Mortgage Markets — U.S. vs. Canada

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.

Oct 31 (Reuters) – Below are key quotes from an appearance by Bank of Canada Governor Mark Carney on Wednesday in Ottawa:

ON REASONS FOR ACCOMMODATIVE MONETARY POLICY:

“As we’ve been discussing there are a lot of headwinds against the Canadian economy from the rest of the world. There’s a challenge to encourage business to invest. There are pressures on the currency. There are a variety of reasons why it’s advantageous to have very accommodative monetary policy and that’s what we have here in Canada, very accommodative monetary policy. And monetary policy consistent with that 2 percent inflation target.”

ON HOUSING MARKET ADJUSTMENT:

“We’re getting some mixed signs in terms of the evolution of household imbalances. There’s been a slowing in the rate of growth in debt that is notable, we think that is continuing as we speak. There has been signs of adjustment in the housing market itself in various pockets … the condo market is still pretty hot. The other housing markets are adjusting and so we with others are continuing to watch the situation and be vigilant and will respond as appropriate.”

ON STRENGTH OF THE CANADIAN DOLLAR:

“Despite the very considerable headwinds that this economy faces from abroad, weakness in the United States one example, weakness in Europe another obvious example, the strength of our Canadian dollar which is related to that, we continue to grow and our expectation is that we will over the course of the next year take up the remaining amount of slack gradually.”

ON GOVERNMENT BONDS AND MORTGAGE RATES:

“The other risk that individuals have to take into account is not necessarily a bet on where Bank of Canada policy goes, exclusively, because  the mortgage rate obviously is a product of where the bond market goes and well we’re all familiar with how low government bond rates are on a global basis. There are scenarios where there could be an increase over time in government bond rates, not because of monetary policy but because of just the sheer level of borrowing and uncertainty that develop on a global scale about the sustainability, so a credit premium coming into those bonds, and so that would also affect mortgage rates as well over time.”

ON LIMITING THE SIZE OF CANADIAN BANKS

“If the question is should we, is our view that we should have a specific cap on size in Canada, the answer would be no. Do we have a cap on size in Canada? The answer is no. But is there a competition policy in Canada, are there other financial stability considerations? The answer of course is yes. And do those effectively limit the degree of concentration and size? Yes, certainly in terms of concentration and mergers, with the ultimate responsibility being held by the minister of finance.”

ON BANKS BEING “TOO BIG TO FAIL”

“There are two broader issues for a country like Canada that need to be considered. The first is relative size of the financial sector versus the economy as a whole  we don’t think this is the case in Canada but there were other economies in the world where the size of their financial sector was multiples of their GDP.”

“Every economy has to think about this question of ending too big to fail, and ending the perception of too big to fail and … ending too big to fail is central to the agenda of the Financial Stability Board and by extension to Canada as a whole. There’s a variety of mechanisms or policies that are necessary to do that.”

ON RISK OF HIGH DEBT-TO-INCOME RATIO

“When you’re in a situation, as we are, where debt as a whole is very high relative to income in the economy, the possibility of procyclicality happening when there is a shock to the economy, so there is a shock, unemployment goes up, some people start to be unable to service their mortgage for obvious reasons, that starts to hit house prices. That reduces the willingness of people to buy houses. At the moment they hold back as prices move down, and there is less activity in the housing sector, there’s more unemployment. These types of procyclicalities can cause the problem. It’s one of the reasons why we obviously focus on the debt side and the liquidity and the ability to service that debt side on a variety of circumstances. All that said, our warnings about this issue are driven from a position of the country and officials and individuals being able to do something about it. The horse is not out of the barn.”