Few foreclosures, no bank failures: Canada offers lessons

By Kevin G. Hall | McClatchy Newspapers

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.

Bank of Canada raises rates, but sees soft recovery

Hike will be noticed immediately by those who have variable mortgages, lines of credit

By Fiona Anderson, Vancouver Sun September 9, 2010

The Bank of Canada raised its benchmark lending rate Wednesday, the third increase in just over three months.

The bump of 25 basis points brings the bank's target rate for overnight loans between financial institutions to one per cent. Canada's largest banks followed suit by raising their prime lending rate to three per cent.

The increase in prime lending rates will be noticed immediately by anyone with loans -- like variable mortgage rates or lines of credit -- that calculate interest according to the prime rate.

People with big lines of credit "are the people who are going to hurt," said Andrey Pavlov, associate professor of finance at Simon Fraser University.

But that's what the Bank of Canada was thinking when it raised the overnight rate, he said. The bank wants to slow consumption and it does that by hitting those who consume the most.

"Now they're not out there to hurt anyone in particular, but they do need to slow down the economy because if we grow too fast we're going to get inflation," Pavlov said.

But whether fixed mortgage rates will be affected is a different story. While the central bank has been raising its overnight rate since June, commercial banks have been lowering mortgage rates.

"So it doesn't necessarily mean that the fixed rate will go up," said Tsur Somerville, director of the centre for urban economics and real estate in the Sauder School of Business at the University of British Columbia.

"But it certainly means the variable-rate mortgages will go up [and] so by definition it has to dampen the housing market."

With the higher variable rate there will be some downward pressure on house prices, he said. But at the same time, the strengthening economy should have a positive effect on the market.

"And the strength of the economy is going to be a more important factor for the housing market," Somerville said.

Despite the rise in variable rates, and the uncertain effect on fixed-rate mortgages, Pavlov believes that variable-rate mortgages are still the way to go, especially since he believes this rate increase will be the last for some time to come.

"I wouldn't be surprised to see another year with no further increase," Pavlov said.

So although people who took out a variable-rate mortgage six months ago or a year ago now are paying a little bit more compared to a fixed-rate mortgage they could have taken out six months ago, they are still way ahead, he said.

"If [rates] do hold for another year you'll surely be ahead regardless of what happens afterwards because you're paying down your mortgage. You should be keeping your payments high; then even if interest rates go up they are going to be on a lower balance," Pavlov said.

But whether the Bank of Canada will hold rates steady or not is an open question. In its announcement, the central banker said economic activity in Canada had been softer than expected and that the economic recovery was now expected to be slightly more gradual than projected. But it also said "consumption growth is expected to remain solid and business investment to rise strongly."

As a result, "any further reduction in monetary policy stimulus would need to be carefully considered in light of the unusual uncertainty surrounding the outlook," the bank said.

Douglas Porter, deputy chief economist at BMO Capital Markets, called the central bank's statement "a bit more hawkish than we expected."

"The Bank of Canada clearly retains its tightening bias, and seems generally unfazed by the recent cooling in the Canadian economy," Porter wrote in a note. "While we had been expecting the bank to now move to the sidelines for a spell, it appears that it will take a deeper slowdown in domestic spending ... than what we have seen so far to prompt them to stop raising rates."

Avoiding the crash

For all the ominous talk of a housing market collapse, the end result could be yet another rebound in prices

by Jason Kirby on Saturday, September 4, 2010 10:20am
PHOTOGRAPH BY SIMON HAYTER

As the housing market stalls, several people who bought pricey Vancouver condos before they were built are suing to get out of the deals. In Toronto, condo sales during the first half of the year fell for the first time since 1994. And at least one homeowner near Halifax just offered to give away his house for free, so long as whomever took it assumed the $395,000 mortgage. Everywhere, tales of real estate woe and miserable sales data have prompted predictions of a crash. James Grant, a prominent U.S. investment newsletter author well known for his bearish outlook on the American economy, has warned house prices here are primed to fall: “The median Canadian house is, in fact, certifiably unaffordable.” Even if prices tumble, though, as happened in 2008—when the economy was also teetering and house prices were at record levels—they could still make another surprising comeback.

No question Canadian prices are outrageously high. As Grant points out, compared to rental rates, home prices in Canada are more than 60 per cent above the historical average. And with home ownership rates and household debt levels higher than they’ve ever been, Scotiabank economist Derek Holt says there’s nowhere for prices to go but down. “This time when we come off the boil, prices are going to stay lower,” he says.


