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September 23, 2014

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Why the 30-year mortgage works

Those of us who write about the housing market and the virtues of the 30-year fixed home loan — as we often do — can calibrate our watches by how long it takes a reader to respond as follows:

“Hey, Canada doesn’t have 30-year fixed mortgages, and their housing market’s doing just fine!”

Usually about a nanosecond.

This is a popular line of chatter for pundits too. In August, Matthew Yglesias of Slate.com questioned why “there’s some urgent need for the government to subsidize 30-year fixed-rate mortgages. If you cross the border into Canada it’s not like people are living in yurts.”

That’s true. Canada doesn’t have fixed 30-year mortgage terms. But that’s not the only difference between the U.S. and Canadian mortgage finance systems, by a long shot. I wonder whether the consumers, bankers and free-market ideologues on The Wall Street Journal editorial page who say the problem with housing in the U.S. is government interference would really be prepared to live in the Canadian system.

Actually, I don’t wonder. I know they wouldn’t.

Let’s see why.

To begin with, the Canadian system is considerably more creditor-friendly than the United States. In Canada, lenders typically have full recourse in cases of default, meaning they can attach all of a borrower’s assets, not only the house. In the United States, that’s not permitted in 11 states, and foreclosure proceedings are complicated even in the other states.

The standard mortgage in Canada isn’t the 30-year fixed, as it is in the United States, but a five-year mortgage amortized over 25 years. That means the loan balance has to be refinanced at the end of five years, exposing the borrower to any increase in rates that has occurred in the interim. Prepayment penalties for borrowers hoping to exploit a decline in rates, on the other hand, are very steep.

This looks as if it’s a clear win for banks, which are minimally exposed to increased rates and protected from prepayments. But Canadian mortgages are also portable — if you move before the five-year term is up you can apply your old mortgage to your new home. (If it’s a more expensive home, you take out a new loan for the excess.) That restores some of the balance in the borrower’s favor.

More important, observed Canadian economists Arthur Donner and Douglas Peters in a 2012 report for the Pew Charitable Trusts, the short term of Canadian mortgages allowed them to be funded from local short-term bank deposits at retail bank branches. The mortgage-lending system in Canada to this day resembles the American banking system up to the 1970s, when deregulation took hold and placed fancy, risky and careless lending at the center of the business model. (By the way, mortgage interest isn’t tax-deductible in Canada, so there’s no incentive to over-borrow.)

That may be the single most important factor distinguishing the U.S. and Canadian systems. Canadian banks haven’t had a free ride in regulation like their American cousins. Mortgage terms are very closely supervised, as are the safety and soundness of lending banks.

The Canadian system requires, and incentivizes, banks not to sell their loans but to keep them on their balance sheets. That factor alone discouraged Canadian banks from offering the kind of wild, who-gives-a-damn mortgage structures that infected the United States. It also prevented the erosion of underwriting standards seen here.

Canadian banks didn’t have access to the private-label securitization that created that welter of toxic mortgage securities in the United States, but they didn’t need it. Securitization reached 40 percent of the market in the United States by 2007. In Canada, according to David Min of the Center for American Progress, it never exceeded 3 percent.

The idea that the U.S. government meddles in the mortgage market more than those free-market paragons in Canada is dead wrong. The truth is just the opposite.

Yes, the U.S. backs the conventional 30-year fixed loan through Fannie Mae and Freddie Mac, its government-sponsored home loan firms. But the government-owned Canada Mortgage and Housing Corp. has an even greater influence over that country’s market. It accounts for some 70 percent of all mortgage insurance, which is required on all loans covering less than 80 percent of the home value and guarantees the entire mortgage.

The Canadian regulatory system simply didn’t allow the development of exotic mortgages designed to create loans for sale that had to be dressed up by fraudulent appraisals and flagrantly bogus credit ratings.

Put all these factors together — tighter regulation, little securitization, less borrowing, etc. — and you come close to an explanation for the different experience with delinquencies and defaults in the two countries. In the U.S., defaults peaked at about 5 percent of all mortgages and exceeded 20 percent for those deregulated subprime loans. In Canada, defaults soared in 2008 and after, just as they did in the U.S. But they topped out at about 0.45 percent of all mortgages.

You have to be careful about drawing a lesson from these results. Plainly, the 30-year fixed mortgage isn’t the culprit in the housing crash, and isn’t a major factor in the slowness of the U.S. housing recovery. If you think it needs replacing, as Yglesias, Felix Salmon and others do, you have to be prepared to accept the other differences between the United States and Canada that kept the Canadian market afloat.

But American bankers won’t like that. They won’t like heightened meddling in their balance sheets by a government agency that can’t be bought, or limits on how clever and deceitful they can make mortgage terms. They’d love to be rid of the borrower-friendly 30-year fixed mortgage but also rid of regulations that would prevent them from piling on to borrowers in so many other ways. They don’t want an improved system in the U.S., just one that’s better for them. Heads they win, tails we lose.

As it was in the 1930s, the 30-year fixed mortgage is one of the few banking products that unquestionably favors the American banking customer. We do away with it at our peril.

Michael Hiltzik is a columnist for the Los Angeles Times.

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