How tighter rules are pushing homebuyers toward riskier mortgages

Would-be buyers are finding it ever more difficult to get a mortgage from mainstream financial institutions. Is greater regulation driving them into the shadows?

Couple at the end of a dark alley, holding house keys

(Illustration by Brian Stauffer)

The breezy animated ad begins with a chipper man in a business suit asking rhetorically how Alpine Credits, a B.C. mortgage lender, has managed to approve over $1 billion in home loans. He throws open an office door to reveal rows and rows of clerks cheerfully rubber-stamping applications. Suddenly, one of the clerks pauses: His client wants to put up a four-storey waterslide. “Well,” our chipper guide asks, “is he a homeowner?” The clerk responds that he is. “Then…he’s approved!” Everyone cheers, confetti drops from the ceiling, and someone pops a bottle of champagne.

There is perhaps no better encapsulation of the frothy Canadian real estate market than Alpine’s 30-second spot. The company’s parent, Amur Financial Group, loves to advertise aggressively: Its radio spots plugging fast and easy loans have been in heavy rotation in Toronto in recent months. Amur has had a heady run since 2008. What started as a mortgage brokerage in 1969 has since ballooned into a complicated mass of direct-to-consumer mortgage brokers in B.C., Alberta and Ontario, as well as a mortgage investment corporation (MIC) that raises capital from private investors to issue loans.

The privately held firm, which is not regulated by the Office of the Superintendent of Financial Institutions (OSFI), claims its assets under management jumped more than tenfold to $225 million between 2009 and 2015. Those who invest in Amur’s MIC have been rewarded with average returns of over 9% since 2009. Indeed, Amur’s spreads haven’t been this robust in years.

According to Arif Mulji, vice-president of business development, Amur’s fortunes vividly reflect some of the forces that have dominated Canada’s economy in recent years: Its customers tend to be people looking for short-term mortgages, home renovation loans or debt consolidation. Their ranks include borrowers, many self-employed, who want to cash in on the real estate boom but have been shut out by a banking sector increasingly preoccupied with risk. As for Amur’s investors, Mulji says they tend to be sophisticated individuals looking for alternative but competitive securities. “In general,” he says, “as new investors get familiar with private lending, [they] see residential real estate and mortgages as a relatively safe place [to invest].”

Private firms like Amur have proliferated in the past few years, which is hardly a surprise, given that Canada’s stubbornly low interest rates have pushed investors into alternative asset classes, and residential real estate has generated stunning returns for investors and homeowners alike. Credit has become so ubiquitous that even some of Toronto’s gaudiest gold-for-cash outfits (namely, Harold the Jewellery Buyer and Oliver Jewellery) have started promoting mortgages and home-equity loans on behalf of brokers.

Now, thanks to tough new mortgage lending and insurance rules announced by federal Finance Minister Bill Morneau in October, some analysts predict that so-called “shadow banking” firms, which operate largely outside the purview of regulators, will see a surge of fresh business from frustrated homebuyers who can’t get conventional loans. Those federal rules, which double down on restrictions adopted in 2014 and stern warnings to lenders issued by OSFI earlier this summer, require banks to qualify borrowers at higher interest rates, impose additional limits on mortgages for buyers with small down payments, and compel financial institutions to share the risk by taking out insurance policies on low-ratio mortgages. As these lenders are compelled to become increasingly selective about who is approved for home loans, desperate borrowers will seek mortgages from unregulated firms that aren’t required to take out federal mortgage insurance. Such borrowers will face higher mortgage rates, but they might view them as the price of admission to lucrative property markets that seem almost impervious to corrections.

Analyst Ben Rabidoux, a principal at North Cove Advisors, predicts Morneau’s measures “will force more volume out of the traditional banking space and…into this unregulated space.” Jake Abramowicz, a Toronto mortgage broker, is even more blunt: “Private lending is going to explode.”

The question is whether Morneau’s new regulations, which are intended to cool property markets, may unintentionally create other forms of pent-up and potentially contagious economic risk: a credit bubble on top of the real estate bubble, as it were. That’s obviously a big problem, given the Wild West atmosphere in the private lending industry. Unchecked expansion in this opaque corner of the credit market means a buildup of Canadians carrying uninsured short-term subprime mortgages, putting them at a greater risk of distressed home sales and personal bankruptcies in the event that interest rates go up. “We are concerned about unintended consequences,” wrote Gabriel Dechaine, an analyst with Canaccord Genuity, in an October research note. “If this market grows, then the government may simply be creating a different set of problems.”

Federal officials downplay the risks and have declined to increase their scrutiny of such lenders. The dilemma “is whether we regulate them fully or force them to be more open,” says Jeremy Kronick, the C.D. Howe Institute’s senior policy analyst for financial services. “The way forward, from a regulatory perspective, is not clear.”

The term “shadow banking” encompasses a huge range of financial activities and organizations—everything from hedge funds to credit unions. This giant sector accounts for about 40% of the country’s nominal gross domestic product, according to the Bank of Canada. Private mortgage lending is but a fraction of that and is predominantly made up of mortgage insurance corporations and other pools of mom-and-pop investors that essentially lend through mortgage brokers.

