Canada has experienced drastic changes in its economy during the global financial crisis. This Selected Issues paper discusses the evolution of equilibrium real home prices in key Canadian provinces in the post-crisis period, Canadian dollar movement during and after the global financial turmoil in line with other world currencies, assessment of impacts on Canada’s potential growth, development of Canadian automotive sector—namely, NAFTA partners during the crisis, and the role of Canada Mortgage and Housing Corporation (CMHC) in Canada’s housing market.

Abstract

Canada has experienced drastic changes in its economy during the global financial crisis. This Selected Issues paper discusses the evolution of equilibrium real home prices in key Canadian provinces in the post-crisis period, Canadian dollar movement during and after the global financial turmoil in line with other world currencies, assessment of impacts on Canada’s potential growth, development of Canadian automotive sector—namely, NAFTA partners during the crisis, and the role of Canada Mortgage and Housing Corporation (CMHC) in Canada’s housing market.

V. Canada’s Housing Finance System: Policy Backdrop1

1. Canada’s housing finance system has remained remarkably resilient throughout the recent financial crisis. This is partly because Canadian public policy, unlike that in the United States, does not explicitly favor homeownership over rental housing in the same way as in the United States. Also, the government maintains direct control over the terms and conditions of mortgage insurance, which is required on mortgages held by regulated deposit-taking institutions and securitization vehicles effectively backed by government guarantees.

2. In general, Canadian government policy recognizes that homeownership is not the most sensible option (versus renting) for many households. For example, unlike in the United States, interest on homeowner mortgages is not tax deductible. Also, Canadian lenders are not subject to legislation comparable to the Community Reinvestment Act that encourages U.S. depository institutions to lend in low-income neighborhoods. Also, Canadian lenders generally have recourse to borrowers’ assets and future income in the event that foreclosure sale proceeds do not cover the outstanding debt, whereas in many U.S. states, this is not the case.2 Thus “strategic” defaults are rare in Canada.3

3. The role of Canada Mortgage and Housing Corporation (CMHC) in the Canadian residential mortgage market is somewhat similar to that of the U.S. Federal Housing Administration (FHA) and Veterans Administration (VA). For example, they sell mortgage insurance (MI) that protects lenders against losses due to mortgage loan default. However, whereas CMHC MI can cover loans across the quality spectrum, FHA/VA coverage is limited. For example, the FHA only insures high debt-to-income and/or loan-to-value loans, and the VA insures armed forces personnel.4

4. Also, CMHC and the U.S. government-sponsored enterprises (GSEs) play key roles in mortgage securitization markets by guaranteeing timely payment on mortgage-backed securities (MBSs). Under the National Housing Act (NHA), CMHC guarantees timely payment on mortgage-backed securities (NHA MBS) backed by pools of residential mortgages insured against borrower default. CMHC also guarantees timely payment on Canada Mortgage Bonds (CMBs) which are backed by pools of NHA MBSs issued by Canada Housing Trust. In the United States, Ginnie Mae guarantees the FHA and VA insured loans that it securitizes, and Fannie Mae and Freddie Mac guarantee the “conforming” loans that they securitize. Conforming loans are those that meet underwriting guidelines that are set by the Office of Federal Housing Enterprise Oversight, in terms of loan size, documentation, debt-to-income ratios, loan-to-value ratios, and so on.

5. However, government-controlled mortage insurance (MI) plays a bigger role in housing finance in Canada than in the United States. The Bank Act prohibits Canadian federally-regulated lending institutions from providing mortgages without MI issued by approved insurers for loan amounts that exceed 80 percent of the value of the home. Also, MI is required on mortgages securitized through CMHC’s securitization program.5 In the United States, MI is only required on FHA/VA loans securitized by Ginnie Mae, and high loan-to-value (greater than 80 percent) loans securitized by Fannie Mae and Freddie Mac. Also, Canadian MI covers 100 percent of the loan, whereas in the United States, private MI typically only covers the amount in excess of 80 percent of the home value.

6. Due to the regulatory capital reductions provided by MI, banks and other deposit-taking lenders insure their low loan-to-value ratio mortgages. Mortgages insured by government-owned and–backed CMHC, are assigned a zero risk weight for regulatory capital requirement purposes. Mortgages covered by approved private insurers are assigned a slightly higher weight, but one that is lower than 35 percent on uninsured mortgages. CMHC accounts for about 70 percent of all outstanding MI in Canada, and two private insurers, operating in accordance with rules set out by Canada’s Department of Finance, account for almost all of the rest. The private insurers agree to abide by these rules in order to meet the government’s eligibility standards, and in return for a 90 percent government backstop on their MI business.6

7. The Canadian government uses its control over MI terms and conditions to influence mortgage loan availability. For example, since 2008 the maximum loan-to-value ratio on insured loans has been 95 percent, amortization terms have been limited to 35 years, and debt service costs have not been allowed to exceed 44 percent of gross income.7 As an example of this control in action, the rules were tightened in February 2010 to reinforce the long-term stability of Canada’s housing market. For example, the maximum amount that could be withdrawn during mortgage refinancings was lowered from 95 percent to 90 percent of the home value. Also, a minimum down payment of 20 percent became required on non-owner-occupied properties purchased for speculation.

References

  • Bhutta, Neil, Jane Dokko, and Hui Shan, 2010, “The Depth of Negative Equity and Mortgage Default Decisions,” Federal Reserve Board Finance and Economics Discussion Paper No. 2010–35, May.

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  • Joyce, J. Robert and Michael F. Molesky, 2009, “Addressing Financial System Procyclicality: A Role for Private Mortgage Insurance,” Housing Finance International, March, pp 3037.

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  • Kiff, John, Steven Mennill, and Graydon Pualin, forthcoming, “How the Canadian Housing Finance System Performed Through the Credit Crisis: Lessons for Other Markets,” Journal of Structured Finance.

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1

Prepared by John Kiff (MCM), based largely on Kiff, Mennill and Paulin (forthcoming).

2

Alberta does not always offer recourse to lenders, though this is dependent on both the vintage and nature of the loan. In Saskatchewan, recourse only applies to re-financed mortgages.

3

Strategic defaults are those in which the borrower stops making payments on mortgages where the outstanding loan balance exceeds the home value. See Bhutta, Dokko, and Shan (2010).

4

The FHA/VA programs are designed for low-income, first-time homebuyers with very small down payments. To qualify for an FHA loan, a borrower needs less than a five percent down payment. VA MI is only available to U.S. armed forces active duty personnel and veterans, reservist/National Guard members, and some surviving spouses.

5

Due to the regulatory capital reductions provided by MI, the majority of Canadian mortgages are insured, even those with loan-to-value ratios below the required threshold.

6

The government guarantees that lenders will receive the benefits payable by approved private mortgage insurers, less 10 percent of the original principal amount of the loan, in the event that the insurer is bankrupt or insolvent. This public-private model is close to that advocated in Joyce and Molesky (2009). However, they advocate a full guarantee to provide a level playing field between private insurers and CMHC. They also recommend removing the insurer insolvency condition, saying that it may introduce inadvertent procyclicality.

7

For borrowers with lower credit scores (below 680 on the FICO scale), the CMHC and private mortgage insurers set a debt service cost limit at 42 percent of gross income. The CMHC definition of debt service costs include mortgage principal and interest payments, property taxes, and heating expenses, plus other debt payments. For U.S. “conforming” mortgages debt service costs do not include heating costs, and they are limited to 28 percent of gross income. The maximum LTV on “conforming” loans is 80 percent.

Canada: Selected Issues Paper
Author: International Monetary Fund