Tuesday, February 05, 2013

Canadian Mortgages Vs US Mortgages

The Canadian mortgage market has been sitting on the edge of a precipice ever since the American market burst in 2007. Six years later skeptics and pundits alike are still trying to predict when the housing market and the corresponding mortgage market will burst in Canada.

6 years later in 2013 the proverbial dam still hasn't burst.

If you want to buy a home in Canada you should first arrange financing and think in terms of whether you can actually afford this mortgage - or whether it is better to wait until real estate prices come down in 2015-2016 - when the dam is expected to finally burst.

According to CIBC economist, Benjamin Tal, there are many rational reasons why the Canadian mortgage market continues to sit on the edge of a precipice - and is firmly entrenched there, waiting for the eventual avalanche.
Tal admits that all is not well with Canadian housing. It is floundering and there is a lot of doubts and lack of confidence in the market, and yet Canadians keep buying homes and condos anyway because people need a place to live and they're tired of waiting for the market to collapse. Patience is a virtue, but everyone has their limits for how long they will wait.
"Any comparison to the American market of 2006 reflects deep misunderstanding of the credit landscapes of the pre-crash environment in the U.S. and today’s Canadian market.”says Benjamin Tal.
In a nutshell the Canadian and USA mortgage markets differ in the following ways:

The U.S. mortgage interest tax deduction - This American tax benefit played only a limited role in stoking the U.S. housing bubble. The absence of this rule in Canada means that Canadians can't claim mortgage interest on their income taxes, and thus they have to be more prudent and careful about whether to buy a house and get a mortgage.

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,” says Tal. In the USA, only 12 states have no-recourse law. According to some sources the probability of mortgage default is actually up to 20% higher in non-recourse states - meaning Americans in the USA were more likely to default on their mortgages - which meant the banks would take bigger losses.

When you default on a loan (any kind of loan) in Canada, lenders send the hunting dogs after you in the form of really annoying phone calls from collection agencies and letters from lawyers - but if you don't have any money or assets or a job, they really can't do anything to you. And worse comes to worse, you declare bankruptcy and have bad credit for 7 years.

Canada’s low arrears rate - Canada’s minuscule default rate is pretty stellar and is slightly less than half that of the American average default rate (pre-2006). However we should note that Canada's other debts (credit cards, student loans, lines of credit) have skyrocketed since 2008, suggesting that many Canadians are paying off debtors by borrowing money from other sources - and eventually that money has to be paid back.

In contrast in the USA: “In a short eighteen-month period in 2007-08, the serious mortgage arrears rate in the US surged by more than 300%," says Tal.

So Canada hasn't reached that point yet. But we could if Canadians continue to pile on consumer debts with credit cards/etc.

The American arrears spike was also largely caused by legal underwriting that was either near-criminal or even outright criminal on the part of the banks giving out mortgages. 

Rate Sensitivity - Canadian mortgages are more vulnerable to interest rate hikes than the average American because our terms are far shorter (5 years versus 15-30 years).

Less subprime - The American crash and "Great Recession" was largely the result of subprime mortgages and risky floating rates. Canada still has subprime mortgages but they are comparatively rare because Canadian banks are more cautious about who they give mortgages to.

However this doesn't completely protect Canada. Foreign investment in Canadian real estate has created a bubble in major cities, and if something ever happens to hurt the bubble then those markets will collapse in a flash. If a collapse happens in Canada it won't be subprime mortgages, it will be foreign investors pulling out all at once which will sink the ship.

Negative Equity - One-third of American mortgages in 2005-2006 were already in negative equity. Over 50% of the mortgages had less than 5% equity, thus “making [Americans] highly exposed to even a modest decline in prices,” says Tal.

In Canada however only 15-20% of new mortgages have less than 15% equity. Plus negative equity is virtually non-existent in Canada, and out of fear such mortgages were phased out pretty quickly by Canadian banks.

No teasers - Millions of Americans got teaser mortgages with rates that reset a few hundred basis points after 2 or 3 years. So they would start a mortgage thinking they got a deal and could afford it, but when the rates reset they were screwed and couldn't afford the home they had purchased - and were locked into it so they had no choice but to default. Over $2,000,000,000,000 dollars worth of mortgages were reset in 2006-2007 alone.

Canadian banks don’t give teaser rates. Borrowers must prove they can afford the normal higher rates in advance.

Tighter housing supply - New Canadian housing starts have exceeded household formation by only 10% in the past decade. That means that Canadians have a comparatively small number of available homes whereas the USA was building new homes like crazy, building so many that it was outpacing demand. The USA was outpacing demand by 80% right before the crash.

Note: In Toronto and Vancouver the new condo market is outpacing demand by approx. 40%, and those condos will be finished being built by 2014-2015, which means Toronto's condo market should implode by that time.

Debt-to-income Ratio - The debt to income ratio doesn't really matter as long as the economy in Canada stays stable. Yes, Canada's debt to income ratio is really bad and is growing worse... but as long as the economy and employment rate stays the same Canadians should be okay.

Better credit - Canadian credit scores have improved since 2008. In contrast during the four years heading into America's Great Recession, the ratio of “risky” borrowers rose by 10+ percentage points and comprised 22% of the market. Many Americans simply had really bad credit, largely due to a floundering economy during the Bush era.

Yes, Canada hasn't been touched yet. But if we keep piling on household debt and spending beyond our means the collapse will come eventually.

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