Our second episode of At The Rotterdam sees Jeff and Rasheed discuss a market they follow closely. Both are homeowners in two of the world’s frothiest housing markets, and Rasheed ran a fund that invested in distressed mortgages from the US, UK and peripheral Europe.
Could Canada really be in danger of a major financial system shock triggered by the real estate market? The answer is yes. Even though the probability remains low, the threat is there.
Of course there is an opportunity to go back into financial history again. This time Rasheed recounts the US mortgage crisis of the 1930s and uses that to explain why Canada needs to clean up its act when it comes to the structure of its mortgage market.
Just before the Great Depression, US mortgage markets looked a lot like Canada’s do right now, with most loans due in the 0-3 years and very little principal being paid down. In the 1930s, severe deflation across the board put pressure on housing prices. Those with mortgages coming due could not refinance as the new required down payment (LTVs were often 50%) while banks with credit troubles were reluctant to lend at any price. During the downturn, most US mortgages came due and at one point almost half the mortgage market was in default.
Policy makers then realized that longer term fixed rate mortgages would be safer, and that is what the US now has: 30 year fixed rates. As long as the borrower can afford the monthly, they can stay in their home for a very long time. There is less chance of a wave of required refinancing in a bear market resulting in forced sales by homeowners who borrowed when prices were much higher.
Canada’s reasons for having a market of mostly 5 year terms with 20-30 year amortization periods are structural, related to the Bank Act, how mortgages are financed, and the term of available mortgage insurance. These can all be changed through government policy to incentivize long-dated mortgages. Those mortgages are less likely to mature at a point where prices are below the borrower’s origination price, and a crisis is much less likely. Is it worth it?