Fiduciary Responsibility
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Learning lessons from the U.S. Sub-Prime Market Meltdown
The American sub-prime mortgage market collapse of recent months has created a frenzy of activity within this segment of the financial services sector. Mortgage brokers have been viewed as unscrupulous and sub-prime lenders have been deemed reckless. (financial.seekingalpha.com) The purpose of this paper is to examine the fiduciary duty of those professionals involved in the sub-prime marketplace.
The sub-prime mortgage market
The American sub-prime mortgage market collapse of recent months has created a frenzy of activity within this segment of the financial services sector. Mortgage brokers have been viewed as unscrupulous and sub-prime lenders have been deemed reckless. (financial.seekingalpha.com) The purpose of this paper is to examine the fiduciary duty of those professionals involved in the sub-prime marketplace. The sub-prime market will be outlined and the reasons leading up to the sub-prime meltdown will be explored. The impact of the collapse on the Canadian sub-prime mortgage market will be addressed and the responsibilities of those professionals acting in this market will be analyzed.
Smith-Eivemark recognizes that a fiduciary duty occurs, when a special relationship, consisting of confidence and trust, exists such that one person has a reasonable expectation that another person, or organization, (the fiduciary) will act in his or her (the beneficiary) best interests, even to the detriment of the fiduciary's interests. (28)
Within the sub-prime mortgage market the mortgage broker may receive a finder's fee from a mortgage lender and/or charge the client a broker fee for facilitating the mortgage transaction. In either case, the borrower is dependent upon the broker. The mortgage broker will have a fiduciary responsibility to the borrower and the interests of the borrower must take precedence over all other interests.
In the situation where a client has excellent credit and ample monetary resources Smith-Eivemark posits that there is less fiduciary responsibility towards the client. (Smith-Eivemark, 28) The borrower is less reliant on the mortgage broker because a mortgage can be readily secured from many other lenders within the marketplace. In the U.S. marketplace it has become evident that the fiduciary responsibility of the mortgage broker to the sub-prime borrower has not been taken seriously and this lack of duty is partially to blame for the present situation.
Smith-Eivemark recognizes that a fiduciary duty occurs, when a special relationship, consisting of confidence and trust, exists such that one person has a reasonable expectation that another person, or organization, (the fiduciary) will act in his or her (the beneficiary) best interests, even to the detriment of the fiduciary's interests. (28)
Within the sub-prime mortgage market the mortgage broker may receive a finder's fee from a mortgage lender and/or charge the client a broker fee for facilitating the mortgage transaction. In either case, the borrower is dependent upon the broker. The mortgage broker will have a fiduciary responsibility to the borrower and the interests of the borrower must take precedence over all other interests.
In the situation where a client has excellent credit and ample monetary resources Smith-Eivemark posits that there is less fiduciary responsibility towards the client. (Smith-Eivemark, 28) The borrower is less reliant on the mortgage broker because a mortgage can be readily secured from many other lenders within the marketplace. In the U.S. marketplace it has become evident that the fiduciary responsibility of the mortgage broker to the sub-prime borrower has not been taken seriously and this lack of duty is partially to blame for the present situation.
Reasons for the meltdown
The following sections will delve into the reasons for the meltdown and analyze the parties that have failed to perform both ethically and responsibly. Valuable lessons can be learned which should then be applied to the growing Canadian sub-prime market.
