Canadian Bank Mortgage Interest Rates

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					Canadian Responses to the Current World Financial Crisis

                                         J.D. Han and P. Ibbott

                                        King’s University College

                                     University of Western Ontario

The authors would like to sincerely thank Ms. Karen Xuan’s excellent research assistance. The financial
assistance from the Ministry of Foreign Affairs of the Canadian government is acknowledged.
2. Differences between the Canadian and American Financial System

There are a lot of similarities between the Canadian and the U.S. economies due to the geographical
proximity, cultural similarities and, most of all, the North American Free Trade Agreement. More than
70% of Canadian international trade is with the U.S. However, the degree of economic integration goes
far beyond commercial interactions and reaches the stage of the industrial integration that, for instance,
the Eastern Canada is well integrated in the U.S. Supply Chain of automobile industry. However, one of
the economic areas in which Canada stands notably apart from the U.S. is the financial system: The
Canadian financial system is quite distinct from the U.S. counterpart. The financial industry is a classic
example of the ‘Tales of Two Cities’ in the sense that the two countries are adjacent to each other but
have quite different stories as far as the financial system goes.

The Canadian banking system has a legacy of the Scottish free banking system: The Scottish banking
system of the late 18th to the early 19th century, which operated without government controls, has
proven to be more effective, efficient and stable than the English counterpart, which was heavily
regulated by the government. Indeed, the Canadian banking system was by and large based on industry
self-regulation or ‘free-banking system’ until the Bank of Canada was established amid the Great
Depression. The key difference between the Scottish banking and the English banking system was that
there was less regulation and, accordingly protection by the government rendered to the financial
sector in Scotland, and thus the Scottish banking system was working on the basis of self-regulation; the
lack of government regulation and protection led to more prudence on the part of the private banking
sector; and finally this turns out to be more effectively stabilizing for the financial sector than the
government regulation and protection which was in place in England. There is a strong tradition of
industry self-discipline in the Canadian banking industry. The last bankruptcy of a Canadian bank was in
the 1980s, and the major banks of Canada are in great health as indicated by their credit ratings.

 The strength of the commercial banks also goes across the board in the financial sector. The
relationship between the commercial banking and the investment banking or securities business in the
Canadian financial system is different from that in the U.S. system. The separation between the
commercial and investment banking was abolished in Canada prior to the U.S. counterpart. However,
the Canadian version of investment bank is called a ‘securities house’ and securities houses are primarily
of the status of subsidiary to commercial banks, which are called ‘chartered banks’ in Canada. In Canada
there is no notable predominance of securities business as observed in the U.S. Rather, securities
business has a subordinate status to the commercial banking in the corporate structure of the Canadian
financial system. And this serves as the natural check on the securities sector in the Canadian system.

The current financial crisis did not hit the Canadian economy as hard as it did the U.S. economy. The
current financial crisis originated from the burst of the financial asset bubble in the financial securities
market, primarily of the mortgage loans and then of the Mortgage Backed Securities(MBS hereafter)
which are financial derivatives based on mortgage loans. Thus, the financial crisis of the primary source,
that is, mortgage loans had spill over to the related securities market. Specifically Canadian mortgage
business has been healthier than the U.S. counterpart. In addition, traditionally Canada has had the
market of mortgage backed securities (MBS, which is much smaller than by its scale factor to the U.S.
economy. And thus there is a little cross-board contagion or propagation of financial crisis.

 The apparent conservative lending behaviors of the Canadian financial system should be attributed to
the fact that the Canadian financial institutions have less protection rendered by the government from
the default risk, and thus they have to adopt more prudent measures when it comes to lending.
Paradoxically, it is less government intervention that has made the Canadian financial institutions more
prudent compared to their U.S. counterparts.

The default rate of mortgage loans was much lower in Canada than in the U.S. As of 2007, in the U.S.,
subprime mortgages account for 20 per cent of the market, while here they make up less than 5 per
cent; the subprime default rate is approximately 2.1 per cent in Canada versus a U.S. default rate for
subprime mortgages of 6.8 per cent. 1 In Canada, it is customary that mortgage loans should have
collateral, and the total amount of loans does not exceed 75% of the market value. So called High Ratio
Mortgage Loans that exceed this limit of loan-to-value ratio are rarely provided by the Canadian
financial institutions. As mortgage loan insurance is typically required for lenders in this case. To obtain
mortgage loan insurance, lenders pay an insurance premium to the Canadian Mortgage and Home
Commission(CMHC hereafter). Typically, a lender will pass this cost on to the borrower. The interest
rate would be proportionally higher for this type of loans. And the ultimate risk is passed onto the
society in general because, in the worst case of massive defaults of mortgage payments, the CMHC
needs the transfusion of rescue funds from the government and the tax payers.

Subprime mortgages in Canada can be defined generally as those offered when home purchasers do not
fit the banks' prime mortgage customer profile. They may include self-employed people or those with
insufficient credit history.

