Two weeks ago, a key China-linked concern that made headlines back in 2013 and 2014 reemerged after an extensive analysis by Reuters reporter Engen Tham found that China's "ghost collateral" problem, or collateral that was either rehypothecated between two or more loans, or simply did not exist, had not only not gone away but was still as prevalent as ever if not worse.
The report, a continuation of extensive reporting conducted on this site, said that 60% of all loans issued in China’s system are backed by property, and that China’s property values are “wildly misleading, which is part of the reason that China’s credit rating was recently downgraded." Reuters reported that Chinese lenders are prone to fraud with loan officers turning a blind eye to the quality of collateral and knowingly accepting dubious and even fraudulent documents.
Now, in a follow up by the Vancouver Sun's Sam Cooper, the real estate reporter explains that China's "ghost collateral" problem has jumped across the Pacific and is threatening the Canadian banking system.
As Cooper notes, "as a result of the flood of money pouring from Mainland China into Vancouver real estate in recent years, some financial experts say they believe Canadian banks are directly exposed to shadow lending in China and the risks of so-called “ghost collateral”, collateral that may not exist or is used continuously to secure loans for multiple borrowers."
And the stunner: "Postmedia confirmed that Canadian banks are allowed by the federal regulator, the Office of the Superintendent of Financial Institutions, to accept collateral from China to secure real estate mortgages in B.C."
“OSFI does not dictate what type of collateral (federally regulated banks) can accept,” spokeswoman Annik Faucher said. “Whether the borrower is foreign or domestic, OSFI (allows) financial institutions to compete effectively and take reasonable risks.”
The underlying reason for Canada's growing, if paradoxical, exposure to Chinese collateral is due to an explosion of Canada's shadow banking system. An investigation by Cooper found "massive and risky home loans are increasing in number across Metro Vancouver, while mortgage fraud cases are also on the rise, connected to the growth of so-called “shadow banking." This is similar, if smaller in scale, to the gargantuan $8.5 trillion shadow banking market in China, where "shadow" lenders and creditors bypass conventional banks to provide and obtain funding, often at far higher terms than prevailing rates, an increasingly dangerous proposition at a time when Chinese interest rates, especially on the short-end, are suddenly spiking.
The Vancouver Sun adds that as a result of tighter federal lending rules, borrowers trying to buy million-dollar-plus properties in Vancouver’s market "are increasingly taking out dangerous loans from shadow bankers in a fast-growing and poorly regulated financial market."
The trend of increasingly risky loans underlying Metro Vancouver’s high home prices is illustrated by Bank of Canada figures that show the rapid growth since 2014 of large mortgages made to people with relatively low incomes.
Cooper adds that there is also evidence of growing links between shadow banks and traditional banks, according to the Bank of Canada’s June 2017 report, as people borrow large amounts from shadow lenders to use as down payments in order to qualify for lower-interest loans from federally regulated banks.
According to a December 2016 Bank of Canada report, shadow lenders now account for $1.1 trillion in debt — about half as much as the traditional banking sector — and that over the past decade “these new players have become more important and have changed the face of the Canadian mortgage market … (as) tightening bank regulation can lead to migration of activity from the traditional banking sector to the shadow banking sector.”
Just like in China, Canada's shadow lenders are non-bank lenders that boost the supply of credit in Canada’s financial system without facing bank regulation or oversight. "Critics say shadow banking is vulnerable to loose lending standards, mortgage fraud, money laundering, and collateral that is overly leveraged (also called re-hypothecated) — meaning debt backed by property assets is used over and over again by related lenders to issue more home loans, in ever riskier chains of debt."
Among the various shadow lender groups identified by Postmedia include mortgage investment corporations, hedge funds, and private lenders such as realtors, crowdfunding companies, real estate lawyers and mortgage brokers. In other words, virtually anyone who is sitting on cash and want to generate a higher return than offered by the bank, is looking for a way to make this capital available to Canadian home buyers, in the process sending local real estate prices even higher and making Canada's housing bubble even more acute.
Some examples.
As Cooper explains, shadow lending can be as simple as a mortgage loan provided by one person to another in need of financing, or as Byzantine as the complex processes through which credit is created and exchanged and repackaged between various lenders to fund mortgages.
For example, the director of a Surrey lumber and real estate investment company explained to Postmedia that his group’s business model consists of pooling the real estate assets of an extended group of family and shareholders, and using these homes as collateral to borrow money from financial institutions. The borrowed capital is then issued in mortgages to home buyers that can’t obtain financing from chartered banks.
In another example researched by Postmedia, lending documents show that controversial “crowdfunding” developers are using single-family homes owned by investors in Vancouver to secure loans from subprime lenders that are active in B.C. in order to fund condo developments in Vancouver and Burnaby.
Quoted by Cooper, Hilliard MacBeth, an Alberta-based author and wealth manager, said that the Bank of Canada loan risk statistics and the related growth of shadow banking in Vancouver and Toronto "heralds a crisis."
