Consumer Watch Canada October 10, 2006

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1 Economics & Strategy Consumer Watch Canada October 10, 2006 Jeffrey Rubin Avery Shenfeld Benjamin Tal Peter Buchanan Warren Lovely David Bezic (416) (416) (416) (416) (416) (416) Sub- As Target The Surging Non-Conforming Mortgage Market in Canada Benjamin Tal With the number of new players entering the market at an unprecedented pace, the Canadian non-standard and sub-prime mortgage market is receiving increased attention. And for a good reason. The market is currently rising at an annual pace of more than 50% by far the fastest growing segment of the mortgage market. What is behind the meteoric ascent of this controversial business line? Is it sustainable? And what does it mean for the mortgage market of tomorrow? Relying primarily on industry data and survey-based information 1, we provide a detailed picture of the non-conforming/sub-prime market in Canada. More specifically, we focus on its relative size, growth and growth prospects, as well as its regional and demographic breakdown. We then discuss the implications of the surging non-conforming market for the housing and mortgage markets from both growth and risk perspectives. The Changing Canadian Mortgage Scene The Canadian mortgage market is in transition. Recent innovation in mortgages, along the line of what is already available in other countries, is a clear reflection of an evolving market. And this is just the beginning. Over the next 5-10 years, innovation in the mortgage market will accelerate at a pace not seen before in Canada. The mortgage market of the future will be almost unrecognizable when viewed against today s standards. Lenders will face more flexibility, alongside steeper competition and increased risk. Consumers will enjoy increased options and better access to home ownership. The rising competition in the market place is already visible, as growth in mortgage lending by non-bank mortgage providers is now exceeding growth in banks mortgage totals outstanding (Chart 1). In this context, the emergence of the non-conforming/ sub-prime market in Canada is one of the most important trends to monitor. This fast growing and controversial segment of the market is underresearched and poorly understood. Chart 1 Value of Outstanding Mortgages 14 y/y % chg Banks Non-Banks CIBC World Markets Inc. PO Box 500, 161 Bay Street, BCE Place, Toronto Canada M5J 2S8 WGEC1 (416) CIBC World Markets Corp. 300 Madison Avenue, New York, NY (212) , (800)

2 What is Sub-? We can define the non-conforming/sub-prime market as lending at relatively costly interest rates and fees to credit-impaired or otherwise higher risk borrowers. Whereas prime loans are typically offered to borrowers who have a strong credit history and can demonstrate a capacity to repay their loans, non-conforming loans are typically made to borrowers who are perceived as deficient on either of these grounds. The lender also accepts riskier mortgage characteristics, such as a higher loan to value ratio, or attributes of the property that cause the loan to carry elevated credit risk. In fact, looking at the credit score distribution of the non-conforming market in the US, we find that almost 70% of non-conforming mortgage loans have a credit score of at least 600 a level that indicates adequate, or better, credit rating. No less than 9% of non-conforming mortgage loans have a credit score that s rated as excellent (Chart 2) 2. Chart 2 Distribution of Credit Rating of Non- Conforming Mortgages (US) 59.8% We can roughly segment the mortgage credit market according to the following sub-groups: Good credit history, and good asset and income positions. 31.1% 9.1% Non- Conforming Alt.A/Near Good credit history and low loan to value ratio, but does not meet traditional bank guidelines mostly due to lack of proof of income. Sub- Bad credit history, low asset base and high loan to value ratio. Based on this segmentation, the combination of Alt.A/near prime and sub-prime is traditionally referred to as non-conforming credit. Often the terms subprime and non-conforming credit are used interchangeably, but it is more appropriate to view the sub-prime market as being the riskier segment within the broader non-conforming credit spectrum. Risky Business? Bad Reasonable/ Good Credit Rating Having said that, one has to recognize that the more risky part of the business (sub-prime) is tremendously risky. While those with bad credit account for only 30% of the non-conforming mortgage market, they are responsible for almost two-thirds of total losses in this business line (Chart 3). In the US, the probability Chart 3 Distribution of Credit Losses of Non- Conforming Mortgages (US) 63.7% Excellent This distinction touches upon one of the most popular misconceptions regarding the non-conforming mortgage market. Many assume that non-prime loans are, by definition, characterized by higher credit risk. But that s not necessarily the case. Alt.A borrowers can be relatively good risk, but they do not fit into traditional lending guidelines due to lack of proper proof of income. Bad Reasonable/ Good 35.4% Credit Rating Excellent 0.9% 2

