I have been asked by hundreds of investment advisors, portfolio managers, mortgage professionals and clients my perspective on the syndicated mortgages as a whole. Here is my most simplified opinion on the matter along with a simplified explanation. I have no financial gain in writing this and will never comment on individual projects or their respect risk/return measures.
When a real estate owner needs to raise cash for whatever reason, they may consider taking out a mortgage on their property. Traditionally, banks and mortgage companies are the principle real estate lenders, but these institutions are highly regulated and generally focus on higher-quality, lower-risk mortgages. If there is anything unusually risky or uncertain about the deal — uncertain credit, a potential for declining property values, existence of pre-existing mortgages or other liens on the property — these lenders will usually turn the loan request down.
That’s where syndicated mortgages come in.
In Canada, syndicated mortgages provide alternative means of financing higher-risk mortgages that the banks and other traditional lenders aren’t willing to take on. Borrowers work through mortgage brokers to find private buyers willing to take on the substantial risk — in exchange for a higher interest rate. As a result,an estimated 20,000 investors have purchased more than $1.5 billion in syndicated mortgages, mostly in Ontario, according to regulators.
These rates are higher than those normally available with other traditional low-risk income vehicles like certificates of deposits, life annuities, guaranteed income contracts (GICs) and even diversified bond funds. And at first blush, they’re often very attractive to individual investors looking for income.
What soon becomes obvious is that these products are extremely risky and, to put it bluntly, are not suitable for the clear majority of investors — even well-capitalized or highly sophisticated investors. In a very public case, a small group of 120 syndicated mortgage investors lost more than $9 million. As certified fraud examiner Bill Vasilious explains, syndicated mortgages can be legitimate, legal investments to help develop a property, but they can also be used to perpetuate fraud. Attorney David Franklin who reviewed the Black Bear Homes case, estimates that in Ontario alone, investors have lost well over $1 billion in risky syndicated mortgages. However, I have never seen an form of reliable report to support that claim.
After receiving numerous complaints from consumers, the Financial Services Commission of Ontario recently clamped down on sales of certain syndicated mortgages – requiring that brokers complete a suitability review and placing a $60,000 cap on individual investments in non-qualified syndicated mortgages in any given 12-month period. On the business side, Ontario lawyers were issued a notice from the Law Society of Upper Canada in November 2017, highlighting the risks of participating in syndicated mortgage selling. Earlier this year, mortgage brokers were notified by one major insurance provider that the firm will now longer provide Errors & Omission insurance — insurance against professional liability — to any mortgage broker who sells syndicated mortgages in Canada.
Nevertheless, many consumer advocates argue that marketing these products to individual retail investors should be completely prohibited, with no grey zone allowed.
Qualified vs. non-qualified syndicated mortgages
It’s important to understand the difference between qualified and non-qualified syndicated mortgages. The $60,000 limit applies only to non-qualified syndicated mortgages. To be a qualified syndicated mortgage, the mortgage must meet all these criteria:
- It must be sold or arranged through a mortgage brokerage.
- The property must be primarily residential, with not more than four units.
- Combination commercial and residential properties must have not more than one unit used for commercial purposes
- The mortgage, combined with all other debts attached to the property of equal or better seniority, must not exceed 90 percent of the fair market value of the property (excluding value to be added by pending development or improvement.
- Loan proceeds are not intended to be used for construction or development.
- There is only one debt obligation with the same term as the syndicated mortgage.
Part of the problem: Many of the licensed mortgage brokers who have been selling non-qualified syndicated mortgages to retail investors have little or no training in investing and securities. Many of these products are sold as retirement income products and as alternatives to diversified bond portfolios and income annuities. This could not be further from the truth. Alternative investments of this nature are generally only deemed to be suitable for accredited investors
That’s where the dilemma arises. While the vast majority of mortgage brokers are trained in mortgages and real estate, few have any experience or education in retirement planning, personal risk management and insurance products. Still, for brokers without these qualifications the high commissions earned when they sell a syndicated mortgage is too attractive. This prompts unqualified selling of unsuitable products to investors who cannot absorb the risk of a default.