“These properties in Vancouver are so expensive that you need people either laundering money or loan fraud or people borrowing such large amounts of money that should never be allowed, in order to keep it going,” MacBeth said. “If everyone is reporting their incomes honestly in Vancouver, there is no way that housing prices can stay where they are.” And yet, as we showed in early June, the world's biggest real estate bubble, Vancouver home prices, just hit new all time highs despite last year's 15% property tax targeting foreign buyers, an attempt to rein in the market.
One of the side-effects of exploding shadow banking is a spike in mortgage fraud. Postmedia’s review of enforcement hearings by British Columbia's regulator, Financial Institutions Commission, shows an increase in the number of alleged mortgage fraud cases in B.C., mostly linked to private mortgage lenders and mortgage brokers.
“We have experienced an increase in mortgage broker complaints in the last few years,” Chris Carter, acting registrar of mortgage brokers, confirmed. “About a third of our investigations relate to application fraud.”
Meanwhile, the abundance of easy "shadow" credit means that as real estate prices have exploded, even the Bank of Canada has been warning of two key risks in Canada’s housing market.
The first is that property prices and household debt have reached such extremes in Vancouver and Toronto, that “just about anything” could trigger a correction, Poloz said last week. Highly indebted borrowers could be forced to sell in a correction, the Bank of Canada says, leading to further selling, tighter lending, and a potential domino effect on banks and shadow banks.
The other elevated risk is the potential for a shock from China’s volatile economy. China has its own shadow banking problems, the Bank of Canada says.
This is where the China connection emerges: in China, “linkages between the banking and shadow banking systems are also becoming more complex and opaque, increasing the underlying credit risk,” the Bank of Canada’s December 2016 risk report says. “The experience of the 2007-09 global financial crisis showed that financial stability can be threatened by vulnerabilities originating in the shadow banking sector.”
As noted above, due to influx of money pouring from China into Vancouver real estate in recent years in an attempt to evade exposure to the local banking system, and bypass China's capital controls, Canadian banks have become directly exposed to shadow lending in China and the risks of so-called “ghost collateral.”
Cooper quoted a U.S. hedge fund manager who said that “we all know that the ghost collateral is a huge deal, and we all know that the shadow banking and other Chinese influence in Vancouver is profound. The issue is that the ghost collateral ends up re-hypothecated and laundered. So by the time it shows up in Vancouver, it will likely just look like a rich Chinese cash buyer with a suitcase of money.“
The question, of course, is what "collateral" was used to create this suitcase of money, and whether it even exists.
Cooper then shows how high risk loans in Metro Vancouver have spread in recent years, as shown in Bank of Canada maps that show where new ‘high-ratio’ loans - those where the buyer makes less than a 20% down payment on a home purchase and borrows the rest — have been issued.
If the value of the loan is 450% of annual income or more, the borrower is considered particularly vulnerable. The Bank of Canada will not reveal the number of high-ratio loans issued in Metro Vancouver, but says they are concerned with the rapid growth in these loans. In 2014, across Metro Vancouver, 31 per cent of new high-ratio mortgages were at least 450 per cent of the borrower’s income. In the second half of 2015, this figure rose to 37 per cent. By late 2016, it was 39 per cent.
Confirming the dramatic impact of shadow loans on the Vancouver market, the Bank of Canada has said that under the new tighter federal rules, roughly 43% of the high-ratio loans issued in Vancouver between September 2015 and September 2016 would have been rejected. This means either that an increasing portion of buyers in Metro Vancouver will be unable to get loans in the future or that the shadow lenders will fill the void.
For now, courtesy of the nearly $20 trillion in excess liquidity created by central banks, it's the latter however that may soon chance as central banks start to contract their balance sheets.
To be sure, the warnings are there. Ben Rabidoux, a Canadian real-estate analyst and Zero Hedge contributor, has said that his research with on-the-ground mortgage brokers suggests that loan fraud is a systemic concern in Ontario and B.C.
“The shadow market is absolutely booming,” Rabidoux said. “Of course B.C. has a mortgage fraud problem, but you won’t really see it until there is a problem with collateral in the system.”
For now, most Chinese collateral problems as we explained recently, have been swept under the rug with the express blessings of Beijing, which is desperate to prevent the re-emergence of fears about the domestic financial system and avoid further capital outflows.
What is one possible catalyst that may expose that China's "collateral emperor" is not only naked but a ghost? Global, coordinated central bank tightening of liquidity, i.e., the Fed's balance sheet unwind followed by the ECB and BOJ. At that moment, China's "ghost collateral" problems will come back with a vengeance, only this time they will also have a direct - and dire - impact on Canada's economy, unless urgent measures are taken by local regulators and government, both of which however realize that any aggressive attempts to rein in Canada's breathtaking home price appreciation could lead to an even more acute financial crisis. As a result, regulators, banks and officials will likely remain paralyzed even as Canada's "shadow market" grows and until something finally snaps, by which point it will be too late to prevent the "crisis."