The country of Canada has quite a reputation around the world. Immediately the first word that comes to mind is ”prudent” and this doesn’t just describe the banks either. There has been a strong history of prudent behaviour in the Canadian economy.
In the 1930s, roughly 9,000 American banks had failed during the Great Depression, yet not one Canadian bank failed.
During the Savings and Loans crisis (S&L) in the ‘80s, roughly 3,000 American banks had gone under yet only two small Canadian banks failed during the same period. And these were the first Canadian bank failures since 1923.
And in 2008 when the biggest financial crisis since the Great Depression occurred, 200 American banks had collapsed on their own balance sheets whereas Canadian banks so much as felt a breeze (relatively speaking).
In the western world, Canada remains the single country that has survived the stresses that have plagued the U.S. and the western Eurozone countries.
So what is Canada’s big secret? We explore this in the financial and mortgage markets
- Shorter-Term Fixed Rates in Canada.
- Canadian mortgages carry a fixed interest rate for a maximum of five years, and rates are then re-negotiated for the next five years, similar to a five-year adjustable rate. This helps in allowing banks to reach a better maturity between the relevant assets (i.e. loans, mortgages) and interest income on their books, and their liabilities (deposits) and interest expense, which protects them from the kind of maturity mismatch and interest rate risk that resulted in the American Savings & Loans crisis in the late 80’s.
- Mortgage Insurance On More Parties.
- Roughly half of Canadian mortgages currently retain mortgage insurance vs 30% in the U.S. after the crisis in 2008/ and only 15% before the crisis. In Canada, home buyers with less than a 20% down payment have to purchase mandatory Mortgage Insurance Premium
- Mortgage insurance in Canada also covers the full loan amount for the full life of the mortgage. It cannot be eliminated like it can in the U.S. when the property value exceeds the mortgage balance. The higher percentage of mortgage insurance payers in Canada is thought to help stabilize Canada’s mortgage and housing markets
- Private Insurers Authority
- Private insurance companies in Canada can insure mortgages and they have the authority to approve or reject the property appraisal. This helps to give them a strong financial incentives to only approve realistic property appraisals.
- Full Recourse Mortgages.
- Almost all Canadian mortgages are full recourse loans, meaning that the borrower (homeowner) is fully responsible for the mortgage even in the case of foreclosure. If a bank in Canada forecloses on a home with negative equity, it can file a deficiency judgment against the borrower, which allows it to attach the borrower’s other assets and even take legal action to garnish the borrower’s future wages. The U.S. has a mix of recourse and non-recourse laws that vary by state, and even in states with full recourse loans, the use of deficiency judgments to attach assets and garnish wages is infrequent. The full recourse feature of Canadian mortgages is argued to lead to fewer delinquencies, more responsible borrowing, and fewer foreclosures than in the United States. It also helps to curb real-estate speculation
- No Tax Deductibility of Mortgage Interest
- Home mortgage interest is not tax-deductible in Canada, thus there becomes no tax advantage to home ownership vs renting. An exception to this, is any capital gains that might have accumulated from the sale of a principal residence in Canada, in that case this is not taxed.
- Also, there is no tax benefit in converting home equity into household debt in Canada. This has led to a larger accumulation of equity in Canada at 70% of total real estate value, in comparison to the US with 45% of real estate value.
- The incentive in the Canadian system is actually in paying down the mortgage in Canada as it is a tax-free investment. This, yet again, also encourages greater equity accumulation than in the U.S. What’s interesting, is that despite the tax advantage of home ownership in the U.S., the homeownership rate in Canada has been larger.
- Higher Prepayment Penalties.
- Prepaying mortgages in Canada is allowed however there is much stiffer prepayment penalties (i.e. such as paying three months of mortgage interest) than in the U.S. This policy in the Canadian real estate system has discouraged the kind of refinancing that took place in the United States leading up to the housing meltdown, and often involved pulling home equity out in the refinancing process (encouraged by the tax deductibility of mortgage interest).
- Public Policy Differences for Low-Income Housing.
- In Canada, the Government has provided public funding for low-income rental housing instead of encouraging homeownership for low-income households. This has ensured that good, yet low-income renters do not turn into bad homeowners.
- In contrast, the US has policies as the Community Reinvestment Act that promoted and encouraged homeownership for lower-income and less credit worthy borrowers who were commonly financed with subprime (riskier) mortgages.
- Greater Diversification of Banks
- Canadian banking regulations have not prevented banks from achieving wider geographical diversification for their deposits and loan portfolio’s. In the US, there have been laws put in place that have prevented interstate banking until 1994. This difference could help to explain why the U.S. had over 9,000 bank failures during the Great Depression, with each operating only within one of the 48 states due to a prohibitional ban on interstate branching. During the same time period in the 1930’s, not a single Canadian bank (who all had their branches nationwide) had failed.
- Much less mortgage securitization in Canada vs the U.S.
- Canada has held a significantly smaller subprime (riskier) mortgage market. As emphasized in an earlier point, this ties in to the social policy that the Canadian system adheres to.
- Banks in Canada have been servicing 68% of the mortgages on their own balance sheets that they originate and underwrite, which helps to encourage prudential lending since it is the banks that place much of their own capital at risk. This also means, that should there be a large correction in the housing market, the Canadian banks could be in for a world of trouble. Thus the real estate market is vital for the health of the banks, but whether the banks have actually been prudent themselves, is another topic of discussion
- A great majority of mortgage payments in Canada are established electronically by an automatic payment arrangement which ensures to minimize late payments
- More equitable mortgage insurance
- All Canadians pay the same premium based on the size of their down payment. That means even good-risk clients are charged the same as poor-risk clients
- American consumers are rewarded for better creditworthiness with lower rates. Homebuyers at a higher-risk naturally face higher mortgage insurance premiums. U.S. mortgage insurance is based on the actual risk characteristics of the individual borrower rather than pooled across all citizens, like it is in Canada.
