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Due North: Canada’s Marvelous Mortgage and Banking System

Friday, February 26, 2010

What about the Canadian banking system allowed it to survive the recent worldwide slowdown without a single bank failure? What can the United States learn from Canada about sound banking?

There were some significant differences between Canada and the United States during the recent financial crisis. In general, Canada’s banking system proved more prudent, more resilient, and much less prone to excesses. Taking a closer look at these differences might tell us how the United States got into the mess it is in, and illuminate some ideas for future reforms.

Consider, for example, some of the following facts, illustrated with charts.

Canada didn’t have nearly the real estate bubble and subsequent corrective crash in home prices as the United States:

 Bank2.A

Canada has had nowhere near the problems with mortgage delinquencies and home foreclosures as the United States:

Bank3.B

Yet Canadian banks remained profitable and reported positive return on equity even in the worst year of the meltdown, 2008, when U.S. banks (and banks in the United Kingdom and Europe) lost money and had negative returns on equity.

Banks1.B

These were some of the more interesting banking statistics present recently at the American Enterprise Institute’s seminar, “Canadian versus U.S. Housing Finance: Comparison and Implications,” organized by AEI resident fellow Alex Pollock.

And this recent financial crisis isn’t the first time that Canada’s banking system showed greater signs of stability and less exposure to stress than U.S. banks. In the 1930s, when 9,000 U.S. banks failed during the Great Depression, not a single bank in Canada failed. When almost 3,000 American banks failed during the Savings and Loan (S&L) Crisis, only two small Canadian banks failed in 1985, and those were the first bank failures in Canada since 1923. And while almost 200 U.S. banks have failed since the start of the global recession in early 2008, Canada remains the only industrialized country in the world that has survived the last two years of financial and economic stress without a single bank failure.

Canada remains the only industrialized country in the world that has survived the last two years of financial and economic stress without a single bank failure.

What about the Canadian banking system allowed it to survive the recent worldwide slowdown, and even the Great Depression, without a single bank failure, and what can the United States learn from Canada about sound banking? Below is a summary of some of the distinctly different features of Canada’s banks and mortgage markets discussed at the AEI seminar, which help explain the greater financial stress resiliency of Canadian banks compared to American banks.

1. Full Recourse Mortgages in Canada. Almost all Canadian mortgages are “full recourse” loans, meaning that the borrower remains fully responsible for the mortgage even in the case of foreclosure. If a bank in Canada forecloses on a home with negative equity, it can file a deficiency judgment against the borrower, which allows it to attach the borrower’s other assets and even take legal action to garnish the borrower’s future wages. In the United States, we have a mix of recourse and non-recourse laws that vary by state, but even in recourse states, the use of deficiency judgments to attach assets and garnish wages is infrequent. The full recourse feature of Canadian mortgages results in more responsible borrowing, fewer delinquencies, and significantly fewer foreclosures than in the United States.

The full recourse feature of Canadian mortgages results in more responsible borrowing, fewer delinquencies, and significantly fewer foreclosures than in the United States.

2. Shorter-Term Fixed Rates in Canada. Canadian mortgages carry a fixed interest rate for a maximum of five years, and rates are then re-negotiated for the next five years, similar to a five-year adjustable rate. This practice allows banks to achieve a better maturity match between their assets (mortgages and loans) and interest income, and their liabilities (deposits) and interest expense, which protects them from the kind of maturity mismatch and interest rate risk that resulted in our S&L crisis and almost 3,000 bank failures in the 1980s and 1990s.

3. Mortgage Insurance Is More Common in Canada than in the United States. About half of Canadian mortgages carry mortgage insurance (compared to 30 percent in the U.S. currently and only 15 percent before the crisis), primarily for those mortgages financing the purchase of a home with less than a 20 percent down payment, and the borrower is required to pay the full mortgage insurance premium upfront. Another difference from the U.S. is that when private insurance companies in Canada insure mortgages, they have the authority to approve or reject the property appraisal, and they have strong financial incentives to only approve realistic property appraisals. Mortgage insurance in Canada covers the full loan amount for the full life of the mortgage, and cannot be eliminated like in the United States when the property value exceeds the mortgage balance. The traditionally much higher frequency of mortgage insurance in Canada compared to the United States helps to stabilize Canada’s mortgage and housing markets, and is one of the many features that contribute to its ranking as the safest banking system in the world.

