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A Tale of Two Housing Markets

|Includes:FMCC, Fannie Mae (FNMA), FXC, IYR, SRS

Americans are often accused of not looking beyond their own borders for sound policy ideas. This is unfortunate, in my opinion, because there is much that we can learn from other countries. Perhaps one such example is Canada's apparently successful approach to housing.

Oh Canada, How Did You Dodge the Housing Bomb?

As part of my week in Vancouver, B.C. at the Agora Financial conference I've been reflecting on the striking differences between the performance of the U.S. and Canadian housing markets the past few years. I wonder how many Americans are aware of the following:

  1. Approximately 70% of Canadians own their own home (which is in line with U.S. home ownership)
  2. Canada has not experienced a precipitous decline in housing prices
  3. It was unnecessary for Canada to bailout its banks (unlike the U.S.'s nearly $4.7 trillion bailout and counting)

Canada, not China, is the U.S.'s largest trading partner. The huge relative size of the adjacent U.S. economy certainly influences Canada's economic fortunes. One might naturally assume that as goes the U.S., so goes Canada. So why didn't Canada experience a similar housing crash? The answer may be found by reviewing the key differences between their respective housing markets.

Fundamentally Different

There are at least four major structural differences that help explain why the Canadian housing market has managed to remain afloat while the U.S.'s has sunk:

  1. Canadian banks keep their mortgages. In the U.S. many mortgages were "securitized", meaning they were sold by the original lender to someone else. When a mortgage is sold the original lender can largely avoid any immediate financial cost if the borrower defaults. However, the new holder of the mortgage (say from Dusseldorf) suffers the immediate financial cost of the default. In contrast, if there is a mortgage default in Canada the original Canadian lender takes the hit. One can argue that the Canadian approach promotes greater mortgage lending accountability.
  2. CHMC is no Fannie. While it may first appear that Canadian Mortgage and Housing Corporation (CHMC) is the equivalent of Freddie Mac and Fannie Mae, there are several key differences. First, CHMC does not own anywhere near the 50% of total domestic mortgage market that Fannie and Freddie hold. But perhaps more importantly, Fannie and Freddie were publicly traded for-profit enterprises with all the accompanying pressure to meet shareholders expectations. CHMC has one shareholder -- the Canadian government. Even though it also has a mandate to assist low income earners with housing, it took on lower risk than the formerly high flying Fannie Mae. (Legendary Fidelity Magellan manager Peter Lynch kept a photo of Fannie's HQ in his office and ironically suggested that "The stock has been so great they ought to retire the ticker symbol")
  3. The U.S. has non-recourse states. In the U.S. homeowners in non-recourse states can walk away from their mortgage without any risk that the mortgage lender will come after their other assets. Perhaps not coincidentally states like Nevada, Arizona and California that have been hardest hit by the housing bust are also non-recourse. In Canada borrowers remain personally liable for their mortgage loans. If a Canadian were to strategically default then his/her car, savings, or other assets could be pursued by the bank.
  4. Canada has no mortgage interest tax deduction. Prior to the crisis I often heard a number of Americans talk about how much they loved their mortgage tax deduction. What many Americans never realized is that this deduction served as a significant incentive to take on large housing debt. A bigger mortgage = bigger interest deduction = lower taxes. Financial reform did not contain any changes to the mortgage interest deduction. However, heavily leveraged America should perhaps think twice about whether the tax code should incentivize incurring huge quantities of mortgage debt.

Can the U.S. import any of Canada's policies? At present it seems unlikely. The securitization genie is completely out of the bottle. And while it may be logical to repeal an incentive to go into massive debt there is a very large constituency of home owners who would lobby hard against dropping the mortgage interest tax deduction. Any change to this tax rule, or a reduction in Fannie's and Freddie's mortgage holdings, would also put additional pressure on a still very fragile (and probably heading lower) U.S. housing sector.

American Myopia?

Returning to the criticism that led off this post, why don't American's take more interest in the policies of Canada or other countries for that matter?

The simple answer perhaps is that success breeds hubris. Americans have somewhat understandably felt that, when compared to the rest of the world, their country has done a lot right for a long time. But I think there is more to the story.

Another reason may be that Americans simply don't get around as much. While a growing number of Americans hold passports, according to a 2008 GAO study only 28% of Americans do so. I don't find it reasonable to compare American passport percentages with say Europeans, where a much higher percentage of citizens hold passports simply due to the fact that many Europeans live in immediate proximity (often within only an hour or two) of several different countries. Perhaps our closest comp is Canada where approximately 53% of Canadians -- or nearly twice as many as Americans -- hold passports.

However, there is some evidence that a more outward looking attitude is taking hold in the U.S. During healthcare reform there was public discussion of foreign approaches, such as the German and Swiss healthcare models which are generally considered to deliver equal or better overall healthcare at a substantially lower cost than the U.S.'s healthcare system. Perhaps more ominously, here at the Agora conference I was discussing Arizona's controversial immigration law with an Arizonian and he referenced ancient Rome and Cicero's writings about what can happen to an empire which fails to control its borders.

Disclosure: Long FXC