Canada’s mortgage market is not like the U.S. The bottom line is that we do believe there to be considerable downsides to the Canadian housing market, but that comparisons of Canadian mortgage market prospects to the U.S. experience are off-base.
Debt growth over the full cycle
Much is being made of the fact that Canadian debt growth relative to incomes over recent years has been on par with the U.S. Ergo, one is led to conclude, Canada must face similar stresses to its own housing and mortgage markets.
Nonsense. One must look at the full cycle and use the right measures.
Recent Canadian debt growth reflects the unleashing of pent-up demand from the 1990s. Canada’s recession in the early 1990s was more severe, and the effects were longer lasting due to how long it took housing markets and the consumer sector to get back on track. The U.S. recession of the early 1990s was comparatively mild, and the economy rebounded faster, such that U.S. debt growth over the long haul has exceeded debt growth in Canada.
Leverage —
night and day comparisons
Canada’s ratio of household debt-to-income is much lower than the U.S. However, this is the worst way to analyze leverage since it compares total debt amortized over decades to a single year’s after-tax income which is a stock-to-flow comparison that most economists avoid. One doesn’t take out a mortgage on January 1 with the expectation of having to pay it all back out of the current year’s income by December 31, so why make the comparison?
The best way to judge the full cycle’s influences upon debt growth in Canada versus the U.S. is to look at where the two countries stand today on leverage on the household balance sheet (i.e., debt as a share of assets). This must be done by making adjustments to ensure comparability of Canadian and U.S. household sector balance sheet data. In Canada, total debt as a percentage of total assets sat at 20 per cent at the end of 2007. The U.S. ratio is approximately 26 per cent). In comparison, Americans have incurred nearly 30 per cent more debt to purchase assets than Canadians.
Clearly, Americans and Canadians have different debt tolerances.
Mortgage markets fundamentally healthier than U.S.
Canada’s sub-prime market is small (five to six per cent of outstanding mortgages) whereas the U.S. share peaked at approximately 18 per cent. As a share, 20 to 25 per cent of new mortgages in the U.S. were sub-prime over the 2004-06 period. So, Canada isn’t nearly as exposed to the products that caused most of the damage in U.S. housing markets.
Not only is Canada’s sub-prime market much smaller, but it isn’t truly sub-prime. Canada’s sub-prime market is more akin to the U.S. near-prime market, whereas the U.S. sub-prime market would often lend to borrowers with poor credit.
Adjustable rate mortgage (ARMs) resets also caused many of the problems stateside, but those resets occur much more suddenly in the U.S. By contrast, the closest parallel Canadian product is the variable rate mortgage, but they are constantly adjusted so that people aren’t caught off-guard years later. Furthermore, in Canada, some variable rate products adjust the principal, not the payment. On balance, the shock effect from payment resets in Canada is nowhere close to what has caused much of the problem in the U.S.
Canada’s mortgage equity withdrawal market isn’t like the U.S. We’ve seen secured home equity lines of credit (Helocs) grow in Canada as a way of withdrawing equity, but nothing compared to the U.S. withdrawals picture. U.S. homeowners’ equity has been in free-fall with mortgage debt growth outpacing housing assets since the early 1990s. Canada, by contrast, retains much higher homeowner equity, and while possibly reaching a plateau, the figure has risen in recent years while the U.S. position has deteriorated.
Mortgage interest is deductible against income taxes in the U.S. It generally is not in Canada. That creates vastly different incentives to leverage oneself in the two markets.
The nature of the products has been very different in Canada and the U.S. Examples of Canadian innovation, such as long-amortization mortgage products bear no resemblance to Ninja (no income, no asset, no job) mortgages. Mortgage innovation was needed in Canada, but has been relatively more conservative.
Furthermore, long-amortization mortgage products actually extend the Canadian credit quality cycle. Long amortization periods of greater than 25 years have been dominant as a share of new mortgages issued since the 40-year mortgage was introduced almost two years ago. However, there is still an overwhelming majority of Canadians who face the option of extending from the previously standard 25-year product into longer amortization products in a manner that lowers their payments in the face of shocks. Even though insured 40-year mortgages are now banned in principle, 35-year mortgages still provide this flexibility.