That’s quickly becoming the prevalent view. And another modest eight to 10 per cent correction could occur. But if that happens, there are reasons to expect a repeat rebound, as happened previously when the Teranet-National Bank house price index slipped eight per cent in 2008 and then roared back 18 per cent, reaching an all-time high two months ago. That’s because mortgages remain wildly cheap and, if anything, are getting cheaper. True, the Bank of Canada has raised interest rates twice since June to 0.75 per cent. That only affects homebuyers taking out variable-rate mortgages, though, which currently sit at 2.75 per cent. The fact is, lenders are furiously cutting fixed-rate mortgages. Since May, five-year fixed mortgage rates have fallen to 3.99 per cent from 4.75 per cent, according to Canequity.com.
Another reason house prices rebounded so sharply after the 2008 drop was that there were far more buyers than sellers. As the financial crisis hit in 2008, new home construction slowed while sellers yanked properties off the market, lest they get caught in a downward price spiral. But when the Second Great Depression in Canada turned out to be Just Another Recession, home buyers flocked back to the market before sellers had a chance to react, thus driving up prices. A similar phenomenon could play out again.

But if another rebound occurs, it will likely be triggered by Ottawa. The Harper government has repeatedly intervened to micro-manage the $2.8-trillion housing market. Before the U.S. subprime mortgage crisis hit, Ottawa dramatically loosened mortgage rules, allowing Canada Mortgage and Housing Corporation to insure zero-down, 40-year mortgages. Ottawa reversed course when such loans were shown to be dangerous. But with the recession, Ottawa swung back into action. It offered first-time home-buyer subsidies, allowed Canadians to withdraw more from RRSPs to buy homes, and authorized CMHC to take $75 billion of mortgages off lenders’ hands. Finally, as the market began to overheat in February, Finance Minister Jim Flaherty tightened mortgage lending standards. But Holt says Ottawa may loosen mortgage restrictions once again if the housing market craters. And it seems entirely possible the government will use its clout through CMHC to spur banks to lend and people to buy.

Efforts to halt prices from falling sharply might keep homeowners, and hence millions of voters, happy, but it’s bad economic policy. First-time buyers would be forced to take on even more dangerously large mortgages. At the same time, if the housing market continues to swing up and down, that eventually translates into stagnation—albeit at high levels.

Which is why many believe it’s time to let the housing market pursue its own trajectory—and, given recent data, that would appear to be down. “There’s a strong case to be made for letting the markets follow their natural evolution, and the U.S. offers a good lesson,” says Holt. “Every time they’ve tried to use stimulus to avoid what’s inevitable in the long run, they end up making things worse.”

Perspectives: Canada Sidesteps the Worst of the Financial Crisis

August 30, 2010 BestWire Services Email Print Free Newsletter

Financial institutions in developed nations worldwide reeled from the effects of the financial crisis that began in September 2008. But Canada and its life insurers escaped the worst of the crisis.

Canada's financial-services regulatory framework and positive relationships between regulators and companies all played a role in insulating life insurers from the adverse effects of the recession, according to Frank Swedlove, president of the Canadian Life and Health Insurance Association.

But the nature of the Canadian economy mattered, too.

"The Canadian economy itself has proven more stalwart through the financial crisis, in part because it entered the recession in better shape fiscally, with less debt-to-gross domestic product and smaller deficits," said Dean Connor, chief operating officer of Sun Life Financial.

A primary reason for the Canada's economic strength was that the housing bubble--the centerpiece of the United States' recession--was not as big an issue in Canada, Connor said. "We have shorter-term mortgages, and mortgage interest is not tax-deductible, so you didn't see the kind of leverage in the housing market here that we did in the U.S.," he said. "And although the economy in Canada slowed last year, it has rebounded faster and is in pretty good shape."

To judge the housing markets' impact on insurers' portfolios in Canada and the United States, one need look no further than Sun Life's Canadian and American businesses. Because of mortgage-backed securities in the portfolio of Sun Life's U.S. subsidiary, the parent company in Canada had to make capital contributions to it the past two years, reducing financial flexibility for the group, according to July's A.M. Best Credit Report for Sun Life Assurance Company of Canada (U.S.).

Connor said commercial and residential mortgage-backed securities have been common and important investments for U.S. life companies, including Sun Life. Canadian life companies were invested in real estate and mortgages to a lesser extent, so their credit experience was much better, he said.

Stephen Irwin, vice president in the life/health ratings division of A.M. Best, said that the subprime and Alt-A types of mortgage securities so prevalent in the United States did not exist to the same extent in Canada because of better mortgage underwriting standards. Meanwhile, mortgage underwriting in Canada remained disciplined, said Richard McMillan, managing senior financial analyst at A.M. Best. And a few years ago, in reaction to weakening conditions in the housing market, the Canadian government refused to provide government insurance on longer amortizing loans.

"You could say there was some restraint by the regulators that helped to keep the market more reasonable than it was in the U.S.," he said.

As a result, Canada for the most part avoided a run-up in property values that occurred in many parts of the United States, McMillan said.

Other factors were also at play. One is the role played by the Office of the Superintendent of Financial Institutions, Canada's primary regulator and supervisor of federally regulated deposit-taking institutions, insurance companies and federally regulated private pension plans. Connor said OSFI oversees the operations of Canadian life insurers wherever they do business.