                                   United States(billions of dollars)
Year                             2000 2001 2002 2003 2004 2005 2006 2007 2008

Mortgage Backed Security          684 1671 2249 3071 1779 1966 1987 2027 2400
Other Asset
                                  337     383     469     600    869 1172 1253          865     956
Backed Securities
Source: US Census Bureau

    The Star, April 30, 2007.
                                         Canada(billions of dollars)

Year                             2000 2001 2002 2003 2004 2005 2006 2007 2008

Mortgage Backed Security           6.2       0.7   10.0   13.3    17.5   20.1   22.2    39.1    81.7

Other Asset Backed Securities      5.5       5.5    5.5     5.5    5.5    5.5     5.5    5.5     5.5

Source: Bank of Canada

This disproportionate smallness of the MBS market can be attributed to the differences in the financial
sector and its regulatory environment. The mortgage backed securities are usually issued to transform
illiquid assets of long-term mortgage loans into short-term marketable securities. Thus, the process of
combining a pool of mortgage loans and issuing MBS is called ‘securitization’, and securitization is to
diversify risks and to make assets liquid. In the U.S., mortgage loans are offered for the term of 20-30
years for amortization. However, the financial institutions finance these loans by accepting the deposits
whose terms on average are much shorter than the terms of assets. Thus, the U.S. financial institutions
offering mortgage loans are faced with the problem of ill- or mis-match of terms between liabilities and
assets. The misalignment of terms between the asset side and the liability sides can cause a problem of
liquidity to the financial institution, particularly when the short-term interest rate rises: the rising
interest rate put a strain on the financial institution’s capacity of paying interest payments to deposits of
short-terms while the interest income from the long-term mortgage might be fixed. In other words, the
misalignment of the terms of the asset and liability sides may expose the financial institution to interest
rate risk as well as to liquidity risk. Thus, it would be ideal for the financial institution to match term
structures of the asset and liability sides.

In order to make the terms of their loans or assets, they are eager to enhance the liquidity of terms of
their assets or loans. One of the solutions is securitization: Pooling a multiple number of mortgage loans
diversified across boards, and issuing a multitude of securities which are backed by the pool of mortgage
loans. Here the financial institution can make any terms out of the newly issued securities. It can set
the maturity term of the newly issued mortgage backed securities to be long enough so as to match the
term of mortgage loans. Thus, it can theoretically remove the interest rate or liquidity risk caused by
the mismatch of terms of assets and liabilities. The interest payment and repayment of the MBS are
backed up by the payment of interest and principal of the mortgage loans. If the mortgage borrowers
default on their interest payment or the principal repayment, the financial institutions would not be able
to carry interest payments or repayment of the MBS, either. This securitization also removes the limit to
mortgage loans which could be set by the amount of deposits that the financial institution can attract: as
long as it can issue and sell the MBS, it does not have to rely on the deposits by its customers or clients
and can get an additional source of funding. As long as the securities market is active, the mortgage
loans will continue to swell. Given the level and size of financial securities industry in the U.S., it is
natural that the securitization of mortgage loans has become the major business activity for the last one

However, the institutional arrangements of the Canadian mortgage business are quite different. Even
though the amortization period during which the mortgage payments are divided might be of the same
length as the U.S. counterpart, rarely the interest rate of the Canadian mortgage is fixed for the entire
period of amortization. Instead, the Canadian mortgage institutions offer fixed interest rate up to the
maximum of five years, and at the expiration they open up the negotiation of interest rates. During one
amortization period, there are couples of roll-overs and contracts of sub-periods. In a sense, the
Canadian mortgages are all medium term ones when it comes to the contract of interest rate.

Thus, from the viewpoint of terms of assets and liabilities, this rather shortness of terms of mortgages
helps lesson the interest risk that the Canadian banks may face: The length of contract periods for the
loans on the asset side is somewhat aligned with that of the deposits on the liability side. Why do the
Canadian mortgage institutions have to offer the medium term contracts of mortgages? Or why can
they not afford to offer mortgage of such long term fixed interest rate as offered in the U.S.? The
answer lies in the fact that the Canadian banks are faced with institutional limitations and are limited in
their offering. In fact, in Canada, the longest term of time deposits is five years. This is due to the time
limit of the Canadian Deposit Insurance system, which insures the deposits which expires no longer than
five years. It is because in Canada, unlike in the U.S., there is no public protection of deposits which
expire longer than five years. If they would attract them, the Canadian financial institutions have to
make a substantially high interest payment to such deposits. Thus, the time deposits beyond 5 years of
terms would be prohibitively costly from the viewpoint of the Canadian financial institutions. This is the
limitation imposed on the funding side of the Canadian banks. The Canadian financial institution is
making efforts to cope with such limitation on the funding side. To match the risk profile of term
structure of the liability of deposit side, the Canadian financial institution offers only up-to five year
terms of mortgage loans. In a sense, the is the case where no absence of protection rendered by the
government leads to autonomous and voluntary measures of the private banks to come up with their
own prudence measures. The lesson is clear: the government protection is no substitute for the
industry’s own prudence. Alternatively put, too much of government protection may poster a
dangerous moral hazard on the part of financial industry as is the case of the U.S. financial system.

Due to this difference in the Canadian mortgages, there is less need for securitization in the Canadian
financial industry. The size of the securities market remains relatively to be of a manageable size for the
economy. And there were no bubbles of the financial securities market in Canada. Thus, there was less
systemic risk of contagion and propagation of the core problem from the securities market to the entire
financial system. In general, we note that there are somewhat different approaches to risk between the
U.S. and Canada: In the U.S., the risk itself is not to be shunned and is to be dealt with by an invention of
creative financial engineering such as derivatives and securitization. In contrast, the Canadian financial
system is to create the least amount of risk at the very source. Of course, when the financial
engineering of risk management fails, then a risk of a sector can be propagated to become systemic risk.
This was precisely the situation of the current financial crisis which originated in the U.S. securities

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