In the Black Bear Homes case, mortgage broker Dominic Ha was receiving a 10 percent commission on all the syndicated mortgages he sold – a commission that is more than ten times what he would’ve earned if he’d completed the job he was qualified to do (find loans for people).
What makes syndicated mortgages so attractive?
In theory, these mortgages are generally secured by a lien on an underlying asset, such as land or property. If the borrower defaults, you have the option to foreclose on the property, and possibly recoup your losses when you sell the property. For this reason, syndicated mortgages are attractive. Most of us understand and appreciate the concept of buying a property with a mortgage, so the idea of becoming the banker and earning the rewards is very attractive. But the default rate on syndicated mortgages is much, much higher than traditional mortgages. And just because a borrower defaults, doesn’t mean you, the investor, can get your money back. There are several different risks that make syndicated mortgages so much riskier than other retirement planning investment products. For instance:
The market value of the property may not be what you anticipated. The borrower may have inflated the value of the property, or the appraiser may simply have overestimated its worth. Real estate prices may have broadly declined simply because of broad market forces or the property may have been damaged.
You may not be first in line to get paid if the deal goes south. Syndicated mortgages are often second or third in line for repayment when a foreclosed property is sold. The second- or third- and subsequent positioned lienholders only get paid with what’s left over after senior lienholders get paid.
Foreclosure itself is a long and expensive process. If the borrower does default, it could take months to complete a foreclosure, and you may have to pay thousands of dollars in fees before you can sell the property and begin recouping your investment. You should ensure that the borrower has enough equity in the property to cover your risk in the event of default.
‘Secured’ does not mean ‘guaranteed.’ You may have a lien on the property, but a lien is just an IOU. As you can see, even holding a lien on an over-mortgaged property is no guarantee that you will be paid on a loan that defaults.
When you still can’t shake the promise of those advertised returns
Before you write a cheque or transfer funds for any investment, you should understand the following:
Returns advertised are not guaranteed. Some products come with a greater sense of security, while others are far riskier. For instance, Guaranteed Investment Certificates (GICs) are considered an industry staple for stable, predictable returns, but that doesn’t mean they are risk free. The key is to appreciate what type of risk is attached with each type of investment product and how likely those risks will impact your investment returns. Finally, any product that claims ‘guaranteed returns’ is an investment you need to walk away from — now.
Syndicated mortgages are risky. Borrowers — the firms and builders who seek out loans through syndicated mortgages — occasionally default for all sorts of reasons. You should be aware that you may lose some or even all their investment if the borrower defaults, or if the broker commits fraud.
There is no government backing of any kind on these products. The government will not bail you out if you lose money on these products. Nor is there any other investment protection fund that will make good on these contracts should the borrower default.
Syndicated mortgages are highly illiquid. There is little or no secondary market for syndicated mortgages available to the retail investor. If you purchase one, you should be prepared to have your assets tied up in the mortgage for years. If you want to cash out, you can expect to sell at a significant discount, pay a hefty commission, or both — if you are able to cash out at all.
Before you invest in any product, do your due diligence:
- Is the seller licensed? Mortgage professionals must be licensed with the Financial Services Commission in your province. Syndicated mortgage sales also require additional due diligence for ‘Know Your Client’ or ‘KYC’. To see the FSCO, “Duty to Ensure Product Suitability and Duty to Disclose Risks”. Under page 13 of that training which FSCO made very clear that all mortgage professionals needed to know it reads:
”A suitable mortgage or investment does not expose the borrower, lender or investor to undue risk.”
Some mortgage professionals have extensive licensing and training beyond the basic mortgage course, but some only have the basic required minimum. Mortgage professionals who did not do this properly follow the standard of care on this matter will very likely be facing material fines, litigation and/or license suspension or revocation.
- Are the promises realistic? If the rate is unusually high, it’s for a reason. When you consider that a sub-prime residential borrower can borrower for approximately 1% more than the bank’s posted rates that should give perspective on relative risk for anything more than a 5% rate of return. Borrowers such as developers don’t want to pay high interest rates unless they must – because institutional lenders won’t touch the deal. If the broker tries to tell you any syndicated mortgage is guaranteed or risk-free, walk away – and notify mortgage regulators in your province.