The sub-prime mortgage market cannot be specifically defined. It generally includes borrowers that represent a greater risk of default on their mortgages. Lenders offer sub-prime mortgages to individuals who do not meet conventional lending criteria. The borrower may display a lack of credit history or a weak credit score on their credit bureau. Payment delinquency may be present on the credit report or income may be difficult to prove. The mortgage lender will offset the higher risk involved in lending by increasing the cost of borrowing mortgage funds. Xceed Mortgage Corporation is an example of a sub-prime lender operating in the Canadian mortgage marketplace. Xceed defines itself as a "non-traditional residential mortgaging company with a main client base of non-traditional customers who are unable to satisfy the strict underwriting criteria of traditional mortgage lenders." (Ottawacitizen.com)
It must be noted that the sub-prime mortgage market in Canada is in its infancy when compared to that of its American neighbours. According to the Canadian Association of Accredited Mortgage Professionals (CAAMP)(formerly known as the Canadian Institute of Mortgage Brokers and Lenders (CIMBL) "the sub-prime market makes up 5% or less of all outstanding mortgages in Canada. In the U.S. the total sub-prime market is closer to 20%." (investmentexecutive.com) The Canadian sub-prime market however, is growing rapidly and more American companies are infiltrating the Canadian marketplace. Companies such as Wells Fargo Financial, Equitable Group Inc and Home Capital Group Inc are new players in the Canadian sub-prime mortgage market and more sub-prime lenders are expected. Michael Hapke, managing partner of Mortgage-Brokers.com in Ottawa states "Subprime in Canada is the next real big wave of business, we're years behind with the subprime market, but the U.S. mortgage lenders who handle this business are starting to pour in." (Ottawacitizen.com) It is quite simple to discount this segment of the Canadian mortgage market because of its present market share; however the growth trend within this market segment should not be overlooked.
The sub-prime mortgage market cannot be specifically defined. It generally includes borrowers that represent a greater risk of default on their mortgages. Lenders offer sub-prime mortgages to individuals who do not meet conventional lending criteria. The borrower may display a lack of credit history or a weak credit score on their credit bureau. Payment delinquency may be present on the credit report or income may be difficult to prove. The mortgage lender will offset the higher risk involved in lending by increasing the cost of borrowing mortgage funds. Xceed Mortgage Corporation is an example of a sub-prime lender operating in the Canadian mortgage marketplace. Xceed defines itself as a "non-traditional residential mortgaging company with a main client base of non-traditional customers who are unable to satisfy the strict underwriting criteria of traditional mortgage lenders." (Ottawacitizen.com)
It must be noted that the sub-prime mortgage market in Canada is in its infancy when compared to that of its American neighbours. According to the Canadian Association of Accredited Mortgage Professionals (CAAMP)(formerly known as the Canadian Institute of Mortgage Brokers and Lenders (CIMBL) "the sub-prime market makes up 5% or less of all outstanding mortgages in Canada. In the U.S. the total sub-prime market is closer to 20%." (investmentexecutive.com) The Canadian sub-prime market however, is growing rapidly and more American companies are infiltrating the Canadian marketplace. Companies such as Wells Fargo Financial, Equitable Group Inc and Home Capital Group Inc are new players in the Canadian sub-prime mortgage market and more sub-prime lenders are expected. Michael Hapke, managing partner of Mortgage-Brokers.com in Ottawa states "Subprime in Canada is the next real big wave of business, we're years behind with the subprime market, but the U.S. mortgage lenders who handle this business are starting to pour in." (Ottawacitizen.com) It is quite simple to discount this segment of the Canadian mortgage market because of its present market share; however the growth trend within this market segment should not be overlooked.
According to the Canadian Imperial Bank of Commerce "the Canadian sub-prime market is growing rapidly, at about 50 percent annually." (ca.today.reuters.com)
The sub-prime mortgage market has gained acceptance and momentum within the U.S. for at least a decade. Large lending companies were established to cater exclusively to the sub-prime marketplace and competition for mortgage originations has since been fierce. A strong American economy, increased new housing starts and a strong resale market have lent to this diverse and competitive marketplace. Keith Gumbinger, a vice president with HSH Associates states that, five years ago, lenders required subprime borrowers to make large down payments and carefully document their income to make up for their sketchy credit. As competition heated up, many lenders lowered or eliminated these requirements. Some even let subprime borrowers make interest-only payments. (Sfgate.com)
As the real estate market surged forward and demand increased, sub-prime lenders were happy to underwrite mortgage loans. The lenders were receiving a higher return based on the associated risk and these mortgages were viewed as relatively safe due to an increase in equity created by continually rising real estate prices. (sfgate.com) It was thought that if borrowers could not meet their monthly obligations, they would either refinance or repay their loans by selling the house and profiting from the increased equity.
