Is Canada’s Mortgage System a Model for the US?

I recently stumbled across a provocative editorial (“Few foreclosures, no bank failures: Canada offers lessons“) which wondered whether the US wouldn’t be wise to try and emulate the Canadian mortgage system: “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. Less than 1 percent of all Canadian mortgages are in arrears.” Given the stark contrast with the US situation, he might have a point.

The apparent virtues of the Canadian system can be summarized as follows: strict lending standards and increased accountability. The absence of Fannie & Freddie discourages lenders from making risky loans. Canadian lenders are required to set aside funds to mitigate against potential losses. 20% down payments are common, as are loan durations of 25 years. The first five years typically carry a fixed interest rate, which later reverts to a variable rate. There is no mortgage interest tax deduction, and the absence of non-recourse rules means that all loans must be repaid.

A closer inspection of the data, however, reveals that the Canadian system also has a few cracks. First, Canadians appear inclined to obtain long-duration mortgages (30+ years). Prior to their being outlawed, 40-year loans represented 30% of total mortgage lending. Next, Canadians can obtain 95% LTV original mortgages and 90% LTV refinances. Perhaps, that’s why Canadian household debt – at 148% of income – is now higher than in the US. In fact, the Canadian Finance Minister has implemented a few changes to mortgage lending, such as eliminating 35 year mortgages and lowering loan limits.

In the US, meanwhile, more borrowers are inclining towards 15-year mortgages. Lenders have voluntarily tightened lending standards and stopped originating risky mortgages. Like Canada, new regulations will soon force them to have some skin in the game for certain types of mortgages. 20% down payments are once again becoming the norm, and those that can’t meet this threshold are being forced to pay a higher interest rate and/or purchase mortgage insurance. The government hasn’t yet phased out the mortgage interest deduction or eliminated Fannie/Freddie, but both have been proposed.

I wonder if the only reason Canada is still so complacent about its mortgage system is because its housing market hasn’t yet experienced a painful correction. “You don’t think condo buyers and the people they’re trying to borrow money from are capable of a sober-minded judgment about whether the loan being contracted is likely to be paid back?” Asks one columnist. Wasn’t it that same specious line of thinking that caused the US housing bubble and subsequent bust?

According to the WSJ, “Consumer insolvencies filed in Canada in October 2010 was 22.5% higher than in 2007-08, before the economic crisis that led to the recent recession….over the past decade, the volume of home-equity lines of credit and loans has risen by 170% – twice the rate of mortgage debt – and now accounts for 12% of overall household debt.” When you consider that the majority of Canadian mortgages carry variable interest rates and have very little equity, well, you do the math.

Maybe in the wake of the inevitable bust, there will be articles in the Canadian press calling for an emulation of the US system. Wouldn’t that be ironic?!