Canada is not just seeing an increase in the number of highly indebted buyers. They have little equity

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Canada’s central bank warns of a rapid deterioration in the mortgage environment. Yesterday we unpacked Bank of Canada (BoC) data on highly indebted borrowers representing a larger share of mortgage arrangements. Today we’re looking at an issue that builds on this – these borrowers have little equity. Heavily indebted households with little equity are the perfect recipe for disaster. They also represent a growing share of day-to-day mortgage arrangements.

Being heavily in debt is different from having little equity

Heavily indebted households have much greater debt than their income. A household is highly indebted when its loan / income ratio is greater than 450%. For example, a household with an income of $ 100,000 / year and a mortgage of $ 500,000 has a loan-to-income ratio of 500%. They would be heavily indebted, according to the Canadian banking regulator.

Having little equity means you have a high loan-to-value (LTV) ratio on the house. Let’s say you still earn $ 100,000 and have a mortgage of $ 500,000, but the house is worth $ 2.5 million. The LTV ratio is 20 percent and requires an 80 percent drop to eliminate the owner. This borrower is heavily indebted, but not necessarily at high risk because he can draw on his own funds. This allows them to “smooth out” missed payments.

Less fairness would make it a different situation. If you’ve earned the same amount, on the same mortgage, but your house is worth $ 555,000, your LTV is 90%. House prices only need to drop 10% for that borrower to be wiped out. Not only are they heavily in debt, but they also don’t have the equity to overcome the problems.

People with little skin in the game may be quick to give it up. This makes them more dangerous. The risk increases when that person is both heavily in debt and has little equity in their home. The most dangerous person is often the one with the least to lose.

Don’t take my word for it though, the BoC has calculated the numbers on the data. Households with a loan-to-value ratio below 65% have a 7.5% risk of defaulting on payments. As the LTV increases, so does the risk. LTV 66-80% (+ 9.4%), 81-94% (+ 13.5%) and the highest over 95% (+ 16.4%). Missed payments are obviously the biggest sign of financial distress. It can mean foreclosure, but often means forced sale. That is, the owner is in distress and needs to make a list, but it might not be obvious that he needs to sell.

Missing mortgage payments by Canadian households: probability

The probability rate for Canadian households to miss a mortgage payment, based on the mortgage loan-to-value (LTV) ratio.

Source: Bank of Canada; Bank deposits; Better accommodation.

Canada sees heavily indebted mortgage borrowers with small increase in equity

Highly leveraged borrowers are stealing a greater share of loan arrangements these days. Borrowers with a loan-to-income ratio of 450-550% captured an additional 3.66 points of market share in 2020. Broken down by LTV, we find that the increase is significantly higher in homes with less equity . LTVs of 65% or less (+0.31 point), 66-80% (+1.86 point), and 80% or more (+1.49 point) all show big gains in 2020.

People with even more debt experienced a similar rate of mortgage origination. Households with a loan-to-income ratio of 550 to 800 percent gained 2.88 points from mortgage origination. If broken down, we see LTVs of 65% or less (+0.64 points) and 66-80% (+2.24 points) represent the full increase. The share of loans to households with an LTV of 80% or more remains unchanged

Canadian homebuyers with more reasonable leverage give up

Households with lower leverage are withdrawing from the market. Households with a credit / income ratio of 350 to 450% recorded a drop of 1.13 points in the share of arrangements. All ranges of LTV recorded a relatively sharp decline – 65% or less (-0.27 point), 66 to 80% (-0.49 point) and more than 80% (-0.37). Households with lower loan-to-income ratios tend to have higher incomes.

Changing Composition of New Mortgages in Canada

The evolution of the share of new mortgage debts issued between 2019 and 2020. The data are grouped by loan-to-income ratio and broken down by loan-to-value (LTV).

Source: Bank of Canada; Bank deposits; Better accommodation.

Those with the lowest leverage disappear the fastest from this market. The share of arrangements with a loan / income ratio of less than 350% fell by 5.45 points in 2020. LTV distribution: 65% or less (-1.81 point), 66 to 80% (-1.97 point) and 80% (-1.67 point). These are generally the households with the highest incomes.

Mortgages do not only degrade in quality because of the extent of leverage. The market is also seeing highly leveraged borrowers making smaller down payments. This not only increases the likelihood that they will not be able to pay, but also helps to push up the prices. If you are prepared to have a smaller share of the equity, the prices may go up even more than they have.

Can you blame them? Canada has just suspended mortgage payments for anyone who asks. There was no income requirement, just an offer to take a break from paying for your accommodation. Households most likely think this is the new normal, no matter what. The risk is dead. Long live the risk.

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