Where did the United States sub-prime market go wrong? Last year sub-prime loans began defaulting at a higher than anticipated rate. Estimates fromt the U.S. Centre for Responsible Lending show that "approximately $1 trillion U.S. in subprime mortgages are in default and one-in-five of the subprime loans written in the past two years is headed for default." (ottawacitizen.com) One key factor associated with the sub-prime meltdown is the bursting of the American real estate bubble.
U.S. housing starts and resale volumes have fallen roughly 25 per cent and 10 per cent, respectively, over the past year. Average prices have flattened since mid-2006 and are posting significant declines in many of the previously heated markets in the western and southern states." (cbc.ca)
The sub-prime mortgage market has gained acceptance and momentum within the U.S. for at least a decade. Large lending companies were established to cater exclusively to the sub-prime marketplace and competition for mortgage originations has since been fierce. A strong American economy, increased new housing starts and a strong resale market have lent to this diverse and competitive marketplace. Keith Gumbinger, a vice president with HSH Associates states that, five years ago, lenders required subprime borrowers to make large down payments and carefully document their income to make up for their sketchy credit. As competition heated up, many lenders lowered or eliminated these requirements. Some even let subprime borrowers make interest-only payments. (Sfgate.com)
As the real estate market surged forward and demand increased, sub-prime lenders were happy to underwrite mortgage loans. The lenders were receiving a higher return based on the associated risk and these mortgages were viewed as relatively safe due to an increase in equity created by continually rising real estate prices. (sfgate.com) It was thought that if borrowers could not meet their monthly obligations, they would either refinance or repay their loans by selling the house and profiting from the increased equity.
Where did the United States sub-prime market go wrong? Last year sub-prime loans began defaulting at a higher than anticipated rate. Estimates fromt the U.S. Centre for Responsible Lending show that "approximately $1 trillion U.S. in subprime mortgages are in default and one-in-five of the subprime loans written in the past two years is headed for default." (ottawacitizen.com) One key factor associated with the sub-prime meltdown is the bursting of the American real estate bubble.
U.S. housing starts and resale volumes have fallen roughly 25 per cent and 10 per cent, respectively, over the past year. Average prices have flattened since mid-2006 and are posting significant declines in many of the previously heated markets in the western and southern states." (cbc.ca)
Another factor influencing the sub-prime debacle is poor underwriting practices. According to SMR research, based on hard numbers from SMR's annual survey, we now know that subprime mortgage origination volume leaped by nearly 60% in 2004! It was the sharpest rise in the history of the industry. And it happened in a year when prime-quality mortgage production tanked. This means subprime mortgage lending is now by far the fastest-growing business in the world of consumer finance. (fin.gc.ca)
It is clear that low to moderate income families wanted to jump onto the housing bandwagon during this boom time and the sub-prime mortgage underwriters were thrilled to lend a helping hand. George Gutowski submits "there is increasing anecdotal evidence that subprime mortgages were given to just anyone, even in some circumstances to individuals whose income was left off the application/underwriting form." (financial.seekingalpha.com)
Another major factor that influenced the American sub-prime collapse involved specific products that the industry was offering to its borrowers. Adjustable-rate mortgage loans (ARMs) offered low interest rates (teaser rates) during the first two or three years and market rates subsequently. "The idea is that if borrowers can't afford to make the increased payments at the end of the initial two-year period, they will refinance with new loans, supported by the increased value of their home." (ottawacitizen.com) Approximately $265 billion worth of sub-prime loans will have their rates adjusted in 2007. (progecon.wordpress.com) When the loans were underwritten in 2005 there was not much concern about the impact that the two year rate reset would have on the mortgagor. The lack of concern stemmed from the fact that approximately 80% of these ARMs were paid off within the first two years. Rising home values would lessen the mortgagor's loan to value ratio and allow the borrower to refinance at a lower rate.
