There's a lot of chatter today on the Canadian real estate market -- that Canada will soon go the way of the U.S. real estate market circa the 2000's. Those who write such poppycock (been dying to use one of Conrad Black's favourite words) have not taken the time to read a study or two of the underlying conditions in the Canadian market, compared to the U.S. in the lead up to the mortgage crisis.
First off, let's be clear. The Canadian market is starting to correct. Housing starts are falling, though average housing resale prices are still holding up relatively well in most areas. Most economists, even those who still view the Canadian real estate market in a positive light, acknowledge that Canadian real estate prices are likely to decline over the next year or two. There is the considerable possibility of a housing "soft landing".
But here's why Canada is very unlikely to experience a U.S. style implosion.
First off, and most importantly, Canada does not have a Fannie or Freddie Mac or Ginnie Mae. And on that, why do these state owned corporations have such friendly names? I'd prefer Government Owned Agency of Mortgage and Economic Destruction, or something that provides that kind of clarity and honesty. Fannie's and Freddie's purpose is to expand the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities (MBS). Hmmm? Did a government agency create the infamous MBS? The ultimate weapon of economic destruction? That looks to be the case.
It has never been Canada's housing policy to encourage or subsidize lending to the lower income Canadians. Private banks (notably Canada's six largest banks) make loan decisions based on the merit of the home buyers. All income must be verified and the buyer must be in a position to afford a five year fixed mortgage rate. Period.
Which brings us to the root cause of the U.S. mortgage implosion -- policy. It was, and is U.S. government policy to "make" housing available for lower income citizens. It was all during the Great Depression when the Fannie's and Freddie's were created. You can blame both parties. As a Canadian, and hence, one who is on the outside looking in, there should be no argument about which party caused the housing meltdown. It was both parties. It has always been both parties.
It is not Republican policy, or Democrat policy, it has been U.S. policy to social engineer and socialize the risk by putting lower income Americans in homes.
I'm not for a second suggesting that there was not a long list of unscrupulous private sector mortgage providers who went on a good ol' fashioned and unscrupulous profiteering rampage, but government set the conditions and laid the groundwork. And as we read above, they even invented the MBS product.
I'm a big fan of the U.S., I sometimes joke that I'm an American born into a northern nation known as Canada. But in the area of mortgages, the U.S. is more socialist than Canada, or Europe. It's unfortunate that the land of the free, in the pursuit of the American dream and home ownership, attempted to accomplish the goal by means of government, instead of the free market. Canada is certainly more of a "socialist" country when it comes to healthcare, and … well I guess it's healthcare and that's about it. And fortunately we leave the lending to the private sector and our sound banking industry to decide who gets to purchase a home. We do (unfortunately) have a government mortgage insurance scheme, but that is being unwound by our current federal government. Hopefully, one day the government (aka the taxpayer in Canada) will be completely out of the mortgage business.
And on that, the government mortgage insurance agency models of the U.S. and Canada are essentially polar opposites. Canada, by law, has to ensure all mortgages with a LTV (loan to value) above 80%. In essence, when the buyer does not put down more than 20% of the home value, he or she must purchase mortgage insurance. In the U.S., it is essentially the opposite. The Fannies and Freddies of the world ensure the LTV's greater than 80%. The riskier mortgages are not insured.
That's like insisting that the best drivers on the road who haven't had an accident in the past 30 years should all be insured, but the 17 year-olds who bang into a few cars every year or two should not be insured.
Here are a few other '"facts". Canadians on average, own over half of value of their homes. Canadian banks are ranked the most solid on the planet. See my article on the "One Stock Portfolio" that details the history of the Royal Bank of Canada and the Canadian big banks as an investment option. Canadian banking operates under a unique oligopoly situation where the "Big Six" rule, and profit. Those six banks are Royal Bank of Canada (NYSE:RY), Toronto Dominion Bank (NYSE:TD), ScotiaBank (NYSE:BNS), Bank of Montreal (NYSE:BMO), Canadian Imperial Bank of Commerce (NYSE:CM) and The National Bank of Canada (OTCPK:NTIOF).
And according to a friend of mine who holds a very senior position in a major Canadian bank, here's the number one reason why Canada cannot have the same experience as the U.S. housing market meltdown.
Our market cannot and will not freeze up, as it did in the U.S.
In the U.S., almost half of the mortgage market simply went away. That sent shock waves throughout the entire U.S. mortgage market. One of the key and damaging characteristics of the U.S. real estate meltdown was the inability to get a non-conforming (higher risk/subprime) mortgage. Some 30-40% of the U.S. mortgage market completely closed. It disappeared. Many people had non-conforming mortgages in the U.S., either due to high loan to value, due to large mortgage size, or poor underwriting criteria. In Canada, even if there was a significant pull back in house prices, CMHC (Canadian Mortgage and Housing Corporation) will still be available to insure high LTV loans. And Canadian banks can pay CMHC to have them insured at their discretion.
So it is difficult to imagine any reason for banks to stop lending any form of mortgage that exists today. While it's cold up in Canada these days, the mortgage market is not about to freeze up.
We simply don't do a lot of subprime. For that reason alone, the risk of a major Canadian "housing bust" is greatly mitigated, at least compared to the U.S. experience. Also, you cannot simply walk away from your mortgage and debt responsibilities in Canada. They have laws against that sort of practice. LOL!
If a mortgage does run into arrears, Canadian banks do not have a stay period of 90 days (or any extended lockout periods) to foreclose on that mortgage. They can swoop in and immediately take care of their investment. Once again, the private sector does its thing. If you can't pay your mortgage, banks will take back the property and then go after your future earnings.
In Canada, there also is no incentive to over leverage to take advantage of the mortgage tax deduction. A mortgage does not qualify for a tax deduction in Canada. Canadians take on a mortgage and in most cases try to get rid of it as quickly as possible. There is very limited use of teaser rates in Canada.
Canadian banks are not forced to lend to lower income applicants, such as the coercion that exists in the U.S. CRA, the Community Reinvestment Act that mandates banks (okay, okay -- "encourages") to lend a certain percentage of their book to low income communities.
And a few points from a paper by Avery Shenfeld of Canadian Imperial Bank of Commerce. The speculative activity in Canada is well below that of the U.S. (when they were heading into the meltdown). Housing starts in Canada have recently been about 10% above household formations. In the U.S. it was 80% of household formations. That's drastic to say the least. Non-conforming mortgages in Canada for 2012 are just above 5%. In the U.S. they were well above 25%. The number of negative equity position mortgages in the U.S. in 2005 and 2006 was one third, even before the price drop(s). In Canada, the negative equity position is zero, according to CIBC.
It should be very clear, that Canada is not the U.S. when it comes to the mortgage industry, and situation. It's just not apples to apples. It's more like apples to maple trees.
Given the strengths and precautions outlined above, it's possible (but not guaranteed) that Canada can engineer a soft landing. That's difficult for sure, but the current government has been tightening lending regulations, and our Central Bank has been trying to talk down Canadians, warning them of the risks of high debt levels. Some steam is coming out of the market. Falling and stabilizing home prices, is a healthy event.
And as I wrote in the "One Stock Portfolio" article, I still think that Canada's big banks are a great place for Americans to invest (long term) and Canada sits in a very unique place, full of opportunity with exposure to the U.S. and emerging market growth. Canadian banks are worth a look. Just recently, they've reported some incredible numbers. Royal Bank led off the Canadian Banks' earnings season with fourth-quarter profits that rose 22 per cent to C$1.9 billion. RBC also reported record profits for the year.
A U.S. style mortgage market meltdown in Canada? Don't bank on it, eh.