Special Update:
Canadian Mortgages
Global Economic Research
Capital Points is available on:
Bloomberg at SCOE and
Reuters at SM1C Derek Holt (416) 863-7707
derek_holt@scotiacapital.com
Karen Cordes (416) 862-3080
karen_cordes@scotiacapital.com
Canada's Mortgage Market is NOT Like the U.S.
We're fielding client inquiries about risks facing Canadian housing and - more importantly - mortgage
markets. The following points summarize some key thoughts that we've made over time. 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.
1. 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. experience.
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 by way of how long it took housing
markets and the consumer sector to get back on their feet. 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. As chart 1 demonstrates, the effect has
been for the U.S. to outpace Canada on growth in total household sector
liabilities relative to incomes throughout the past two decades.
2. Leverage - night and day comparisons
Canada's ratio of household debt-to-income is much lower than the
U.S. Despite its popularity, however, this is the worst way to look at
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 1st with
the expectation of having to pay it all back out of the current year's
income by December 31st, 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% as at the end of 2007. The
U.S. ratio is about 26% (chart 2). By corollary, Americans have used
nearly 30% more debt to purchase assets than Canadians. Clearly,
Americans and Canadians have different debt tolerances.
3. Canadian mortgage markets are fundamentally healthier than the U.S.
a. Canada's subprime market is small (5-6% of outstanding mortgages) whereas the U.S. share peaked at about
three times that. As a share of originations, 20-25% of new mortgages in the U.S. were subprime over the
2004-06 period. So Canada isn't anywhere near as exposed to the products that caused most of the damage
in U.S. housing markets.
This Report is available on:
Bloomberg at SCOE September 25, 2008
Chart 2: Household Liabilities as %
Assets
Chart 1: Household Liabilities as %
Personal Disposable Income
Special Update:
Canadian Mortgages
2
Global Economic Research September 25, 2008
b. Not only is Canada's subprime market much smaller, but it isn't even really subprime per se. Canada's subprime market
is more like the U.S. near-prime market, whereas the U.S. subprime market often lent to borrowers with extremely
impaired quality.
c. 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 Canadian product parallel is the variable rate mortgage, but they get
constantly repriced 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.
d. 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 like 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 it may have reached a plateau, the figure has risen in
recent years while the U.S. position has deteriorated (chart 3).
e. Mortgage interest is deductible against taxes in the U.S. It generally is not in Canada. That creates vastly different
incentives to leverage oneself in the two markets.
f. The nature of the products has been very different in Canada versus the U.S. Examples of Canadian innovation like longamortization
mortgage products are absolutely nothing like Ninja mortgages. Mortgage innovation was needed in Canada,
but has been relatively more conservative.
g. Further to this latter point, long-amortization mortgage products actually extend the Canadian credit quality cycle. Long
amortization periods of over 25 years have been dominant as a share of new mortgage originations 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 now banned in principle, 35 year
mortgages still provide this flexibility.
h. Investor mortgages were among the first products to default in the U.S. where they account for about 9% of all
outstanding mortgages, similar to the UK (9.5%) and Australia (10%). In Canada, however, they are about 2-3% 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.
i. If there is an imminent problem brewing, then it's not showing up in terms of industry-wide mortgage delinquency
patterns. Mortgages 90+ days in arrears in Canada remain at 27 basis points which is the range around which they've
been floating 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. We're of the
opinion that delinquencies will deteriorate going forward, but will be nowhere close to the U.S. experience.
j. The extent of runaway house price inflation was much more muted in Canada than in many other countries. Canada's
priciest market is Vancouver, and prices have gone up by about 80% since the mid-1990s start of the global housing
cycle. London England, by contrast, went up by about 270% over this time period. Canada's house price appreciation
was, on average, significantly below the U.S. experience since then, and much below the experience of many European
countries.
4. Canadian mortgages are funded, underwritten, and enforced in a totally different manner
a. Canada's funding model is completely different from the U.S. The majority of mortgages are held on balance sheet in
Canada, with only 24% having been securitized. Thus, much 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
originating since they are mostly stuck on balance sheet.
Chart 3: Homeowners Net Equity as
% of Household Real Estate
Special Update:
Canadian Mortgages
Global Economic Research September 25, 2008
This Report is prepared by Scotia Economics as a resource for the
clients of Scotiabank and Scotia Capital. While the information is from
sources believed reliable, neither the information nor the forecast shall
be taken as a representation for which The Bank of Nova Scotia or
Scotia Capital Inc. or any of their employees incur any responsibility.
Scotia Economics
Scotia Plaza 40 King Street West, 63rd Floor
Toronto, Ontario Canada M5H 1H1
Tel: (416) 866-6253 Fax: (416) 866-2829
Email: scotia_economics@scotiacapital.com
b. Further, the majority of the securitized totals have been done through the CMHC - 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 explicit government backing for the underlying
assets through the Canada Mortgage Bond program.
c. Furthermore, Canadian financial institutions are not as reliant upon short-term lines extended by other financial
institutions. The degree of 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.
d. Mortgage-Backed Securities (MBSs) were not placed in off-balance-sheet SIV and CDO structures as in the U.S. So,
Canada 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.
e. 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., such that all those
questions your banker asks in Canada have a purpose that somehow got lost on many American bankers. The no-incomeno-
job-no-asset ("Ninja") style, here-are-the-keys-to-your-brand-new-home lending just didn't take hold in Canada.
f. Appraisal standards are generally higher in Canada, where appraisals are more likely to low-ball estimates of property
value before making the final decision on how much to lend.
g. 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 and go through great
expense for a potentially lengthy period. Alberta is similar to the U.S. treatment 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 fairly 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.
