suggests that a decline in underwriting standards played an essential role in the US housing market boom and dramaticbust. While monetary policy was very similar in both countries from 2000 to 2008, housing markets (especially thesubprime component) were structured and regulated somewhat differently in each. Unlike in the US, the Canadiansubprime market never expanded significantly into newer products, such as interest-only or negative-amortizationmortgages, whose popularity grew rapidly in the US from 2003 to 2006.
Moreover, while subprime lending increasedrapidly in both countries over 2000 to 2006, the Canadian subprime market remains much smaller than that in theUS, as subprime lenders accounted for roughly 5 percent of mortgage originations in 2006 – compared to 22 percent in the US (Mortgage Architects 2007).Mortgage delinquencies support the key role of underwriting standards in what transpired. While mortgagedelinquencies began to climb
the recession in the US, they only began to rise in Canada after the economicslowdown began. Moreover, the decline in Canadian house prices between August 2008 and April 2009 did not result ina large increase in mortgage delinquencies.Government housing market policies likely played an important role in the evolution of differential underwritingstandards. Governments in both countries provide guarantees to lenders against the risk of mortgage defaults for a significant share of mortgage lending. Government insurance of default risk creates what economists term “moral hazard,”since the insurance reduces the cost to lenders of making high-risk loans. This means that an essential part of government mortgage insurance programs is minimum underwriting standards, which reduce the incentive for banks to lowerunderwriting standards to generate loan volume. If these standards are too “loose,” then lenders have an incentive tomake a large number of risky loans, which in turn sets the stage for high levels of mortgage defaults.Compared to the US, Canada has maintained tighter conditions on government backstopped insurance against mortgagedefault. The
requires all federally regulated institutions to purchase mortgage insurance on loans with downpayments of less than 20 percent (25 percent before 2007).
This mortgage insurance is explicitly backstopped by thefederal government, as the federal government guarantees the insurance provided both by the Canadian Mortgage andHousing Corporation (CMHC) and its private market competitors.
All high loan-to-value (LTV) mortgages (greater than80 percent) insured through this program must satisfy underwriting standards that specify maximum loan-to-value ratios,maximum amortization periods, and minimum standards for credit worthiness and mortgage documentation.During the US housing boom, there was debate over relaxing these underwriting standards so as to allow Canadianbanks to offer products such as interest-only loans and longer amortization periods. However, standards were only gradually relaxed to allow some forms of interest-only mortgages and longer amortization periods between 2003 and2006. Subsequently, underwriting standards were tightened in July 2008, and again in April of this year. As a result, thegovernment-backed insurance program has a small exposure to higher-risk loans.In contrast to Canada, prior to 2007, the US government directly guaranteed a small fraction of high LTV loans,primarily through the Federal Housing Authority (FHA). However, the US government indirectly provided insurance against default risk to a large fraction of risky high LTV loans through the Federal National Mortgage (Fannie Mae) and the FederalHome Mortgage Corporation (Freddie Mac), which purchased and guaranteed large groups of mortgages. Thesegovernment-sponsored enterprises (GSEs) were viewed as having an implicit government guarantee to make good on
I N D E P E N D E N T
R E A S O N E D
R E L E V A N T
3Interest-only mortgages grew from 2 percent of US mortgage originations in 2004 to 18 percent in 2006, while the market share of option ARMs (negative-amortization mortgages) rose from 5 to 9 percent of originations (Financial Crisis Inquiry Commission 2010).4Non-federally regulated institutions such as credit unions can also participate in the program, provided they meet the underwritingstandards. Non-bank institutions can provide mortgage products (such as interest-only loans) that are not eligible for government-backedinsurance.5The federal government is ultimately responsible for the obligations of the CMHC because of its status as a Crown corporation. Thefederal government also explicitly backs private mortgage insurers in the event that they could not meet their obligations to lenders,subject to a maximum of 90 percent of the original principal amount of a loan.