Mortgage Markets — U.S. vs. Canada
Skeptics have analogized Canada’s mortgage market to the U.S market ever since the American bubble started to burst.
And in the 5-6 years since, there have been few better rational comparisons than Benjamin Tal’s report released on Monday.
Tal, a CIBC economist, admits that all is not well with Canadian housing. Yet, he adds, “…Any comparison to the American market of 2006 reflects deep misunderstanding of the credit landscapes of the pre-crash environment in the US and today’s Canadian market.”
We’ve taken his comparison of the two countries and boiled them down into digestible bullets.
To begin with, let’s start with what doesn’t insulate Canada from falling prices.
Tal begins by challenging some commonly-cited reasons why Canada is different, including:
- The U.S. mortgage interest deduction — Tal suggests this U.S. tax benefit played only a limited role in stoking the U.S. housing bubble. The absence of this rule in Canada is not a major saviour.
- Lender recourse— Canada’s recourse system (which keeps people on the hook after foreclosure) does “not provide a full shield from a substantial fall in prices,” he says. In the U.S., only 12 states have no-recourse laws and “there appears to be no significant difference in housing market performance between recourse and non-recourse states.”
- That said, there is conflicting research suggesting the probability of default is actually up to 20% higher in non-recourse states. Moreover, U.S. borrowers in recourse states regularly default anyway, for reasons like this. Lenders often don’t pursue deficiency judgments on these people due to the legal process, costs, uncertain recovery, etc. When you default in Canada, lenders send the hunting dogs after you, and their teeth are long…and sharp.
- Canada’s low arrears rate— We can’t take too much solace in Canada’s minuscule default rate says Tal, who writes, “In a short eighteen-month period in 2007-08, the serious mortgage arrears rate in the US surged by more than 300%.”
- Albeit, the U.S. arrears spike was largely caused by underwriting that was near-criminal (and often criminal). As well, Canada’s arrears rate has long been less than half that of the Americans’ (even pre-2006) thanks to conservative lending practices.
- Rate Sensitivity — Canadians are more vulnerable to rate hikes than the average American because our terms are far shorter (5 years versus 15-30 years).
Tal then goes on to list the reasons Canada is different:
- Less subprime — The U.S. crash was a subprime story, he concludes. Remove subprime and it would have been a “soft landing.” Subprime and Alt-A mortgages were 1/3 of originations in the year before the crash, and 20% of outstanding mortgages. Eighty per cent of those had risky floating rates. In Canada, CIBC pegs non-prime at just 7% of the market.
- Skin in the Game — One-third of U.S. mortgages in 2005-2006 were already in negative equity. More than half had less than 5% equity, thus “making [Americans] highly exposed to even a modest decline in prices,” he says. In Canada, only 15-20% of new originations have less than 15% equity. Moreover, negative equity is virtually non-existent (although, that could change quickly!).
- No teasers — Millions of Americans got teaser mortgages with rates that reset a few hundred basis points after 2-3 years. Two trillion dollars worth of mortgages reset in 2006-2007 alone. Canadian lenders don’t qualify borrowers at teaser rates. Borrowers must prove they can afford higher rates in advance.
- Tighter housing supply — Canadian housing starts have exceeded household formation by only 10% in the past decade. That number was 80% in the U.S. before its crash.
- Inconclusive Debt-to-income — “…As any economist knows, [the debt-to-income] ratio is more a headline grabber than a serious analytical tool,” Tal states. Various countries have had higher debt-to-income ratios than Canada and have experienced nothing “remotely resembling” the U.S. crash.
- Better credit — Canadian credit scores have improved in the past four years. By contrast, in the four years heading into the great recession, the ratio of “risky” U.S. borrowers rose by 10+ percentage points and comprised 22% of the market.
“To be sure, house prices in Canada will probably fall in the coming year or two,” writes Tal. But it won’t be to the same extent as—or for the same fundamental reasons as—our neighbours to the south.
Here is CIBC’s full report.