Mortgage applicants are fluffing income claims
CMHC study
Are Canadian homebuyers overstating their income on mortgage loan applications? A study of CMHC-insured mortgages seems to suggest the answer is yes.
The study revealed that incomes reported on mortgage loan applications were systematically higher than those reported to the Canada Revenue Agency (CRA).
Since the subprime crisis, mortgage fraud became a subject of several inquiries in the U.S. The same has not been true north of the border, where not much has been known about the extent of mortgage fraud, or he degree to which misstatements on mortgage applications affects mortgage default rates.
A recent paper by CMHC researchers, however, explored those very subjects.
Kiana Basiri and Babak Mahmoudi, in a paper presented last week at the American Real Estate and Urban Economics Association conference in Washington, D.C., found that an increase in housing prices increased the incidence of homebuyers exaggerating their incomes on loan applications.
Drs. Basiri and Mahmoudi analyzed the possible income misstatement (PIM) by first time home buyers (FTHB) by comparing the incomes reported on mortgage applications and the ones reported on tax files from 2004 to 2014.
They defined PIM as the difference over time between the growth in income reported to CMHC and the growth in taxable income filed with the CRA at the Forward Sortation Area (FSA) level. FSAs are the areas representing the first three characters of a six-digit postal code.
A positive PIM would suggest that incomes stated on mortgage loan applications by FTHB have grown faster than the incomes reported to the CRA. Thus, it serves as a proxy for the extent that incomes are artificially being inflated to secure loans.
The study reached two interesting conclusions. First, FTHB are more likely to misstate income in real estate markets with affordability challenges. Second, they found a correlation between higher default rates and the incidence of income misstatement.
Unlike repeat homebuyers who often have access to equity from the sale of the existing dwelling unit, FTHB rely on savings, loans and gifts to put together a minimum down payment for a mortgage. Hence, they are more stressed to accumulate sufficient collateral to qualify for a desirable loan amount. Commercial banks usually require 20 per cent down payment for residential mortgage loans.
CMHC provides mortgage insurance in instances where down payment is at least 5 per cent but less than 20 per cent of the loan amount. During 2004 and 2014, CMHC covered 60 to 80 per cent of the insured mortgage loan market.
The study revealed PIM was correlated with a higher rate of mortgage arrears, which represented mortgages that are 90 days or more past due within five years of loan origination. Furthermore, the study also found that an increase in PIM was correlated with an increase in insurance claims that are made once a mortgage has foreclosed.
The correlation between income exaggeration and mortgage default should not raise alarms about the state of mortgage finance in Canada. The Canadian Bankers Association reports a very low incidence of residential mortgages in arrears. At the end of February 2018, only 11,520 residential mortgages were in arrears in Canada representing a mere 0.24 per cent of all mortgages. In comparison, at the peak of the housing crisis in the U.S., the foreclosure rate was over 2.2 per cent.
Whereas housing price escalation has been more pronounced in Ontario and British Columbia, their share of mortgages in arrears was lower at 0.1 and 0.15 per cent respectively. In comparison, the share of mortgages in arrears was significantly higher in Saskatchewan and other provinces where housing affordability challenges have not been as severe.
Another interesting finding was a lack of evidence for lax lending standards by mortgage finance companies (mortgage brokers), which the study defined as nondepository financial institutions. Many believe that unlike the regulated banks and other large lenders, mortgage brokers might be taking on high-risk mortgages with little due diligence on the creditworthiness of the borrowers. The study though found no evidence that suggested a higher incidence of PIM for broker-originated mortgages.
While mortgage fraud sounds alarming, the study also reported two positive outcomes in mortgage lending. First, the study did not discover a sizable difference in income growth between CMHC and CRA data. Second, income exaggeration did not escalate over the study period even when one observed a noticeable increase in housing prices across Canada.