3 of default is currently six times higher for sub-prime loans vs. prime loans. In fact, with the recent slowing in the US housing market, more sub-prime borrowers are defaulting in the early months of their home loans. The number of US sub-prime mortgages with at least one missed payment in the first three months after origination has risen by 14% since the beginning of the year. Anecdotal information for Canada suggests that the delinquency rates on sub-prime business are not very different than in the US. Furthermore, non-prime loans are less sensitive to interest rate changes and, as a result, sub-prime borrowers have a harder time taking advantage of available cheaper financing. Chart 5 Share of US Sub- in Total Mortgage Originations % Rising Fast While the non-conforming market accounts for only 5.0% of new mortgages, it is growing rapidly. During the first half of 2006, sub-prime originations rose by a dazzling 50% vs. the same period in That is almost five times faster than originations of prime mortgages (Chart 4). This means that over the past year alone, the growth in the non-conforming market has enabled no less than 85,000 Canadian households, who otherwise would have been shut out of the market, to become homeowners. Note that as early as 1994, the non-conforming/sub-prime market in the US stood at 5% of total market originations. Today, it stands at 22% (Chart 5). Chart 4 Sub- Market Is Surging % Growth in Mortgage Originations Jan-Jun 06 vs. Jan-Jun 05 Sub- There is little doubt that the recent acceleration in non-conforming mortgages in general, and sub-prime in particular, is driven by the entry of new players to the mortgage lending business and a transfer of business models from the US. This process is only in its infancy. Mortgage Brokers and the Non-Conforming Market Another important driver of change in the Canadian mortgage market is the emergence of mortgage brokers as a significant player in the mortgage credit scene. Mortgage brokers are intermediaries that bring borrowers and creditors together to obtain a mortgage loan. Generally speaking, brokers may reduce borrowers search costs and enable borrowers to obtain lower cost credit than they could find on their own. Similarly, brokers may lower creditors origination costs through economies of scale and specialization. And by using different brokers, a creditor may be able to reach more borrowers than it could on its own. There are currently close to 10,000 mortgage brokers in Canada, accounting for nearly 25% of total mortgage originations in the country up from only 3% a decade ago (Chart 6). Note that mortgage brokers are more popular among young Canadians, with one-third of homeowners under the age of 35 3

4 using their services (Chart 7). This demographic observation suggests that the role of mortgage brokers in the Canadian market will continue to grow, as those young Canadians are more likely to continue with their broker relationship in the coming decade. Chart 6 Broker-Originated Mortgages Rising Fast Chart 8 Brokers Funding Broken Down By Lender Category 9.0% 5.5% Share in Total Mortgage Originations 25.0% 33.5% 52.0% 21.0% Banks Mortgage Banks Sub- Credit Unions/Insurance 8.0% 3.0% Chart 7 Using a Mortgage Broker By Age 33.4% 23.5% Share of Total Mortgage Holders in Age Group for roughly 9% of total broker-originated credit a still relatively small but fast growing segment (Chart 9). We do not suggest that the current fantastic pace of growth in the non-conforming market is sustainable, nor do we expect its share to reach the level seen south of the border. However, it appears that in the foreseeable future these non-conforming mortgages will remain by far the fastest growing segment of the mortgage market propelled by increased numbers of sub-prime players and the growing role of mortgage brokers in the Canadian market. From a more cyclical perspective, the projected slowing in the Canadian 15.8% 16.2% 8.8% Chart 9 Share of Sub- in Broker Mortgage Originations < % 10 9 A widely held misconception regarding mortgage brokers is that this segment of the market services primarily high-risk credit. The data simply does not support this claim. More than 50% of brokers funding is through commercial banks while another one-third is via mortgage banks (Chart 8). Brokers funding through special sub-prime credit providers accounts Q1 04Q4 05Q3 06Q2 4

5 economy over the next 12 months, and the accompanying likely increase in the unemployment rate and consumer bankruptcies, will add to the demand for sub-prime mortgage business. Overall, look for originations in the non-conforming market to rise by an annual average of 20% in the coming 5 years more than double the pace expected for prime mortgage lending. The ongoing and projected growth in the nonconforming mortgage business will also impact developments in the Mortgage-Backed Securities (MBS) market. Note that in the US, roughly 60% of sub-prime loans are securitized the highest rate on record (Chart 10). In fact, the current securitization rate of US sub-prime loans is comparable to that of prime loans in the late-1990s. With the non-conforming sub-prime market in Canada rising rapidly, look for their share in the MBS market to climb. Chart 10 Securitization Rate of Non-Conforming Mortgage Loans (US) The following is a brief discussion of some of our findings: Despite having the worst housing affordability reading in the nation, British Columbia has the lowest rate of non-conforming mortgages among all other provinces. At the same time, Atlantic Canada is the nation leader in this category, probably reflecting the relatively low-income growth in the region, and the recent surge in consumer bankruptcies (Chart 11). Chart 11 % of Households with Non-Conforming Mortgages By Province 5.4% 6.9% 5.5% 5.4% 6.1% 5.9% 3.6% % Securities issued divided by origination value e CAN ATL Que Ont Man/ ALTA BC Sask More than half of sub-prime mortgage holders live in rural areas a fact that is consistent with the relatively high unemployment rate and income volatility in rural Canada (Chart 12). Chart 12 Non-Conforming Mortgage Holders in Rural vs. Urban Areas Segmenting The Non-Conforming Mortgage Market Given the growing importance of the non-conforming/ sub-prime business line, we have taken a closer look at the segmentation of this market in order get a better understanding of the dynamics behind the headline numbers. Urban (Population >= 100,000) Rural (Population < 100,000) ALT.A/Near Sub- 5