Alternatively, a mortgagor would re-establish his/her credit within the two year period and get a better loan or the mortgagor would sell the property repaying the debt. "Battling for market share, lenders didn't worry much about long-term consequences of lax lending." (progecon.worldpress.com)
It is clear that low to moderate income families wanted to jump onto the housing bandwagon during this boom time and the sub-prime mortgage underwriters were thrilled to lend a helping hand. George Gutowski submits "there is increasing anecdotal evidence that subprime mortgages were given to just anyone, even in some circumstances to individuals whose income was left off the application/underwriting form." (financial.seekingalpha.com)
Another major factor that influenced the American sub-prime collapse involved specific products that the industry was offering to its borrowers. Adjustable-rate mortgage loans (ARMs) offered low interest rates (teaser rates) during the first two or three years and market rates subsequently. "The idea is that if borrowers can't afford to make the increased payments at the end of the initial two-year period, they will refinance with new loans, supported by the increased value of their home." (ottawacitizen.com) Approximately $265 billion worth of sub-prime loans will have their rates adjusted in 2007. (progecon.wordpress.com) When the loans were underwritten in 2005 there was not much concern about the impact that the two year rate reset would have on the mortgagor. The lack of concern stemmed from the fact that approximately 80% of these ARMs were paid off within the first two years. Rising home values would lessen the mortgagor's loan to value ratio and allow the borrower to refinance at a lower rate.
Alternatively, a mortgagor would re-establish his/her credit within the two year period and get a better loan or the mortgagor would sell the property repaying the debt. "Battling for market share, lenders didn't worry much about long-term consequences of lax lending." (progecon.worldpress.com)
The scenario outlined above does not fit with a U.S. housing market that is flat and house prices that are declining. Sub-prime lenders have belatedly tightened up their lending policies and borrowers with ARMs will not be able to refinance at a lower interest rate. Brian A. Simon, vice-president of Freedom Mortgage Corp states that borrowers are "going to be forced to stay with the adjusting portion of the loan, it's going to be a real challenge for a lot of borrowers." (progecon.wordpress.com)
The complexity of the sub-prime mortgage products directed at less financially astute borrowers creates difficulty for those individuals attempting to make an informed decision. (fin.gc.ca) The products can include a myriad of upfront and contingency fees, rate variations and conditions regarding the breaking of the mortgage.
This leads to the final reason outlined in this paper for the collapse of the sub-prime mortgage market. The duty of the mortgage broker to the borrower has been neglected. It is imperative that the mortgage broker outline all of the 'what if' scenarios as well as the implications of the various sub-prime products to the borrower. Wachter states that "a financial engineer would be hard pressed to value the effective cost offering of subprime loans effectively let alone a typical consumer." (fin.gc.ca) Unfortunately, it appears that many American mortgage brokers were more interested in closing the deals than performing due diligence with regards to fiduciary responsibility and supplying the client with enough knowledge to make an informed decision. Sub-prime lenders in the United States tend to pay higher commissions to the mortgage broker for supplying the lender with sub-prime business. Finder's fees are typically 150 basis points in the sub-prime market, compared to 100 basis points for a conventional prime mortgage closing. (fin.gc.ca) Wachter proposes that,
the surge in subprime lending during the past decade has led to complaints of abuses, partly because such loans typically are targeted at people who have little experience with the complexities of comparing offerings by various lenders. Many of the loans are made through brokers, who aren't employees of the lenders and can be difficult to police. (fin.gc.ca)
The complexity of the sub-prime mortgage products directed at less financially astute borrowers creates difficulty for those individuals attempting to make an informed decision. (fin.gc.ca) The products can include a myriad of upfront and contingency fees, rate variations and conditions regarding the breaking of the mortgage.