In the lending world, the players at the upper end of the market include the banks and monoline firms, such as First National Financial, which issue mortgages but do not take deposits. These companies are regulated by the Office of the Superintendent of Financial Institutions, the Canada Mortgage and Housing Corporation (CMHC) and various provincial agencies. Those at the lower end, which loan money and carry out no other business, operate almost entirely beyond the purview of regulatory oversight.

How large is that segment? According to a Department of Finance spokesperson, “Unregulated lenders represent a relatively small portion of the mortgage market, estimated at around 15% of new mortgage originations in Canada. As most unregulated lenders insure their mortgages and rely on CMHC securitization programs or the major banks for their funding, most of their mortgages must comply with federal mortgage rules.” (One industry insider, speaking off the record, dismisses such assurances as “nonsense,” noting it’s only monolines that are compelled to secure federal mortgage insurance.)

But it’s quite possible that the unregulated lenders’ market share is poised to expand further, especially if the dour reaction from monoline lenders is any indication. Many firms in this category responded to Morneau’s announcement glumly. First National, Canada’s largest non-bank mortgage lender, with $22 billion in loans each year, has seen its mortgages under administration almost double since 2010. But just days after Morneau dropped his bombshell, the company announced the new rules will directly impact about 41% of its insured residential mortgages, leading to an anticipated drop of as much as 10% of its originations. The reason: Its loans won’t qualify for federal insurance. Borrowers will have to look elsewhere.

Ironically, monolines such as First National and its peer Home Capital Group (HCG) benefited when consumers were turned away from the banks in the past. Founded by Gerald Soloway in the mid-1980s, HCG deployed a strategy of offering mortgages to those who had been rejected by the banks but still had respectable down payments. Through its credit arm, Home Trust, HCG only lent against homes that could be accurately appraised and turned over rapidly after a foreclosure. Home Capital Group “would service the heck out of the accounts,” notes one industry insider. “Gerry’s approach was, ‘If you don’t pay me, I take the house back.’” The formula was a licence to print money, and the company earned returns on equity in excess of 20% for many years. (Soloway retired earlier this year but still serves on the board.)

According to CEO Martin Reid, HCG, which had $23.4 billion in loans under administration at the end of fiscal 2015, has seen an increase in credit-worthy borrowers it describes as “non-prime” or “near prime,” in the parlance of Canadian lenders who are notably eager to avoid the “subprime” label. But in recent years, as the Bank of Canada held interest rates to historically low levels and consumer debt skyrocketed, the federal government tightened mortgage restrictions on regulated financial institutions, including HCG. Many newcomers with scant credit histories and self-employed individuals found themselves unable to secure mortgages, despite having decent down payments. Some of these rules had to do with new anti-money-laundering (AML) regulations, while others sought to take some of the zing out of the market.

Home Capital Group has seen some of its riskier lending business drain away to the private, unregulated mortgage lenders—firms like Alpine Credit or the many so-called “mom-and-pop” shops which proliferated as small investors teamed up with brokers to provide short-term, non-amortized loans. “There are customers we don’t do today that we used to do,” Reid says, referring to primarily self-employed people and immigrants with down payments but no employment income. As a result, the firm hasn’t seen much change in the overall size of its loan book, despite overall growth in the non-bank residential mortgage industry.

At the same time, HCG has had to deal with internal challenges. Last year, a whistleblower shared information that the company had been approving loans sourced by mortgage brokers who had submitted falsified salary documents for borrowers. By some estimates, up to 30% of loans come from mortgage brokers, who are paid a commission by the lenders. Reid stresses that the company severed ties with over 40 brokers and that there has been no hit to the company’s liability.

Private mortgage firms have jumped into the breach to meet the demand from homebuyers, and to satisfy investors eager for the returns short-term, non-amortized mortgages can provide. HCG even offers a “bundled” product—a conventional mortgage issued by HCG and a second loan offered by private lenders. A Reuters report contends arrangements like this allow borrowers to skirt some of the government’s more stringent qualification criteria. (A spokesperson for HCG says the practice predates the government’s new rules by several years and that it was “never meant to be a workaround.”)

Meanwhile, Amur specializes in mortgages with loan-to-value ratios in the 65% to 75% range. Because the firm isn’t required to adhere to OSFI’s banking regulations, its lending criteria are not based on the borrower’s credit score or employment income, but rather the available equity in the property. The firm’s mortgage investment corporation has about 2,400 such loans in its portfolio, with an average size of $85,000, and says it maintained a $4.3-million loan loss provision on a $214-million portfolio last year. To consumers, it plays up its ability to approve mortgage applications quickly—a dig at a banking sector steadily more concerned with OSFI compliance.

