An Explanation of the "Shadow Mortgage Market" in Canada
This articles explains what “shadow lending” is in the context of the Canadian mortgage market, outlines third-party estimates of its size and growth rate, and summarizes concerns policy makers have and what policies they may enact that will affect the industry.
The Rise of Alternative Lending in Canada
Concerns over household debt have been at the forefront of policy makers’ minds in Canada for some time. This has led to several iterations of policy tightening by CMHC in recent years that were aimed at providing stability in housing markets across Canada. The cumulative result of these changes is a tightening of the supply of mortgage funds through prime lenders, such as Bank of Montreal and Scotiabank.
At the same time, house price increase, interest rate decreases, a generally steady economy and strong migration have all led to increased demand for housing and, therefore, mortgages. Concurrently, homeowners have seen strong increases in their wealth through rising equity. Many of them are making the financially prudent decision to draw down on this equity and use it to pay off higher-interest bearing debt, such as credit card debt.
Increasing demand for mortgage debt in an environment of tightening supply due to policy changes has created an increasingly large number of households that no longer qualify for mortgages or re-financing through prime lenders that would have qualified under alternative policy measures. This has led to the rise of alternative “shadow” lending in Canada.
What is “Shadow Lending”?
“Shadow lending” is a particularly ominous term. It bears a connotation of concealment. Shadow lending bears the name because it isn’t monitored in the way that mortgages through prime lenders are monitored, not because it is intentionally hidden. It is also described as “private lending” or “alternative lending”. These monikers provide a more accurate description.
Private lending (in this case we are referring to private mortgage lending) refers to loans issued by individuals and firms that operate on the periphery or outside of the banking system. The Financial Stability Board refers to it as “the extension of credit from entities or activities which are outside the regulation perimeter for banks”. If your parents loan you $50,000 for a down payment on your first house, you have just engaged in shadow banking.
What’s the Problem with Private Lending
Well, for starters, problem is likely too aggressive a term. “Concern” is more appropriate. For private lending to be problematic, it would have to be unstable, unhealthy, and far more systemic than it is. But we’ll get to that later.
The concern with private lending is that it is not properly monitored and there are few or no mandated guidelines.
- In theory, a lender could provide a loan that would bring a homeowners loan-to-value (LTV) ratio to 100%, meaning that they owe as much as the home is worth
- The lender could also charge exorbitant interest rates
In practice, however, there are market forces that generally dissuade such things. Most lenders are unwilling to accept that much risk and most borrowers are unwilling to accept such punitive interest rates. For instance, it is our experience that the majority of lenders do not exceed 75%-80% LTVs, which includes the value of the private mortgage, which often acts as a second mortgage.
The real problem with private lending is that it isn’t monitored properly. There are no market level statistics available that would serve as leading indicators of a problem.
Typical Private Mortgage Clients
Private mortgage clients are occasionally referred to as “sub-prime” clients. Once again, we feel this is misleading. Most private mortgage clients fall into a few broad descriptions:
- Self-Employed Persons – For tax purposes, many self-employed persons report as little income as they can, which makes traditional financing more difficult
- Recent Divorcees – Splitting up assets isn’t always easy, especially when it comes to the family home. With tighter lending guidelines, many people are turning to private lending to split the value of the family home without having to sell it
- Poor Credit Scores – It’s easy to miss a payment here and there and suddenly find yourself outside of the purview of traditional lenders. Private lending can help these individuals transition into a traditional lender faster. If you are wondering what your credit score is, you can find out for free
- As we said earlier, most private lending services will not provide loans that go beyond a certain LTV (75%-80%). This prudent restriction differs from what many would consider “sub-prime”, which is typically associated with high ratio loans (95%-100%) in the United States prior to their collapse.
How Big is Private Lending?
As we said earlier, the market isn’t properly monitored, so accurate assessments of the size of the market are not available. However, CIBC has conducted research on the matter:
- Using mortgage origination data from Ontario, non-prime lending through private lenders (excluding large institutions that are regulated through OSFI) accounted for around 4% or new mortgages since the end of 2012
- Private mortgages are typically smaller, however, which is why private lending accounted for just 2% of all new mortgage volume over that time period
Policy changes have created or widened a niche market in Canada’s mortgage landscape. Private lending firms have stepped in to fill this gap. Even if the industry were contributing to instability to the mortgage market, which we argue it isn’t, it is too small to have any macro-level effects on Canada’s housing market