Why Canada Avoided a Mortgage Meltdown

Suppose we agree that we would like our society to have widespread home ownership and a property-owning citizenry. Does it take government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac with implied taxpayer guarantees, tax advantages for the interest paid on home mortgages, and government pressure for "creative" mortgage lending to achieve this?

The Canadian experience shows that it doesn't.

Canada makes a useful comparison for the U.S. Both countries are rich, advanced, stable, have sophisticated financial systems and pioneer histories, and stretch from Atlantic to Pacific. But Canada has no housing GSEs. Mortgage interest is not tax deductible. It does not have 30-year fixed rate, freely prepayable mortgage loans. Mortgage lending is more conservative and much more creditor-friendly.

This relative creditor conservatism has meant that Canada and Canadian banks have so far come through the international financial crisis in much better shape than their U.S. counterparts.

Canadian mortgage lenders have full recourse to the mortgage borrower's other assets and income, in addition to having the house as collateral. This means there is little incentive for borrowers to "walk away" from their mortgage. The absence of a tax deduction for mortgage interest probably increases the incentive to pay down debt. Most Canadian mortgage payments are made through automatic debit of the borrower's checking account--a technical but important point. Canadian fixed-rate mortgages typically have prepayment penalties to protect the lender and the interest rate on the loan is fixed for only up to five years.

This relative creditor conservatism has meant that Canada and Canadian banks have so far come through the international financial crisis in much better shape than their U.S. counterparts. Canada didn't avoid the recession, but mortgage delinquencies have so far remained much lower than in the U.S., with the percentage of loans delinquent 90 days or more at approximately one-tenth of the U.S. level.

What about the home ownership rate--the percentage of all households owning their own home? Isn't there a home ownership price to pay for this Canadian credit conservatism? No.

Here's the home ownership rate in Canada: 68%. In the U.S. it's 67%. The U.S. rate peaked at the top of the housing bubble at 69%. In other words, two very different housing finance systems, one much riskier than the other, produced virtually the same home ownership rate.

This must cause us to call into question longstanding U.S. beliefs about the relationship of government-subsidized housing finance to home ownership.

The former savings-and-loan industry justified its special tax and regulatory privileges, including its right to pay more interest on deposits than commercial banks were then allowed to, by appealing to its role in home ownership. Then came the savings and loan collapse of the 1980s.

Fannie Mae and Freddie Mac took over the home ownership mantra. In the vast risk expansion of their arrogant days, with very high rates of profitability made possible by government-granted privileges, they justified these privileges by appealing to home ownership. It was often said by their supporters that the GSE-dominated U.S. housing finance system generated the highest home ownership rates in the world, which was false, and that this system was the "envy of the world," which was also false. Fannie Mae's annual reports regularly featured a house with an American flag flying.

Now it is clear to everyone that Fannie and Freddie, having done so much to help inflate the bubble and having been dragged into insolvency by its deflation, are wards of the government. The taxpayer bailout of these GSEs is likely to cost much more than the bailout of the saving and loans did a generation ago. The U.S. Treasury has unilaterally signed the taxpayers up for unlimited support of these bankrupt purveyors of government-advantaged mortgage finance.

So the widespread previous beliefs about the desirability of having GSEs were wildly mistaken. It ought to be clear by now that an entity can be a private company with market discipline, or it can be a government body with governmental discipline, but it can't be both.

In this context, it is important to recognize that Canada does have a government body to promote housing finance: the Canada Mortgage and Housing Corporation, which is the dominant credit insurer of mortgages in the country. Whether or not you like the idea of such a government financing operation, at least its status is perfectly clear and honest. The Canadian government owns 100% of its stock. Its guaranty from the government is explicit. It provides housing subsidies which are on budget and must be appropriated.

Let's remember that the original sin of making Fannie a GSE in 1968 was to get it off the federal budget so the deficit looked smaller. Canada in this respect looks superior to the U.S. in candor as well as credit performance.

Alex J. Pollock is a resident fellow at AEI.

Photo credit: iStockphoto/dra_schwartz

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