As Mulji, Amur’s vice-president of business development, says, “more people are looking for lenders like us because of the speed with which we can get loans approved.” Its Alpine Credit brand claims it can process an application within 24 hours, whereas banks typically take days or even weeks. Speed, of course, is crucial in sizzling real estate markets like Toronto and Vancouver, where bidding wars and double-digit price escalation have forced homebuyers to scramble for pre-approval on huge loans.

Toronto mortgage broker Geoff Carnevale says an increasing number of investors want in on the returns mortgage lending can provide, even if that means extending loans with 12% to 15% interest rates to people who really shouldn’t be borrowing. “If my client has loose credit and a second mortgage for 12%, that’s a death sentence for someone living paycheque to paycheque,” he observes. But mortgages are ubiquitous if the price is right. “There are always people looking to make a buck and [who] don’t care about the other person.”

Such is the desperation that some mortgage brokers will help disqualified buyers bolster their prospects by offering to connect them with people who will create phony salary documents. One Toronto realtor, speaking anonymously, tells of a broker acquaintance who offers such a service. If the buyer can put down a third but can’t show enough income to qualify for a loan, the broker will arrange for fake employment statements that show sufficient income. The cost? Between $2,000 and $4,000. “I always say I don’t want to be involved,” she adds.

Carnevale, who heads the Ontario Mortgage Brokers Association, knows his profession is rife with such tales. “It’s not just brokers supplying those documents,” he adds. “A lot of lenders know what’s going on.”


If unregulated private lending sees a surge of growth, policy-makers could find themselves with a dilemma: Should they increase scrutiny of this Wild West corner of the lending industry? And if so, how?

Financial regulation experts warn of the potential contagion effect of a hopped-up credit market, especially one in which more and more lending flows through unregulated firms. Case in point: In mid-September, three weeks before Morneau tabled his rules, credit reporting agency TransUnion estimated that hundreds of thousands of Canadians carrying variable rate subprime mortgages could be significantly impacted by interest rate increases of even 25 basis points. Mortgages through private lenders already come with high rates; the cost of servicing these loans will only increase should the Bank of Canada raise its benchmark rate.

Former Bank of Canada deputy governor Sheryl Kennedy, now CEO of Promontory Financial Group Canada, also points out that financial busts typically occur in underregulated, speculation-driven sectors where there’s a lot of leverage and “fair-weather” funding. “What happens if backers cut the funding and these entities don’t have sufficient liquidity to weather the storm?” she observes. “They have to have a contingency funding plan to stay in business. Liquidity is essential when providing financial services.”

Other policy watchers say it’s important for the federal government not to over-regulate and risk squelching innovation. “The regulator always has to worry about finding the right point in that balance,” says a former senior federal official who spoke on background. Those in the mortgage industry are not particularly enthusiastic about any call for more regulation. One former private lending executive, who would only comment on condition of anonymity, argues the recent growth in the private lending space represents a market response to excessive constraints on mainstream financial institutions. And despite all the tales of mortgage brokers cutting corners, this source adds, “there’s a very legitimate business here. At what point does caveat emptor kick in?”

Quite apart from the argument over OSFI-style oversight, the former federal official and others stress this segment of the market at least requires more transparency and clearer data so regulators and the Bank of Canada can better understand the credit landscape and the extent of high-risk loans issued by private lenders. “You have to have the capacity for surveillance,” says the former official. In particular, no one seems to have precise data on the size of the private, unregulated mortgage space. “If you don’t know,” says the former official, “you could have a risk problem.”

Interestingly, Mulji says Amur has not received any inquiries from federal regulators about the growth of its loan portfolio.

While most analysts predict a stampede of fresh business for these private lenders, some observers—and government officials, of course—offer up an alternative scenario, one in which Morneau’s new-sheriff routine takes the energy out of the most irrational parts of the housing market: single-family homes in heady urban markets like Toronto and Vancouver. It’s certainly one possible outcome. After all, the Vancouver real estate market did react to British Columbia’s recent foreign buyers tax; the number of homes sold in September fell by nearly a third compared with the year before, according to the Real Estate Board of Greater Vancouver.

It remains to be seen how the housing market in the Greater Toronto Area will react. Morneau’s regulations, as well as earlier lending restrictions, are aimed at homes that sell for under $1 million, which tend to be acquired by the sort of middle-income buyers most likely to become dangerously over-leveraged. If a housing correction does come, the individuals who invested in MICs and mortgage pools may pull out. Bruce Joseph, president of the Anthem Mortgage Group in Barrie, Ont., points out that private lenders like Amur attract “flighty” capital. In fact, Morneau’s clampdown could prompt these investors to seek redemptions and force borrowers already blocked from the mainstream banks to scramble to renew their mortgages—a dynamic that could lead to an uptick in distressed sales and other ripple effects. Indeed, there could be a shakeout in the private lending space. “We’ve seen a lot of players looking for quick returns, and a lot of them will get caught,” says Reid at HGC.

Mulji, however, doesn’t sound worried. His optimism is based on Amur’s experience after the feds’ previous attempts to cool housing markets. “As banks have tightened up,” he says, “more people have come our way.”