Compared to the United States, the Canadian banking system is much more concentrated, with the five largest Canadian banks (out of only 82 in the entire country, compared to more than 8,000 banks in the U.S.) holding more than 80 percent of total bank assets.

4. No Tax Deductibility of Mortgage Interest in Canada. Home mortgage interest has never been tax-deductible in Canada, so there is no tax advantage to home ownership in Canada over renting. (Addendum: Except that any capital gains from the sale of a principal residence in Canada are not taxed). There is also no tax benefit to converting home equity into household debt in Canada, which has resulted in a much greater equity accumulation in Canada (70 percent of total real estate value) than in the United States (currently only about 45 percent). Also, paying down your mortgage in Canada is a tax-free investment and further encourages greater equity accumulation than in the United States. Interestingly, even without any tax advantage for home ownership, the Canadian homeownership rate (69 percent) is actually higher than in the United States (67.2 percent).

5. Higher Prepayment Penalties in Canada. Prepaying mortgages in Canada is allowed, but there are much stiffer prepayment penalties (three months of mortgage interest) than in the United States, which discourages the kind of refinancing that frequently took place in the United States leading up to the housing meltdown, and often involved pulling home equity out in the refinancing process (encouraged by the tax deductibility of mortgage interest).

Home mortgage interest has never been tax-deductible in Canada.

6. Public Policy Differences for Low-Income Housing. To promote affordable housing for low-income households, the Canadian government has not used public policies like the Community Reinvestment Act in the United States, which encouraged homeownership for lower-income and less creditworthy borrowers, financed frequently with subprime mortgages. Instead, the Canadian government provides public funding for low-income rental housing, rather than encouraging homeownership for low-income households, and Canada has thus avoided the American mistake of using misguided policies to turn good, low-income renters into bad homeowners.

7. Differences in Canada’s Bank Concentration and Greater Diversification. Compared to the United States, the Canadian banking system is much more concentrated, with the five largest Canadian banks (out of only 82 in the entire country, compared to more than 8,000 banks in the United States) holding more than 80 percent of total bank assets. This concentration became an advantage during the recent financial crisis because it facilitated critical discussions among the five large banks and the single federal regulator (the Office of the Superintendent of Financial Institutions). Also, Canada has never had branching restrictions like the U.S. laws that prevented interstate banking up until 1994, and this has historically allowed Canadian banks to achieve geographical diversification for their deposits and loans portfolios. It was largely this difference in geographical diversification that help explains why the United States had 9,000 bank failures during the Great Depression (each operating within only one of the 48 states, due to the prohibition on interstate branching) and not a single Canadian bank (all with branches nationwide) failed in the 1930s.

Interestingly, even without any tax advantage for home ownership, the Canadian homeownership rate (69 percent) is actually higher than in the U.S. (67.2 percent).

8. A Few Other Differences that Contribute to Bank Safety in Canada. There is a much lower rate of loan originations by mortgage brokers in Canada (only 35 percent) than in the U.S. (70 percent), far less mortgage securitization in Canada than here, and a much smaller subprime mortgage market. Banks in Canada keep and service 68 percent of the mortgages on their own balance sheets that they originate and underwrite, which encourages prudent lending since banks are putting much of their own capital at risk. Finally, almost all mortgage payments in Canada are made electronically by an automatic payment arrangement, which minimizes late payments.

Bottom Line: Taken together, the features and regulations of banks in Canada outlined above create a healthy and sound “pro-lender” environment absent of political motivations for outcomes like greater homeownership, compared to the often politically motivated “pro-borrower” and “pro-homeowner” policies of the United States. While Canada’s banking system has promoted responsible borrowing and prudent lending and underwriting practices with little politically motivated interference, the U.S. banking system seems to have encouraged excessive lending to risky borrowers because of the political obsession with homeownership.

Canada’s banks are generally ranked as the safest and soundest in the world, and their non-politicized banking system could provide a model for banking reform in the United States. Moving towards the Canadian banking system could go a long way towards stabilizing our mortgage, credit, and housing markets and make us less vulnerable to financial shocks in the future.

Mark J. Perry is a professor of economics in the School of Management at the Flint campus of the University of Michigan, and a visiting scholar at the American Enterprise Institute.

FURTHER READING: Perry recently explained the federal message in “Congress to Healthcare Market: Drop Dead,” and how the “Tech-Driven Natgas Boom Shifts Energy Balance of Power to U.S.” Perry frequently contributes to THE AMERICAN’S blog.

Image by Rob Green/Bergman Group.

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