• How Do Mortgage Brokers Guard Against Moral Hazard?

  • ”Moral hazard occurs when one person takes more risks because someone else bears the burden of those risks. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place” (en.wikipedia.org/wiki/Moral_hazard )

    Moral hazard applies to borrowers, who make a profit at the expense of another. For instance, a client who makes their money by gambling and does not claim the income on their taxes, nor do they pay taxes, however tries to get a mortgage or loan.

    Another more recent example, that changed the economics of our modern world, was the subprime mess that occurred in the US. Freddie Mac and Fanny Mae made countless loans to unsuspecting borrowers, knowing that many of them would not be able to maintain their loans. After selling the loans, the originators bore none of the risk so there was little to no incentive for the originators to investigate the long-term value of the loans.

    Last week I came across my own potential deal of moral hazard and had to write about it. I was speaking to a potential investor client, who is having a difficult time finding a single family investmet in his affordability level. He was finding either single family homes with illegal basement apartments or former grow-ops or they had both. In this specific case, the home in mention had both.

    I advised my client to walk away. He was reticent do so, because in his off-hours from his regular job he was doing renovations for cash and thought he could take this on. He did not realize that without proper training in what to look for – this former grow-op could provide years of anxiety and cost to his bottom line, just from mould alone, not to mention other hazards, such as basement/foundation cracks, asbestos and most important reduced economic life of the property – think exit strategy!

    Three problems exist in this specific case:

    1.  The client is self-employed and could only qualify as a “stated income” individual as he did not have the income to show on his NOA or T1 Generals. Therefore, because the house had an illegal basement apartment (illegal means that the city has not deemed it meeting proper building requirements for a basement apartment), he would not be able to use the rental amount it generated as income in his application, thus he would not be able to qualify for more on his application.

    2.  The Sellers told my client that the house had been remmediated from it’s former grow-op days, but were not willing to provide a remmedition certificate to prove it, unless my client was willing to put in an offer to purchase the property. How absurd right? Now, here is where moral hazard becomes an issue. If the sellers were trying to sell a home, knowing it was a former grow-op, but doing so under false pretenses of a remmediation that had clearly not been done, than they are at risk of a moral hazard burden on the buyer and can be charged as such. Furthermore, the realtor in question can also be charged as he is not doing his own due diligence in requiring a remmediation certificate before proceeding with the sale.

    Furthermore, in the initial MLS listing, the house clearly indicated it was a former grow-op, however after my client requested the remeditation certificate and was denied, the house was delisted and then relisted again with the grow-op information missing from the listing. Again, this is a clear case of moral hazard.

    3.  The client is also at risk because he is hoping to conduct a renovation with no license and perhaps cause further damage to the property, as in this case there could be mould behind the walls, which is not always apparent to the naked eye. Therefore, he would risk insurance on his property.

    Furthermore, if he were in fact to proceed buying this property somehow, and then eventually wanted to sell it, how could he execute his exit strategy? In fact, what type of exit strategy could he have?

    Now are there lenders who will lend on former grow-ops? Yes, there are but you will pay more than the property is worth in rates and fees not to mention renovation costs, which in the end, may not be enough to save an already condemned property.

    When it comes time to buying a property – make sure you are not a victim of moral hazard and or victimizing somebody for your gain.

    It is always better to walk away. Working with your mortgage broker, who can provide alternatives to financing is always the better way to go.

    In this case, the client listened and walked away. We are presently working on some other financing scenarios so he can find the property that he can afford, while not risking moral hazard.