This leads to the final reason outlined in this paper for the collapse of the sub-prime mortgage market. The duty of the mortgage broker to the borrower has been neglected. It is imperative that the mortgage broker outline all of the 'what if' scenarios as well as the implications of the various sub-prime products to the borrower. Wachter states that "a financial engineer would be hard pressed to value the effective cost offering of subprime loans effectively let alone a typical consumer." (fin.gc.ca) Unfortunately, it appears that many American mortgage brokers were more interested in closing the deals than performing due diligence with regards to fiduciary responsibility and supplying the client with enough knowledge to make an informed decision. Sub-prime lenders in the United States tend to pay higher commissions to the mortgage broker for supplying the lender with sub-prime business. Finder's fees are typically 150 basis points in the sub-prime market, compared to 100 basis points for a conventional prime mortgage closing. (fin.gc.ca) Wachter proposes that,
the surge in subprime lending during the past decade has led to complaints of abuses, partly because such loans typically are targeted at people who have little experience with the complexities of comparing offerings by various lenders. Many of the loans are made through brokers, who aren't employees of the lenders and can be difficult to police. (fin.gc.ca)
During the surge within the sub-prime mortgage market, brokers were enticed by high finder's fees and reckless underwriting practices. It was easy to get a sub-prime deal closed and fiduciary responsibility was ultimately forgotten. The resetting of billions of dollars worth of ARM loans will occur in 2007 and many defaults will result. Homeowners who secured their loans through the sub-prime market will soon be paying eleven or twelve per cent. Borrowers with better credit can lock in a thirty year fixed rate loan for just over six per cent. (progecon.wordpress.com) A quote from Pamala G, a medical transcriptionist and mother of three sums up the plight of the sub-prime borrower: "Unfortunately, the gal did not overly explain to me that once the three years [of the teaser rate] were done, the rate would boot way up." (progecon.wordpress.com)
In the wake of the American sub-prime mortgage meltdown, the Canadian Association of Accredited Mortgage Professionals released a statement calling the "domestic mortgage market a picture of health" (cimbl.ca) The association states that the sub-prime market in Canada is very small in comparison to U.S. market and that our housing market continues to exhibit strength, growing at approximately ten per cent per year. The association also states that "Canadian underwriting practices are more prudent, since there has not been a market-share battle over highest-risk borrowers." (cimbl.ca) The association points out that sub-prime lenders have not been using creative mortgage products such as the adjustable rate mortgage loans in Canada. Ivan Wahl, chief executive with Xceed Mortgage Corp states that,
Canadian debt-recovery laws are generally more lender-friendly than those of the U.S. and default levels in both the prime and subprime markets have been substantially lower than the United States. (thestar.com)
In the wake of the American sub-prime mortgage meltdown, the Canadian Association of Accredited Mortgage Professionals released a statement calling the "domestic mortgage market a picture of health" (cimbl.ca) The association states that the sub-prime market in Canada is very small in comparison to U.S. market and that our housing market continues to exhibit strength, growing at approximately ten per cent per year. The association also states that "Canadian underwriting practices are more prudent, since there has not been a market-share battle over highest-risk borrowers." (cimbl.ca) The association points out that sub-prime lenders have not been using creative mortgage products such as the adjustable rate mortgage loans in Canada. Ivan Wahl, chief executive with Xceed Mortgage Corp states that,
Canadian debt-recovery laws are generally more lender-friendly than those of the U.S. and default levels in both the prime and subprime markets have been substantially lower than the United States. (thestar.com)
The biggest difference between the Canadian and American markets relates to tax law. Michael Goldberg, an analyst at Desjardins states "that mortgage interest is not tax deductible in Canada, but it is in the U.S., which encourages people to borrow as much as possible." (nationalpost.com)
Canadian mortgage brokers and professional associations thus have the opportunity to learn from the potentially harmful practices of U.S. sub-prime lenders, underwriters and mortgage brokers. It is clear that the factors affecting the U.S. sub-prime collapse have not yet permeated the Canadian mortgage marketplace and that variation does occur between these sub-prime markets. However, it would be short-sighted to discount the American situation and think that the scenario in the U.S. could not happen in Canada. The Canadian sub-prime market is growing at a rapid rate and American lending corporations with particular lending habits and ideologies are creating a presence in Canada. Canadian mortgage professionals and their associations must analyze and digest the current U.S. sub-prime situation and then draw from this unfortunate incident. It is imperative that both brokers and associations recognize that the onus is on them to strengthen their practices surrounding fiduciary responsibility, especially as it pertains to the Canadian sub-prime mortgage market.