- Government monopoly on Mortgage Market
- The mortgage market in Canada lacks sufficient competition since the Government has the power to set the bar on prices. This is because the CMHC is the dominant player and has significant sway on determining prices. For the initial hiking of amortization periods from 25 yrs to 30 yrs, it was actually the CMHC that leaded the charge forward and began the competitive race to the bottom back in February 2006. The private players: Genworth and AIG followed suit. More information on this can be found in Part 8 of the series on Deregulation of the Financial Market. Advocates of a free market system have argued that this creates a potential incentive problem since the federal government has the power to create the regulatory environment that helps to provide CMHC with a near-captive monopoly, thus giving them greater power over the mortgage market. And since the CMHC is a Crown Corporation, the Government also receives a large benefit from the CMHC’s success, through it’s public policy mandate and surpluses.
- In the U.S. there is seven private providers of mortgage insurance all competing against the federal government. The private sector controls about 2/3rds of the market with the government’s share falling in recent years. There have even been profound differences in Genworth, who is in the Canadian and U.S. mortgage market. In the U.S., Genworth has offered homebuyers a $500 rebate on their mortgage insurance if they arrange their mortgage through preferred lenders on its website. In contrast, Genworth’s Canadian division has not provided such an incentive.
- Interest payments on Mortgage Premiums
- In Canada, the entire mortgage premium is due upfront and is usually rolled into the principal of the mortgage. This means homeowners must pay the interest on their premiums.
- In the U.S. most homebuyers pay their premium monthly. Thus, on average, a homeowner can expect to pay between $50 – $100 per month for mortgage insurance, courtesy of the Mortgage Insurance Companies of America (MICA) trade association. The savings on interest alone due to the monthly schedule can be significant
- Larger cap for payment of mortgage insurance
- Canadians are forced to purchase more coverage than one would expect they would need. First of all, mandatory insurance in Canada applies for anyone that puts down less than 25% of their downpayment on a home.And second, Canadian homebuyers must purchase 100% coverage for their mortgage.
- In the U.S. there is no requirement of homebuyers to purchase mortgage insurance until the 20% down payment level. This means many more homebuyers are exempted from mortgage insurance in the U.S.
- American homebuyers typically purchase only 25% coverage for their mortgage. That means the insurance firm covers the first 25% of losses on a property and lenders are responsible for anything over that amount. Such a scenario recognizes that even in a housing bust, the property would still hold a substantial value. The most precipitous real estate crashes in Canada in the past 30 years–Calgary during the 1980s oil bust and Toronto in the early 1990s recession–resulted in losses of 25% to 28% in the average price of a house. They were large drops, to be sure, but most properties still retained the bulk of their value.
- And even on the mandatory aspect of mortgage insurance is eliminated for Americans once the homeowner’s equity reaches 22% of the value of their property. Thus, after 4 or 5 years, most Americans can stop paying their monthly mortgage insurance premiums altogether. If a homeowner chose to pay down their mortgage quicker, or if a rising housing market boosted the equity on their home, those payments could end even quicker. Thus the system for Americans is set up, so that the individual does not pay for insurance they will never use
When one pulls together all these differences, it means that Canadians have greater costs and less flexibility in their mortgages. But is that necessarily a good thing?
Converting a typical U.S. monthly rate to a lump-sum premium using the rate schedule of PMI Group, (second-largest mortgage insurance firm in the U.S.), an American customer with a fixed-rate 25-year mortgage can expect to pay 1.15% of the loan value to insure a mortgage with 10% down.
The rate in Canada is 2%. At an average home price in Canada of $251,000, the Canadian homebuyer will face $1,924 in additional insurance premiums and when you add on the interest costs of amortizing this over 25 years at 5%, then the cross-border difference is more like $3,400.
Thus Canadians generally do pay more for their mortgages (if they cannot plunk down the 25% downpayment necessary for High-Ratio loans).
However, even with Canadians paying more for their mortgages, they still end up having less mortgages in arrears. Arrears means there are payments outstanding on a debt loan.
And below is data from the Canadian Bankers Association and U.S. Federal Reserve on the percentage of mortgages in arrears (% of payments outstanding)
The differences in regulatory systems and mortgage markets could not emphasize a bigger difference than the graph illustrates above.
Even during the revaluation of home prices in the mid 1990’s, Canadians have still been more likely to pay off their mortgages thus reducing the probability of mortgage payments having outstanding charges. One would definitely notice that indeed, the Canadian system does have an element of prudence within it.
One can also see the significant rise in percentage of mortgages in arrears since 2007. This is largely due to the financial crash, when it was discovered that there was significant amounts of fraud, theft, and lies that were perpetrated on American home buyers.
Although this will be covered in a future article, the gist of the hardships faced by Americans, was that there were predatory lending practices that were engaged by the large Wall St banks, as well as entities such as Goldman Sachs making speculative bets on their own customers, betting against the homeowners that they themselves would underwrite because they knew the loans would end in foreclosure, as well as robo-signing of bankruptcies in violation of the law, and a whole host of other atrocities.
Critics of the Canadian system have argued it allows the Government to have too much concentrated power in one market which does not help to facilitate a free market process. While this is definitely true, it is not quite so simple as free markets vs state control.
The American system itself was also not operating on free market principles either (i.e. such as the banks not remaining committed towards a full mark-to-market mark down of the mortgages on their books). Thus, the nature on the importance and significance of free markets will be acknowledged in a future article.
And a quick review of the differences helps to see that the differences between American and Canadian systems stems from their very different views on role and nature of Government, policies in protecting the public, and regulatory checks and balances.