6 Non-conforming mortgage holders in Canada are more likely to choose fixed term mortgages than variable rate mortgages (Chart 13). This is very different from the situation in the US, where non-prime mortgage holders are much more likely to choose variable rate mortgages. Chart 13 Fixed Rate Mortgages vs. Variable Rate Mortgages (% of Canadian Households) More than 8% of mortgage holders at the age group of hold a non-conforming mortgage. Note that the rate among the age group is close to 4%. We expect non-conforming borrowings among older Canadians to rise rapidly in the coming few years, due to the expected increase in the rate of self-employment among this age group (Chart 15). Chart 15 % of Households with Non-Conforming Mortgages By Age 72.6% 80.5% 80.3% 8.2% 27.3% 22.5% 22.9% 5.4% 6.9% 6.8% 3.8% ALT.A/ Near Sub- 1.4% Fixed Rate Variable Rate As in the case of the US, non-conforming mortgages are 10%-15% smaller than primebased mortgages (Chart 14). Chart 14 Average Outstanding Balance of Mortgage All Ages < It appears that income level is not a distinguishing factor between prime and non-prime borrowers (Chart 16). However, when focusing on investable assets the picture is much clearer, with households carrying non-conforming mortgages reporting much lower levels of investable assets (Chart 17). $105,742 $92,826 $86,517 Chart 16 Average Income of Mortgage Holders $60,567 $74,778 $65,219 ALT.A/ Near Sub- ALT.A/Near Sub- 6

7 Chart 17 % of Households with Non-Conforming Mortgages By Investable Assets 5.4% 6.4% 5.3% By any measure of financial health, nonconforming borrowers are notably worse off than prime based borrowers (Chart 18). That, of course, is consistent with the nature of the business. Note that the high debt to asset ratio is probably one of the main reasons why many nonconforming borrowers were forced into this category, despite having a good credit score. Chart 18 Financial Health of Households with Non- Conforming Mortgages Financial Health Ratios 3.8% Total <$50k $50k- $100k- $100k $250k 1.3% 1.3% $250k->$500k $500k ALT.A/Near Sub- Debt to Income 123% 158% 169% The Genie is Out of the Bottle At 5.0% of new mortgages, the non-conforming mortgage market in Canada is still small in comparison to analogous mortgage markets in the US, the UK and Australia. And the likelihood that sub-prime providers in Canada will soon become household names, as is the case south of the border, is still slim. However, it is a rapidly growing market. Foreign players are aggressively marketing their sub-prime offers in Canada, and the evidence to date suggest that they are succeeding in penetrating this underserved and high risk/return niche of the mortgage market. More established creditors are also becoming more open to servicing the Alt.A/near prime market, as evidenced by recent acquisitions made by some large Canadian financial institutions. Competition in this segment of the market will only intensify in the coming years, in the form of aggressive marketing tactics, price competition and innovation in product design. In the next five years, originations in the nonconforming market in Canada are projected to double in size, with additional 270,000 households that otherwise would have been priced out of the market, becoming homeowners. The growth in the nonconforming market will introduce even more pricing tiers and product types, which will help move the mortgage market closer to a pure price rationing, or risk-based pricing state. The future growth of the non-conforming mortgage market will not be smooth. Macroeconomic factors and regulatory considerations will add an element of volatility to this young market. But given the current environment of shrinking margins in the prime business, the growing importance of the broker channel, and aggressive entry of foreign players, the non-conforming market is set to continue to expand. The genie is out of the bottle. Debt to Assets 23.3% 40.2% 44.1% Investable Assets to Debt

8 Notes (1) Industry data of the sub-prime market was provided by Filogix. In the survey based information (source: Ipsos-Reid), non-conforming/near prime are defined as mortgage loans with average rate of basis points above the average rate while sub-prime loans are defined as those with rates of more than 125 basis points above average. (2) Score range (based on BEACON): Bad credit rating (<=599); Reasonable/Good credit rating ( ); and Excellent credit rating (>=700). Data sources used in this study: CIBC World Markets; Statistics Canada, Filogix, Fair Issac, MBA, Canadian Financial Monitor (CFM), conducted by Ipsos-Reid*. * CFM is a continuous syndicated research study. Data is gathered from Ipsos-Reid s panel of Canadian households via a mail survey. The sample is distributed proportionally by region to match Statistics Canada targets. The data used in this analysis are presented for the 12 month period ending May During this period 12,051 households completed the questionnaire. includes those who borrowed at prime as well as those who have no debt. Based on the total 12,051 respondents, the margin of error is approximately ±0.89%, 19 times out of 20. For analysis of Non-Conforming Mortgage data the margin of error is approximately ±3.70%, Near Sub- ±5.38%, At Sub- ±5.09%, 19 times out of 20. Conflicts of Interest: CIBC World Markets analysts and economists are compensated from revenues generated by various CIBC World Markets businesses, including CIBC World Markets Investment Banking Department. CIBC World Markets may have a long or short position or deal as principal in the securities discussed herein, related securities or in options, futures or other derivative instruments based thereon. 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