Canadian mortgage brokers and professional associations thus have the opportunity to learn from the potentially harmful practices of U.S. sub-prime lenders, underwriters and mortgage brokers. It is clear that the factors affecting the U.S. sub-prime collapse have not yet permeated the Canadian mortgage marketplace and that variation does occur between these sub-prime markets. However, it would be short-sighted to discount the American situation and think that the scenario in the U.S. could not happen in Canada. The Canadian sub-prime market is growing at a rapid rate and American lending corporations with particular lending habits and ideologies are creating a presence in Canada. Canadian mortgage professionals and their associations must analyze and digest the current U.S. sub-prime situation and then draw from this unfortunate incident. It is imperative that both brokers and associations recognize that the onus is on them to strengthen their practices surrounding fiduciary responsibility, especially as it pertains to the Canadian sub-prime mortgage market.
Works Cited
Text Sources
Smith-Eivemark, Philip. Ethical Practice in the Mortgage Industry. CIMBL, Novermber, 2003.
Online Sources
ca.today.reuters.com "Canada less exposed to subprime market" March 17, 2007.
cbc.ca "Subprime lending collapse in the U.S." March 07, 2007.
cimbl.ca "Strong Canadian market depends less on sub prime products than U.S." March 15, 2007.
financialseekingalpha.com "Subprime mortgage storm brewing" March 15, 2007.
fin.gc.ca "Mandatory mortgage insurance in Canada", 2006 review.
investmentexecutive.com "Canada' mortgage market is the picture of health" March 17, 2007.
nationalpost.ca "Canada sheltered from U.S. subprime storm" March 17, 2007
ottawacitizen.ca "Canada looks like prime territory for risky subprime business" March 17, 2007.
progecon.wordpress.com "The human costs of financial deregulation - US subprime housing lending" March 13, 2007.
sfgate.com "Primer on subprime loans, troubles in the mortgage industry" March 15, 2007.
thestar.com "Healthy market boosts earnings" March 15, 2007.
Scott Henson and Michael Pezzack are Toronto based Mortgage Consultants for Mortgage Intelligence. For more information about Toronto mortgages, visit www.alltorontomortgages.com.
Smith-Eivemark, Philip. Ethical Practice in the Mortgage Industry. CIMBL, Novermber, 2003.
Online Sources
ca.today.reuters.com "Canada less exposed to subprime market" March 17, 2007.
cbc.ca "Subprime lending collapse in the U.S." March 07, 2007.
cimbl.ca "Strong Canadian market depends less on sub prime products than U.S." March 15, 2007.
financialseekingalpha.com "Subprime mortgage storm brewing" March 15, 2007.
fin.gc.ca "Mandatory mortgage insurance in Canada", 2006 review.
investmentexecutive.com "Canada' mortgage market is the picture of health" March 17, 2007.
nationalpost.ca "Canada sheltered from U.S. subprime storm" March 17, 2007
ottawacitizen.ca "Canada looks like prime territory for risky subprime business" March 17, 2007.
progecon.wordpress.com "The human costs of financial deregulation - US subprime housing lending" March 13, 2007.
sfgate.com "Primer on subprime loans, troubles in the mortgage industry" March 15, 2007.
thestar.com "Healthy market boosts earnings" March 15, 2007.
Scott Henson and Michael Pezzack are Toronto based Mortgage Consultants for Mortgage Intelligence. For more information about Toronto mortgages, visit www.alltorontomortgages.com.
Reader Feedback
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jessywaite
thanks for the info. this can come in handy when moving.
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Posted April 22, 2008
All-Toronto-Mortgages wrote...
Posted July 17, 2007
by All-Toronto-Mortgages
Hello I am Scott Henson. a Toronto based mortgage consultant for Mortgage Intelligence, the largest volume independent mortgage broker in Canada.... (more)
