There have been a number of stories in the press in the last month speculating that the major Canadian banks are in danger of suffering the kind of melt-down that almost destroyed the American banking industry in 2008. The boom in Canadian home prices, so goes the argument, has left the banks exposed to risky mortgages which might blow up if and when housing prices go down. One (very small) hedge fund manager declared in the Globe & Mail that he had shorted the Canadian banks. One can admire his courage, but doubt his financial analysis. Here are seven reasons why the Canadian housing market of 2013 does not in the least resemble the US housing market in the heady pre-2008 days, and why our banking system is largely immunized from the disease which came so close to killing the US industry five years ago.
1. Canadian mortgages are full recourse loans. In most American states, a home buyer who incurs mortgage debt can walk away from both the home and the mortgage. The lender’s only remedy is to foreclose on the home and sell it, applying the proceeds against the mortgage. In Canada, the law is very different. Mortgages are personal loans, supported by the home as security. A home owner in Canada is obligated to pay back the lender under almost all circumstances. Handing the house keys to the bank does not relieve the debt or end the liability. As a result, Canadians are much slower to default on mortgages, knowing that default will result in an ongoing debt, and perhaps personal bankruptcy.
2. Mortgage debt in Canada is not tax-deductible. One of the causes of the crisis in the U.S. was over-borrowing by existing homeowners against the inflated value of their homes at the top of the boom. Since mortgage debt, regardless of the use of the proceeds, is tax deductible in the US, homeowners borrowed on mortgages to purchase all kinds of assets including cars, SUVs, vacations and so on. When the value of homes declined, the obligations remained. In Canada fewer homeowners succumb to the temptation of borrowing against their home equity, and our banks are more prudent in analysing the value of the security and the likelihood of repayment.
3. There are no “NINJA” loans in Canada. The mortgage lending frenzy in the period from 2002 to 2006 led to an absurd lack of credit standards in the US, leading to the ultimate idiocy, the so-called NINJA loan, in which the borrower was characterized as having No Income, No Job or Assets. Huge mortgages, with no down payments, were made to numerous NINJA borrowers. There is no suggestion that any Canadian bank has reduced its standards. In fact, as required by the Federal Minister of Finance, banks have recently reduced the maximum amortization period of mortgages and increased the minimum required down payment for new home buyers. The situations could not be more dissimilar.
4. Canadian banks eat their own cooking. At the height of the mortgage boom in the US, most mortgages were put in place by brokers, repackaged by investment bankers, and sold to institutions such as pension funds, insurance companies and foreign banks. There was no connection between the borrower and the ultimate owner of the mortgage debt. Again, the situation in Canada is very different. Most loans are made directly between banks and their customers. The bank owns the mortgage and has direct knowledge of the borrower. Payments are made to the bank, not to an intermediary. As owners of what they sell, banks are naturally much more careful about credit quality and initial vetting.
5. Most new home mortgage debt in Canada is insured. The Canada Mortgage and Housing Corporation provides mortgage insurance to the lenders. As an agency of the Federal Government, CMHC has undoubted credit quality and is therefore a reliable guarantor. Almost all new home buyers who wish to make down payments of less than 20% are required by the banks to have CMHC insurance. As a result, even if house prices crash, all of the riskiest mortgages and many of the rest will be covered by insurance, so that the banks will not take substantial losses. At the moment, about two-thirds of all bank owned mortgage debt in Canada is covered by insurance.
6. Low interest rates make even very high home prices affordable. A $500,000 mortgage at 3% results in interest of $15,000/year. A $250,000 mortgage at 6%, the rate which prevailed for most of the period prior to the recession, also paid interest of $15,000/year. For banks, much more important than the value of the home, is the ability of the borrower to carry the mortgage. Low interest rates work in the bank’s favour and have resulted in very low default rates in Canada. Low rates are expected to continue for at least the next two years. In sharp contrast, in the pre-recession US market, many of the mortgages sold to unsophisticated borrowers were at interest rates that started at low, even zero interest, and then ballooned to over 10% per year. Lacking income to pay, they quickly fell into default.
7. Finally, Canadians are not Americans. We move less. We are more conservative in our personal finance. We have more respect for institutions. In short, we are better credit risks.
The fear that Canadian banks will fall victim to a bursting housing bubble has given rise to a good investment opportunity. Shares of the major banks are trading at low multiples in relationship to other industries. Their common shares are providing yields averaging over 4%, much higher than bonds, and they continue to experience robust growth in earnings.
As always, analysis is more important than headlines. Canadian banks are a buy.