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Private mortgage risk flagged by regulators amid growth in shadow banking


Private non-bank mortgage loans that often come with higher lender fees and interest-only payment options are taking a growing share of residential real estate lending in Canada, a trend that is poised to continue or even accelerate amid rising interest rates and tougher mortgage qualification rules.

Not only are more Canadians taking on these often riskier loans, which are more prone to defaults, but they are holding them for longer. And one market watchdog, the Financial Services Regulatory Authority of Ontario (FSRA), is warning that the terms and true costs of such loans are often misunderstood by those who take them.

“In many cases, you are only paying the interest on a private mortgage. This means you’re not actually paying off any principal,” said Huston Loke, executive vice-president of market conduct at FSRA. He added that research conducted by the regulator “suggests that many homeowners don’t fully appreciate this difference and they may not understand what they are getting into.”

Private mortgage loans tracked by FSRA and the Canada Mortgage and Housing Corp. fall into the broad category of shadow banking, defined by the Bank of Canada as “bank-like activities that are exempt from banking regulation.”

In a series of reports looking at shadow banking since the 2008 financial crisis, Canadian regulators and the Bank of Canada have concluded it is a relatively small segment of the market and doesn’t pose significant risk to the financial system.

In many cases, you are only paying the interest on a private mortgage. This means you’re not actually paying off any principal,

Huston Loke

But even before last year’s steady pace of interest rate hikes combined with bank stress tests to push some homebuyers out of the traditional real estate borrowing market, private non-bank mortgages had soared 72 per cent to $22.4 billion in just two years in Ontario, capturing 10.6 per cent of the market by 2021, according to FSRA, which published its latest figures on Feb. 27.

The data gathered from annual information returns the regulator requires from all licensed mortgage brokerages and administrators in the province show the eye-popping growth stemmed from a combination of a rising number of loans and their average size. 

And the market share trends are continuing on a national level, according to the latest figures from CMHC. 

Mortgage Investment Entities — a group the housing authority tracks that includes mortgage investment corporations and other private non-bank lenders that provide short-term loans with higher interest rates to borrowers who don’t qualify with traditional lenders — originated 10.2 per cent of residential mortgages in the third quarter of 2022 compared to 8.43 per cent a year earlier and 8.26 per cent in the third quarter of 2020.

 Houses and townhouses in Langley, B.C.
Houses and townhouses in Langley, B.C.

And while these mortgage entities held less than two per cent of the outstanding mortgages in Canada, they were responsible for seven per cent of new mortgages in the first quarter of 2022, CMHC noted in a Nov. 30 report.

Moreover, a subset of private real estate lenders known as mortgage investment companies, or MICs, outpaced overall mortgage debt growth in Canada in the second quarter of last year. While mortgage debt grew by close to 9.75 per cent, assets under management of the top 25 MICs in Canada grew by more than 22 per cent in that period.

“This unregulated segment of the industry has likely attracted a higher number of borrowers that were not able to get qualified with a traditional lender in the context of rapidly rising interest rates,” the CMHC report said.

Seamus Benwell, a senior economics analyst at CMHC, said the housing authority has noticed that not only are more people are using private mortgages, about a third of them are staying in the unregulated market for longer than they have in the past. 

It’s really not sustainable for most borrowers to have a loan with a private lender for a long period of time

Seamus Benwell

Most borrowing in the private lender market tends to be short term — as little as 12 to 18 months — because rates are usually higher, he said. So the change signals that a growing proportion of the borrowers are stuck with those rates because they remain unable to qualify for a loan with a bank or credit union.

“Rates are going up and it’s even harder than they thought it would be to get back into the traditional lending space….That’s most likely the reason,” Benwell said in an interview on Mar. 2.

“It’s really not sustainable for most borrowers to have a loan with a private lender for a long period of time.”

Benwell suggested trends in the private market are being driven by the mortgage stress test, which requires banks to qualify uninsured mortgage holders at the the contract rate plus two per cent, or 5.25 per cent, whichever is greater. As the Bank of Canada’s overnight rate climbed to 4.5 per cent in January from 0.25 per cent a year earlier, the stress test became more onerous.

 Bank buildings in Toronto’s financial district.
Bank buildings in Toronto’s financial district.

“That’s the biggest thing that’s changed in the past little bit. What we’re seeing drive people towards the (private lending) market is they’re just not getting getting approved in the traditional lending space,” he said.

FSRA’s Loke warned that while private mortgages can be an option for some home buyers, their sometimes burdensome terms and conditions — and the option to pay only interest while still owing the entire amount of the loan — mean they should be used only as “a short-term stop gap, not a long-term solution.”

Moreover, a lender in the private mortgage sector can be anything from a pooled syndicate to private individual and there is no standardized loan, so terms and conditions are often misunderstood, he said.

What we’re seeing drive people towards the (private lending) market is they’re just not getting getting approved in the traditional lending space

Seamus Benwell

Andrey Pavlov, a professor of finance at British Columbia’s Simon Fraser University who specializes in risk management and real estate, said he’s not surprised by the surge in private mortgages given rising rates and tightening underwriting standards.

Such options can be good for competition in the financial services sector, he said. But this doesn’t come without risk.

“Allowing borrowers to over-extend themselves, either through insufficient income verification or through certain loan features, such as no amortization, increases the risk of default,” Pavlov said, adding that if defaults begin to rise in private mortgage lending, there could be “contagion” in pockets of the housing market where such mortgages are dealt out in higher concentrations.

“If an entire city has a high concentration of risky mortgages, then a few random defaults could put sufficient downward pressure on prices to generate more defaults by otherwise prudent borrowers.”

 The Bank of Canada building in Ottawa.
The Bank of Canada building in Ottawa.

A Bank of Canada report published in 2021 noted that mortgage investment corporations — significant players in private real estate lending — were “highly concentrated in large urban centres.” The report also noted the concentration of MICs “in riskier mortgage products.”

CHMC’s Benwell said large cities like Toronto and Vancouver do tend to attract a greater concentration of private mortgages and that could have an impact if defaults — which remain low — were to rise. With higher interest rates and stressed borrowers, the private market segment would be expected to be among the first hit, and home prices could fall in any situation where defaults rise.

But Benwell said doesn’t expect widespread fallout to in major cities because of the very reasons private lenders tend to concentrate there in the first place: constant demand for housing in big cities means home prices there tend to drop less in down markets.

“Even in Toronto, if we think that the alternative lenders are about 10 per cent of the market, even in the worst case scenario that’s not 10 per cent of the market that’s going to result in … selling the property,” Benwell said.

“In fact, one of the core aspects of the business model of these alternative lenders is that they are looking at the strength of the property, sometimes more so than the actual strength of the borrower, because they know if that borrower gets into difficulty they can ultimately sell the property to recoup their dollars.”

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