Investor mortgages were among the first products to default in the U.S.; accounting for about nine per cent of all outstanding mortgages, similar to the U.K. (9.5 per cent) and Australia (10 per cent). In Canada, however, they are about two to three per cent of all outstanding mortgages. There are problems in the investor segment the world over, but the magnitude of the exposure in Canada is far less significant.
If there is an imminent problem brewing, it’s not showing up in terms of industry-wide mortgage delinquency patterns. Mortgages 90-plus days in arrears in Canada remain at 27 basis points which is the range they’ve been at since mid-2004. By contrast, even when the country had double digit variable mortgage rates and double-digit unemployment rates in the early 1990s, the peak rate of delinquency was about 65 basis points.
Scotia Economics is of the opinion that delinquencies will deteriorate going forward, but will be significantly less common than in the U.S.
The extent of runaway house price inflation was more muted in Canada than in many other countries. Canada’s priciest market is Vancouver, and prices have gone up by about 80 per cent since the mid-1990s — the start of the global housing cycle. London, England, by contrast, went up roughly 270 per cent over this time period. Canada’s house price appreciation was, on average, significantly below the U.S., and significantly below the experience of many European countries.
Funded, underwritten, enforced
in entirely different manner
Canada’s funding model is entirely different from the U.S. The majority of mortgages are held on a mortage lender’s balance sheet in Canada, with only 24 per cent having been securitized. Thus, more of Canada’s mortgage book is funded by on-book retail deposits than is the case in the U.S. That also makes the banks more conservative about the products they are issuing since they are mostly stuck on balance sheet.
Furthermore, the majority of the securitized totals have been done through the Canada Mortage and Housing Corporation — a Crown corporation with explicit government backing — thus avoiding the problems in the U.S. caused by the ambiguity of GSE liabilities. Other insured securitizations have been done through private insurers that also receive government backing for the underlying assets through the Canada Mortgage Bond program. Furthermore, Canadian financial institutions are not as reliant upon short-term lines extended by other financial institutions. The reliance upon such funding in the U.S. is what caused excessive exposure to short-term swings in market sentiments, not to mention adverse incentive effects.
Mortgage-Backed Securities (MBSs) were not placed in off-balance-sheet SIV and CDO structures as in the U.S. Thus, Canadian MBS investors do not face the same heavily leveraged investor risks. This is perhaps the most important point, since origination mistakes in the U.S. were bad enough, but what really caused the problems were dollops of leveraging that occurred after the mortgages were originated.
Unlike many U.S. banks, Canadian banks continue to apply prudent underwriting standards. In other words, they have always checked and continue to check incomes, verify job status, ask for sales contracts, etc., as such all the questions your banker asks in Canada have a purpose — a purpose that somehow was lost by many American bankers.
The no-income-no-job-no-asset (Ninja) style, here-are-the-keys-to-your-brand-new-home lending thankfully didn’t take hold in Canada.
Appraisal standards are generally higher in Canada, where appraisals are more likely to be a lower estimation of property value, which mortgage lenders take into consideration before making their final decision on how much to lend.
Finally, enforcement of Canadian mortgages is not as tilted in the borrowers’ favour as it is in the United States. In the U.S., lenders have little recourse — they can take the keys and settle relatively quickly, or sue at great expense for a potentially lengthy period.
Alberta is similar to the U.S. in this regard, but the rest of Canada provides greater recourse to lenders than in the U.S.
In conclusion, we do believe that the best days for Canadian housing markets are behind us, and that lower volumes of new home construction and resales lie ahead — alongside further modest erosion of house prices. Calgary and Edmonton are the most exposed in this regard. But, arguing that consequences to the overall Canadian economy and to debt markets (particularly in terms of mortgage-backed securities) are as severe as they are in the U.S. is way off base.
— Global Economic Research, Special Update: Canadian Mortgages, prepared by Scotia Economics.