Comparing Canada's Rigid Banking System with U.S. Innovative, Yet Lax Banks

by: David Hunkar

The housing market in U.S. and Canada have taken a different path since the credit crisis began. In the U.S. it continues to get worse since the crash that started last year. In 2008, more than 3 millions foreclosures were filed setting a record. Foreclosures in 2008 were up 71% from 2007. This year foreclosures have been in excess of 250K each month reaching 342K in April but backing down to 321K in May according to Realtytrac. A recent New York Times editorial mentioned that rising unemployment numbers and falling home prices are causing new foreclosures with no end in sight.

Unlike the U.S. housing market crash, home foreclosures have not yet become a serious problem in Canada. Other than losses sustained due to their sub-prime exposure in the U.S., the five major Canadian banks - Bank of Montreal (NYSE:BMO), Bank of Novo Scotia (NYSE:BNS), Toronto-Dominion Bank (NYSE:TD), Canadian Imperial Bank of Commerce (NYSE:CM) and Royal Bank of Canada (NYSE:RY) are staying strong and their earnings have not take a huge hit due to mortgage defaults. This is not the case with American banks such as Bank of America (NYSE:BAC), Citibank (NYSE:C), US Bank (NYSE:USB), Wells Fargo (NYSE:WFC) and many others who have been forced to seek government aid to prevent complete meltdown.

This brings us to the following questions: What are the primary causes of the housing market collapse in the U.S?. Why is the housing mortgage market so strong in Canada? What are the real differences between the Canadian and American mortgage systems? Why didn’t Canadian banks suffer huge losses due to mortgage loan losses?

Some of the answers to the above questions can be found in the following table which lists the differences between the housing markets in Canada and US.

Canada USA
Deposit-taking hold majority of outstanding mortgages Deposit-taking hold only some of outstanding mortgages (30% at end of 2007)
Mortgage securitization not very pervasive (only 29% secritized) Mortgage securitization is very pervasive (about 60% securitized)
Majority of the MBSs issued are guaranteed by government-owned Canadian Mortgage and Housing Corporation (CMHC) Not so here
Most mortgage insurance is underwritten by CMHC (70%) Most mortgage insurance is underwritten by private insurers
Mortgage Insurance covers the full loan amount Mortgage Insurance covers amounts that exceed a certain LTV ratio (eg. 20% on a 80% ceiling)
Entire mortgage insurance is paid upfront by the borrower Part of mortgage insurance is paid upfront by the lender and some paid monthly by the borrower
Mortgage insurance cannot be cancelled Mortgage Insurance can be cancelled once the LTV drops thru a ceiling eg. 80%
Mortgages are five-year fixed rate loans amortized over 25 years reflecting the conservative credit culture Most mortgages are 30-years and have fixed-long term rates
Upfront costs for mortgages are lower Upfront costs for mortgages are higher
Origination fees does not exist Origination fees are high
Rate-lockins are free to hold interest rate during application processing Lenders charge for rate-lockins
The market for Alt-A mortgages is very small The market for Alt-A mortgages is relatively large
Most mortgages are not initiated by brokers Most mortgages are initiated by brokers (70%)
Brokers only act as a middleman Brokers act as originators of loans
Banks service their own mortgage portfolios Not so here
All mortgages are recourse loans Most are non-recourse loans
Lenders have recourse to all the assets and income of borrowers in case of default Not legally possible or very expensive to pursue borrowers
Virtually all mortgage payments are made by auto-debit from the bank account of borrowers This option not much popular here
Borrowers can opt for weekly, biweekly, semimonthly, or monthly payment schedules Most loans require payment at the beginning of the month
Though mortgage markets seem less innovative, consumers are well served Mortgage markets are highly innovative but consumers may not be well-served
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Source: Canadian Residential Mortgage Markets: Boring But Effective?, By John Kiff, June 2009, IMF Working Paper

In summary, in Canada lending standards are much more strict and banks are not as innovative and aggressive as their peers south of the border but perform their main function as deposit takers and housing loan providers. American banks on the other hand, have deviated from their primary functions over the years in order to generate higher above-average returns year after year. Relaxation of regulations by the government and creating favorable environment promoting home ownership by all added fuel to the fire.

Disclosure: No positions