerce announced it probably lost $190 million in the third quarter on collateralized debt obligations (CDOs) and mortgage-backed securities (MBS), among other investments, after prices for securities backed by U.S. home loans dropped.

In a report to its shareholders, The Royal Bank of Canada, the country's largest, noted: "As of July 31, 2007, we had a $1.1 billion net exposure to the U.S. subprime market, representing less than 0.2 percent of our total assets. The exposure is mainly in residential mortgage-backed securities and collateralized debt obligations."

Credit unions

Quebec-based lender Desjardins Group, the largest group of credit unions in North America, said it will buy $100 million worth of ABCP assets held by its funds.

Funds

HSBC Investment Funds (Canada) Inc., manager of the HSBC Mutual Funds; and HSBC Investments (Canada) Ltd., manager of the HSBC Pooled Funds, said they have no exposure to third-party asset-backed commercial paper.

Trust companies

Home Trust Co., Toronto, a federally regulated trust company active across Canada, said it hasn't taken any financial hits in the liquidity crisis because its mortgages are guaranteed by the federal Canada Mortgage and Housing Corporation (CMHC), Ottawa.

[FIGURE 1 OMITTED]

On the contrary, Home Trust says, it has bought several loan portfolios from competitors and is looking for other such opportunities.

(CMHC sells insurance to homeowners for 80 percent of the value of a mortgage on the unlimited price of a single-family house, duplex, condo and other types of residential properties, to protect lenders against buyers' defaulting on the mortgage payments. CMHC ordinarily sells the insurance to buyers who can come up with a 20 percent down payment, but depending on the creditworthiness and financial capacity of buyers, it will also sell 100 percent coverage if buyers can't accumulate a down payment.)

It is inevitable that when markets falter and companies struggle to stay afloat, vulture funds show up to pick up distressed assets at bargain prices--most recently in Canada's ABCP market. Cerberus Capital Management LP, New York, for example, is digging around in Canada, presumably not bothered by the fact that some of the paper was backed by U.S. subprime mortgages (see Figure 2), according to newspaper reports.

[FIGURE 2 OMITTED]

Fortress Investment Group LLC, New York, and Brook-field Asset Management Inc., Toronto and New York, were also reported to be shopping for the paper at substantial discounts.

Albert Warson is a Toronto-based freelance writer specializing in real estate development-related subjects. He can be reached at [e-mail].

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"There aren't a lot of lenders in Canada who will do 100 percent financing," says Nick Kyprianou, senior vice president and chief operating officer of Home Trust Company, Toronto, a wholly owned subsidiary of Home Capital Group Inc.

The company is Canada's largest alternative financing company, with a CDN$5 billion portfolio. Kyprianou expects the company will originate about CDN$2.5 billion in loans this year, mainly from residential first mortgages and securitization of federally insured mortgages as mortgage-backed securities.

Anyone who does get 100 percent financing, Kyprianou says, has a "superb" credit history and overall worthiness, with an excellent job history, great income and good cash flow.

"Canada is not in the same boat as the United States. Our lending systems are so dramatically different. We don't have all those hybrid products," he says. Canadian mortgages have 25-, 30- or 35-year amortizations with renewable terms during each of five years.

"There is no big demand for debt as there is in the United States. Mortgages [loan interest] are not tax-deductible in Canada, so it comes off net income. People are more conservative about borrowing money in Canada. There is no benefit in borrowing, only in paying off a loan," Kyprianou says. "The five major banks in Canada probably do 80 percent of the lending, with strict credit criteria, so a lot of crazy stuff doesn't happen."

Best of all, 80 percent of a mortgage for all home loans in Canada is insured against default by the federal Canada Mortgage and Housing Corporation (for which, of course, the borrower pays a premium). CMHC is the dominant player, with about 60 percent of the market, but there is also private mortgage default insurer Genworth Financial Canada, Toronto (formerly GE Mortgage Insurance Canada), and earlier this year a subsidiary of AIG International Group Inc. (AIG), New York, joined the competition.

Kyprianou notes that his company keeps its loans on the books, like banks, while other mortgage lenders bundle them up into securities and sell them on Wall Street. "When you live with what you do, you tend to be a little more careful," he says. Securitization in Canada has the added advantage of CMHC insurance, guaranteed by the federal government. "If there is a default and a loss, the investors never experience it--nor does the lender," he says.

Banks and trust companies in Canada are also regulated by the Office of the Superintendent of Financial Institutions, Ottawa, which has created lots of policies to protect investors and the public.

Most of the source of funding for banks or trust companies comes from depositors, which is also guaranteed by the federal Canada Deposit Insurance Corporation.

"The asset-backed commercial market in Canada is going sideways," Kyprianou says, "and some companies which use securitization and conduits as lending models are having big problems selling their paper and are charging a premium because of that," he says.

"Sideways" is the operative word. According to Canadian Press wire service, two major Canadian mortgage bankers have temporarily suspended subprime lending in Canada. One is MCAP Financial, Toronto, which provides mortgage financing through brokers and is a partner of the Bank of Montreal and insurance company Clarica, which financed subprime loans through its Eclipse division, formerly known as MCAP SubPrime.

MCAP issued a statement that read: "The Canadian real estate and mortgage markets continue to perform very well by contrast to the United States, where the market is not strong and has resulted in the global credit crunch that is affecting us today. Some of the biggest Canadian financial institutions have been meeting to assist in stabilizing the commercial paper market. Until the market is back to normal, buyers of commercial paper are limited."

GMAC Residential Funding of Canada, Toronto, also confirmed it will no longer extend subprime mortgages. "In response to a challenging mortgage market, GMAC ResCap continues to reduce its nonprime exposure and restrict originations of mortgage products with limited market liquidity," John Schipper, the company's senior vice president of mortgage lending and sales, said in a statement.

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Investment in housing construction (new housing projects and renovations) during the second quarter this year was up by 7 percent to a record CDN$22.8 billion, according to Statistics Canada (the Canadian equivalent of the U.S. Commerce Department) in early September.

The investment was particularly strong in western Canada and Quebec, and in single-family home construction across the country. "The housing sector has been positively affected by western Canada's dynamic economy, still-attractive mortgage rates, appealing financing possibilities, strength in employment and growing disposable incomes," Statistics Canada noted.

Even in the independent territory of Nunavut in the Arctic, housing investment increased from CDN$7.2 million to CDN$41.5 million during that period.

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Some of the highest-profile organizations in Canada, according to various newspaper accounts, have problems with non-bank asset-backed commercial paper (ABCP). These include:

* The Ontario government -- about $700 million (all dollar figures are in Canadian funds)

* Dundee Bank of Canada -- as much as $400 million

* The Greater Toronto Airports Authority, which operates Canada's Lester B. Pearson International Airport, the country's largest -- about $249 million

* Barrick Gold Corporation -- $65 million

* Ontario Teachers' Pension Plan -- $60 million

* Air Canada -- $37 million