Wednesday, June 30, 2010

Oh Canada! Let's Not Get Carried Away

A couple of weeks ago an article in the Wall Street Journal compared Canada's mortgage market to the U.S. The point of the article was that home loans for our neighbors to the north are more conservative than in the U.S. which is why they did not experience the bursting of the housing bubble.

The same conclusion was reached by reporters on CNBC this morning as they praised Canada's home loan system for a variety of reasons (CLICK HERE for a link to the story). Why do people believe Canada is superior to the U.S. when it comes to mortgage lending?

The Numbers

While 9.5% of U.S. homeowners were 3 months or more delinquent as of March, in Canada the ratio is only 0.44%. The latter number is superior, but not surprising when in is noted that subprime lending hardly even existed in Canada. Even though it was (and still is) tougher to qualify for a mortgage in Canada, the homeownership rate is roughly the same as ours, 68%.

The Lenders

Who is doing the lending in Canada makes a difference. In the U.S. most mortgages are originated by mortgage bankers, securitized and sold on the secondary market. Government guarantees on most mortgages add to the liquidity of our markets. In Canada most home loans are originated by banks and kept in the banks' portfolios. The bank makes the loan and retains the risk. Therefore the banks are very cautious about the loans they will approve.

The conclusion one may take from the story is that traditional bank lending is good, and securitization of mortgages is bad. That is an under-informed conclusion.


Another important factor is that all of Canada's home loans are recourse loans. This means that in the event of a default, the borrower is accountable to the bank for any losses incurred as a result of the default. In the U.S. laws related to recourse vary by state. For example in Arizona, the lender may only sue the borrower for a deficiency in a select set of circumstances.

Since Canadians know they are on the hook if they default, they are more apt to find a way to make their payments on time.

Other Side of the Coin

So are Canadian mortgages better than U.S. mortgages in every way? Absolutely not. There is a major downside that was not even mentioned in the CNBC story - There are no fixed rate home loans in Canada.

With all of the negative talk about the securitization of mortgages, it is often overlooked that with securitization comes fixed rates. With fixed rates comes stability and financial security for a homeowner.

Banks do not like to lend fixed rates with their portfolio. Why? Because 30 years (and even 15 years) is a long time, and they don't want to be committed to earning a fixed level of interest over that long period of time. A bank's cost of funds (the rate paid on deposits) will vary over time, so the revenue they earn (rate earned on loans) must also vary. That is why bank portfolio loans are almost always carry adjustable rates.

Risk of the Canadian System

Therefore in Canada, since banks provide most of the home loans with their own funds, the most common loan program is a 5 year adjustable rate mortgage (ARM). ARMs are great when rates are as low as they are today. My ARM is under 3%, so my payment is relatively low. But what will happen when rates increase? Mortgage payments in Canada will increase and I suspect more Canadian homeowners will find it difficult to make their payments.

Yes, Canada is better today based on their low level of defaults, but I suspect their mortgage issues may be masked by low rates.

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