FSCO also very clearly outlines the need for, “Disclosure and Managing the Disclosure of Conflicts of Conflicts of Interest”. If the client does not have an undisclosed material risk or is paying a higher rate/cost at the expense of these items’ regulators will not be as lenient. Last have generally not been overly concerned. The fact is that clients generally don’t get upset or complain to regulators about who is getting paid on a deal, unless that payment adversely impacts their costs.
It is important to note that had mortgage professionals followed the formal regulatory requirements that have been in place then these mortgage professionals will have nothing to worry about. I don’t believe at all that regulators are at fault here. When the law and professional standard of care says that something is to be done a certain way – and the industry players don’t follow best practices then it is the participants fault – not regulators.
Saying that FSCO or the government is responsible for mortgage professionals not following prescribed guidelines is no more ridiculous than saying police are at fault for people drunk driving even though the law clearly prohibits drunk driving. This is not a FSCO problem – its a, ‘I didn’t follow the FSCO guidelines and anyone who got paid on them problem’. For the official record – I fully and completely support the way the RCMP and FSCO are handling this matter.
Last Friday, FSCO announced that:
“Commencing in fall 2018, FSCO will conduct desk reviews and/or on-site examinations of those mortgage brokerages that deal in non-qualified syndicated mortgages to ensure their P&Ps fully comply with all MBLAA requirements.”
- Can you afford a loss? What is the potential impact on your retirement security if the syndicated mortgage goes bust? These are risky vehicles, or they wouldn’t be offering such a high interest rate. Make sure that any risks you take are gambles you can afford to lose. Generally, these products are not suitable for retirement savings you’ll need to live on.
- What is the management’s track record? Look into who is involved.The managing partner for Black Bear Homes, Gary Fraser, had already served time in prison for defrauding investors of $2 million dollars 13 years ago.
- What is the property worth? To cover your risk, consider inspecting the property yourself, have an appraisal done by a third party. If the mortgage, combined with all the other existing debt on the property, is more than the property is worth, you might not get paid back even if the property is successfully foreclosed on and sold.
- If the loan defaults, who gets paid first? 1st-position mortgages are safer than 2nd-tier and lower mortgages, who only get paid from what’s left over in the event the borrower defaults. Black Bear Homes’ operators had taken out additional mortgages on the properties prior to marketing syndicated mortgages to retail investors and didn’t disclose them. Investors were dismayed to learn that they may never recoup their losses.
This is not to say that all syndicated mortgages are a scam, but many syndicated mortgages do carry a great deal of risk. Syndicated mortgages do provide necessary funding for building and infrastructure projects, which makes them a potentially good high-yield opportunity for hedge funds and institutional investors, who have sophisticated ways of creating diversified portfolios. But because of their riskiness and how they have been marketed to ordinary Canadians, they are generally not well-suited for individual investors and registered retirement accounts unless you are an accredited investor and/or work with a portfolio manager who can properly assess your financial and psychological risk.
Two weeks ago, one of the biggest errors and omission insurance providers announced it will not be renewing the professional liability coverage for any mortgage firm that sold syndicated mortgages. Other carriers are also declining and/or failing to renew firms that sod these products. Between professional liability insurance and regulator crack down you can definitely expect to see many mortgage professionals getting early retirement packages delivered from the FSCO who are working hard to get this matter under control. Until this matter resolves there are hundreds of millions of dollars’ worth of consumer investments, developer financing, and mortgage licenses at risk.
For the record – I have never arranged, sold nor invested in any syndicated mortgage investment. Having said that – I may very well have been much wealthier had I invested in that sector. There are a number or very good mortgage investment funds that prudently manage their investors’ money that are being caught up in a mess that largely impacts a select group of firms and players. This of course is a not an uncommon problem where everyone in an industry or society suffers as a result of a few unscrupulous players.
To read some of my previous commentary on this matter – feel free to visit the following:
When you manage people’s money there are only two key rules to follow. I will leave with a man I have read more than twenty books on – the great Warren Buffet.
It would appear from the outside looking in that many people who run syndicated mortgage funds will be in a very material breach of Rule No. 1.