Few Foreclosures, No Bank Failures: Canada Offers Lessons
Tuesday 11 January 2011
The Bank of Nova Scotia in Toronto, Canada. (Photo: BriYYZ)
Toronto - Maybe Canada has something to teach the U.S. about housing finance.
One in 4 U.S. homes is thought to be worth less that the mortgage being paid on it. One in every 492 U.S. homes received a foreclosure notice in November. For the fourth year running, analysts are speculating on where the bottom is for U.S. real estate.
No such worries up here in Canada — yet its system of mortgage finance gets little attention in the U.S.
Not a single Canadian bank failed during the Great Depression, and not a single one failed during the recent U.S. crisis now dubbed the Great Recession. Fewer than 1 percent of all Canadian mortgages are in arrears.
That's notable given that the recent U.S. economic turmoil was triggered by a meltdown in mortgage finance, forcing an unprecedented government rescue of Wall Street investment banks and the collapse of more than 300 smaller banks as the housing sector went bust.
How'd Canada avoid all that?
"This sounds very simple, but one of our CEOs has said we are in the business of making loans to people who will pay them back," said Terry Campbell, vice president of policy for the Canadian Bankers Association in Ottawa.
There's a certain amount of apples to oranges when comparing the two systems of mortgage finance. Canada's population last year was estimated at 34.3 million, while the U.S. population now exceeds 307 million. The U.S. economy is the world's biggest; Canada ranks ninth.
Canadian banks were recently named the best in the world by the World Economic Forum, but they're a much smaller universe of lenders — 71 that are federally regulated, compared with more than 8,000-plus U.S. lenders insured by the Federal Deposit Insurance Corp.
Even so, there's plenty to learn from Canada's conservative — yes, conservative — regulatory regime. It requires more rigorous loan underwriting standards and much bigger set-asides by banks for potential losses during market downturns.
Canada also lacks a big tax write-off for the interest that borrowers pay on their mortgages. They get a capital gains tax exemption on any profits on the sale of their primary residence, and that's it. Yet the rate of home ownership in Canada is equal to, or greater than the U.S. rate, and the lack of mortgage-interest deductions leads Canadians to swiftly pay down their mortgage debt.
"I'm not aware of any disparagement of the Canadian model or dismissal of the Canadian model. There are some interesting features to it," said Stuart Gabriel, a finance professor in the Anderson School of Management at the University of California-Los Angeles. "They've insisted all along on the more rigorous mortgage underwriting, and because of that never found themselves originating subprime and no-doc mortgages . . . some very basic items such as stringency of underwriting seem to go a long way."
Canada doesn't have an equivalent to Fannie Mae or Freddie Mac, which purchase mortgages from banks and pool them into bonds. The argument for Fannie and Freddie is that they take loans off of a bank's books, freeing them to lend more.
Canada has no such secondary market for mortgages, yet it hasn't hurt the ability of its banks to lend or significantly raised the cost for borrowers.
Canadian mortgages aren't non-recourse loans, meaning homeowners can't simply walk away from their mortgages. Even if they lose their home, they still owe their mortgage debt.
"You mail your keys into the bank here and guess what, you are not off the hook," said Gregory Klump, the chief economist in Ottawa for the Canadian Real Estate Association.
Lessons from Canada could prove useful. In the next few weeks, the Obama administration must, by law, outline its vision for what to do with Fannie Mae and Freddie Mac. They've been in government conservatorship since the summer of 2008. The administration must unveil its roadmap for how and when they're to be changed and moved out of government control.
By July, the administration must establish the new Consumer Financial Protection Bureau, whose chief functions will include policing mortgage lending and defining suitable mortgages.
The issue of mortgage-interest deductions probably will come up this year when Congress debates deficit reduction. A blue-ribbon National Commission on Fiscal Responsibility and Reform late last year recommended a serious scaling back of the U.S. mortgage-interest deduction as a means of raising more revenue and lowering deficits and debt.
Defenders of the popular U.S. mortgage-interest deduction call it a big driver of U.S. home ownership, which peaked in 2005 at 69.1 percent. (It fell to 66.9 percent late last year.)
But even without a mortgage-interest deduction, Canada's percentage of home ownership_ at 68.4 percent, according to the most recent Canadian census in 2006 and now thought to be higher — is comparable to U.S. home ownership rates.
"There's an incentive for them to pay off their houses relatively quickly, but the home ownership rates in Canada and the U.S. are comparable. The fraction of people who own their houses free and clear in Canada is much bigger," said William Strange, a professor of real estate at the University of Toronto's Rotman School of Management.
Added Klump: "The sooner you can get out of debt, the faster you can amass retirement savings."
Canadian banks generally provide 25-year mortgages, with 20 percent down payment. The first five years of the loan is a fixed rate, after which it adjusts to current market rates in five-year increments until the loan is paid off.
Should a borrower opt not to put down 20 percent on a home purchase, they must purchase mortgage insurance to cover the debt in the case of default.
U.S. borrowers are accustomed to fixed-rate loans of 15 years or 30 years, and U.S. mortgage bankers warn that the Canadian model of adjusting interest rates every five years may soon be less attractive.
"There is a lot of interest-rate risk that is being put on Canadian buyers. That has worked over the past couple of decades. Now that we're looking at increased borrowing demands by national governments, everyone is projecting interest rates going back up," said Jay Brinkmann, the chief economist for the Mortgage Bankers Association. "As these Canadian mortgages reset, (borrowers) might start looking longingly at a U.S. system" that provides longer fixed interest rates on mortgages.
In some ways, the U.S. is already adopting big parts of the Canadian model.
"I think the U.S. system may be eliminating certain types of loans . . . I think we're seeing greater emphasis on down payments," said Brinkmann, who's careful to call it a return to past practices and not the Canadian model.
Lenders, he said, are shying away from second mortgages. And there are greater demands for private mortgage insurance, even on refinanced mortgages.
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